Why Calling FX Hedging a 'Cost' Costs More

Currency hedging remains a crucial yet frequently misunderstood aspect of modern portfolio management. A letter published in the Financial Times by Haakon Blakstad, CCO at Validus Risk Management, “It’s wrong to look at FX hedging as a cost" helpfully elevated the discussion around foreign exchange risk management in volatile markets. But a persistent misconception continues to hinder optimal investment strategies.

The Cost Misconception

Too often, FX hedging is described as a cost - an expense that acts as a drag on returns. This framing positions foreign exchange risk management as an afterthought rather than an integral part of portfolio construction. In reality, treating FX hedging solely as a cost ignores the mechanics of forward pricing and risks overlooking strategies that can both reduce volatility and enhance long-term returns.

The Interest Rate Differential Reality

Forward rates are determined by interest rate differentials between currencies. Without this mechanism, arbitrage opportunities arise. For example, an investor could borrow cheaply in one currency, convert to another with higher rates, and hedge the exchange risk for risk-free profit.

In practice, this means that when hedging exposure from a lower-yielding into a higher-yielding currency, the forward rate becomes more favorable than today’s spot. Rather than paying for protection, the investor is compensated for the interest gap, shifting the hedge from an operational cost to a value-adding strategy.

Beyond Cost-Benefit Frameworks

This benefit is not a free lunch. The hedge simply captures the interest that would be earned by purchasing and holding the higher-yielding currency immediately. However, this mechanism demonstrates why sophisticated investors should discuss the impact of hedging rather than defaulting to cost-based terminology.

At Validus, our responsibility extends beyond protecting client assets to strategically enhancing portfolio construction. Foreign exchange hedging, when properly understood and implemented, represents a tool that can simultaneously mitigate risk and capture opportunities.

The Real Cost

The hidden cost of a “hedge-adverse” approach may be the opportunities we never pursue, the strategies we never consider, and the value we never capture. In volatile markets, this misconception becomes particularly expensive for investors.

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