Currency risk: Hedge or stay exposed?

It is almost impossible to avoid the impact of currency in long-term investing. When you retire, you will need to pay your bills in euros, yet confining your investment horizons to European markets would mean missing out on appealing opportunities elsewhere. Inevitably, there is a potential mismatch, which creates additional risks for investors.

This currency problem has become more acute as investors increasingly look outside their home markets. The idea of ‘home bias’ in a portfolio has become old-fashioned, with the strong performance of the biggest US technology groups in recent years luring European investors away from their domestic stock markets.

Meanwhile, geopolitical tension and outright conflict, plus rising public debt levels in many developed countries, have led to an increase in exchange rate fluctuations. US import tariffs, the long-running war between Russia and Ukraine, Britain’s withdrawal from the EU and other upheavals with international ramifications have all created volatility in the relative value of currencies.

Geopolitical tension and outright conflict, plus rising public debt levels in many developed countries, have led to an increase in exchange rate fluctuations.

Impact on portfolio returns

This can affect portfolio returns over the short and long term. In 2025, for example, the weakening of the US dollar was a significant problem for European investors in dollar-based assets. A dollar-based investor in the MSCI World index would have seen a return of 21.6%, but a euro-based investor just 6.8%. With US companies accounting for around three-quarters of the market capitalisation of the MSCI World index, this may have made a significant difference to overall returns for European investors.

Some market analysts argue that currency fluctuations even out over time. However, that isn’t always the case. Sometimes currencies gain or lose value against others and take up a new long-term reference value. One recent example has been the performance of sterling in the wake of the Brexit referendum in June 2016. In the immediate aftermath, the value of one pound slid from more than €1.35 to €1.15, and it has never recovered. Japan’s yen has been depreciating against the US dollar since 2011 as a result of the country’s ultra-expansionary monetary policy.

Although currency fluctuations can make a significant difference to returns, that is not necessarily a reason to hedge against them.

Although currency fluctuations can make a significant difference to returns, that is not necessarily a reason to hedge against them. After all, before 2025 the strength of the dollar worked in European investors’ favour, with vigorous stock market returns amplified by strong currency gains. Some investors argue that the costs associated with currency hedging make it often not worthwhile.

Cost vs. potential value of hedging

In fact, hedging costs vary. In general, like insurance after an earthquake, the cost tends to be higher the greater the likelihood of further movement. If the dollar has experienced a great deal of volatility, for example, it will be more expensive to hedge against it becoming weaker. At every stage investors need to weigh the cost of hedging with the value of the protection it provides.

Currency markets are also unpredictable. Many experienced investors avoid hedging currencies because so many complex factors are at work. Exchange rates tend to be influenced by interest rates, inflation, fiscal policy and other political developments. They can be blown off course by war or natural disasters. India’s rupee, for example, experienced a significant sell-off in the first half of 2026 in response to the war in Iran, because India is a major oil importer and traders feared the disruption of petroleum and other markets would dent economic growth.

There is also the problem that it is difficult to know what to hedge. Multinational groups possess a range of currency exposure, even if their business is headquartered in one particular country. They may or may not hedge some of their exposure to other currencies. Either way, their earnings may be enhanced or depressed by the impact on profits generated abroad – isolating the pure effect of currency movements may be difficult.

Sometimes currency is part of the risk an investor is aiming to embrace.

Embracing currency risk

Sometimes currency is part of the risk an investor is aiming to embrace. In emerging markets, for example, the currency return may reflect a country’s growth and development. Investors in emerging market debt may also want local currency exposure as part of the package. At every stage, investors need to consider the risks they want to take, and the cost of hedging against them.

That said, there may be times when it is important to hedge. If you rely on the income from your investments, you may not want to risk losing money as a result of currency fluctuations. Many investors hold international government bonds, for example, to generate a higher income than that available from European bonds, but this leaves them with vulnerability to exchange rate movements that might justify hedging.

Other circumstances might make it more important to hedge. For example, if you have a consistent liability in another currency, such as a mortgage loan abroad, and no earnings in that currency, it can be more important to hedge it. If you are buying a property in another currency, changes in exchange rates can make a significant difference to the resulting cost.

Derivatives and currency-hedged investments

A range of options exist for hedging currency. Derivatives are widely available on broker platforms and provide a variety of choices for investors. For example, options give the right, although not the obligation, to trade currencies at a fixed exchange rate at a certain time in the future. Alternatively, futures allow you to set the price at which you will trade at a specific date, which limits downside risk but also means that you won’t benefit if the currency moves in your favour.

You can also look at hedged versions of traditional investment or exchange-traded funds. Many asset management groups offer hedged versions of their products, particularly in cases where the fund’s base currency is vulnerable to significant fluctuations, such as the yen. Most ETFs have euro-, sterling- or US dollar-denominated versions. Another alternative is to structure a portfolio to create natural hedging, for example by holding a blend of regional exposure that makes the overall portfolio less vulnerable to movements of individual currencies.

Currencies can affect your investment returns, but this is not necessarily a reason to try to hedge out your exposure. Investors need a prudent and selective approach to currency hedging, looking at where it is necessary and where it is not. Ultimately, they need to decide whether the cost of hedging is outweighed by its benefits in dampening volatility and diversification.