How Currency Hedging Changes Foreign ETF Returns
Summary
The document compares a Swiss investor’s returns from a U.S. equity index fund with and without a currency hedge. Its two-period example combines a changing USD/CHF exchange rate with an index that rises or falls in dollar terms. The unhedged position reflects both the equity move and the currency conversion, so the exchange-rate change offsets gains in the stated up case and worsens losses in the down case.
The author proposes a futures hedge intended to neutralize the initial dollar exposure and asks how the hedge should affect the CHF outcomes. The example illustrates that a hedge can shift returns toward the underlying asset’s local-currency performance, though the document’s proposed contract and cash-flow treatment are not independently confirmed by an answer. Actual hedged ETF returns can also depend on hedge sizing, forward pricing, rebalancing frequency, transaction costs, and fund implementation; those details are outside the example.
Key ideas
- An unhedged foreign equity fund’s home-currency return combines the asset return and exchange-rate movement.
- A currency hedge uses derivatives to offset some or all of the foreign-exchange exposure.
- The example proposes a futures position to remove the Swiss investor’s dollar exposure.
- Hedge sizing, pricing, rebalancing, and costs can affect realized returns beyond the simplified example.
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Full text
# How do currency hedged ETFs work?
# How do currency hedged ETFs work?
I am trying to understand how currency hedged ETF returns work with a simple example, namely, that where a Swiss investor can choose between buying a S&P-500 index fund which either a) hedges the USD-exposure in CHF or b) doesn't hedge currency exposure.
Consider a two-period market with the following properties:
At the start, $t=0$, the exchange rate USD/CHF is equal to $1$ and the price of the S&P-500 in USD is $1$.
In the next period, $t=1$, the exchange rate USD/CHF is equal to $\frac{10}{11}$ and the price of the S&P-500 in USD is $1.1$ in the "up state" and $0.9$ in the "down state".
An investor buying an (unhedged) S&P-500 ETF will go from $1$ CHF at the start to $1$ CHF at $t=1$ in the "up state", and they will go from $1$ CHF at the start to $\frac{9}{11}$ CHF at the end in the "down state", leading to returns of $0\%$ and roughly $-18\%$, respectively.
How would the CHF-hedged ETF return look like in this case? As I see it, at $t=0$ the ETF manager would enter a futures contract to buy $1$ CHF for $1$ USD at $t=1$.
In the "up state", the investor would then go from $1$ CHF to $1$ share of S&P-500, which is then worth $1.1$ USD at $t=1$. The futures contract turns this into $1 \textrm{CHF}+0.1\textrm{USD}$, which then gets converted to $\frac{12}{11}$ CHF. Therefore, the return for the Swiss investor is about $9\%$ in the "up state".
In the "down state", the investor would go from $1$ CHF to $0.9$ USD, which then gets converted to $1\textrm{CHF}-0.1\textrm{USD}=\frac{10}{11} \textrm{CHF}$, so the return would be roughly $-9\%$.
Is my understanding of how these returns behave for currency hedged ETFs correct?
(Of course, the situation would be reversed if the USD/CHF rate had gone up instead of down.)Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.