What a Currency Does to a PositionMedium

Every holding in a currency other than your own is two positions: the thing you chose, and one you probably did not. The second one is often the larger, and it is the one no factsheet is written about.

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The second position nobody chose

• A holding priced in another currency has two returns. What the asset did in its own currency, and what that currency did against yours. They multiply rather than add, and over a year the second can be the larger of the two.
• Nobody decides to take it. A decision was made about a company, a bond or an index; the currency arrived with it, unexamined, and it is rarely mentioned in the reasoning that produced the holding.
• Your own currency is a choice too, and one almost nobody makes deliberately: it is wherever the liabilities are — the rent, the pension, the school fees. That is the currency a return has to be measured in, and it is the reason no single "correct" base exists for everybody.
• Which makes this a framework rather than a market. The FX shelf covers the instruments; this page is about what the currency does to everything else on the site.

The arithmetic, and the thing it hides

• They multiply. An asset up 10% in its own currency, in a currency down 10% against yours, leaves you down 1% rather than flat — the cross term is small and it is negative in exactly the direction people assume it is not.
• The cross term grows with both moves, so on the occasions when both are large the approximation "just add them" is wrong by the most.
• And the two are not independent. An exporter's shares and its home currency often move in opposite directions; a commodity producer's currency moves with the commodity its companies sell. Adding a currency exposure to an equity exposure is not adding an unrelated risk, and treating it as one is what makes the combined position surprising. Diversification is the general form of that error.

What hedging it costs, said properly

• The forward rate is not a forecast. It is today's rate adjusted by the interest differential between the two currencies, because any other number would let somebody borrow in one, lend in the other and lock the difference in. The FX forward is the instrument; the arithmetic is arbitrage rather than opinion.
• So the hedge does not cost a fee. It costs — or pays — the differential. Hedging into a lower-rate currency earns carry; hedging into a higher-rate one pays it away, every roll, whatever the currency subsequently does.
• Which means "the hedged share class underperformed" is usually not a fee story. It is the rate differential, arriving on schedule, and it will reverse when the differential does. The factsheet rarely separates the two — reading a factsheet says where to look.
• The residual is a funding position. A hedge is sized on today's value of a holding whose value moves; the mismatch has to be rolled and re-sized, and a hedge that has moved against you settles in cash before the asset it protects has produced anything. That is the same mechanism as variation margin on a future, and it is the way currency hedges actually go wrong.

Exposures that are already currency positions

• A commodity. Almost everything on the commodity shelf is quoted in dollars, so a non-dollar holder of a commodity holds a view on the dollar whether or not they wanted one.
• An emerging market bond in hard currency. The investor has no currency risk and the borrower has all of it — which converts a currency move into a credit event when the borrower's revenues are in the other one. The instrument page and the Asian crisis of 1997 are the same lesson at two distances.
• A multinational's shares. Costs in one currency, revenues in several: the share price already carries a currency position, and hedging the listing currency hedges the wrapper rather than the business.
• A pegged or managed rate. A currency that has not moved for years is not a currency with no risk; it is one whose risk is entirely in whether the arrangement holds. The Swiss franc floor in 2015 is what the whole of that risk looks like arriving in one morning.

The four questions

What this page does not say

• Whether to hedge. That depends on the base currency, the horizon, the correlation and the ability to fund it, and this site knows none of those about anybody.
• Which direction a currency will move. No page here forecasts anything, and the forward rate — the one number the market agrees on — is explicitly not a forecast.
• What it does say is narrower and more useful: a foreign holding contains a second position, the cost of removing it is an interest differential rather than a fee, and the removal creates a funding obligation of its own.