Currency risk for euro-based investors and simple hedging ideas
Measure how exchange rates change the euro return of foreign investments and compare unhedged, fully hedged and partly hedged positions.
What you will learn
- How to split a foreign investment's euro return into a local return and a currency return.
- How a forward hedge works and why its cost depends on the interest-rate difference.
- How to compare unhedged, fully hedged and 50% hedged outcomes.
- Simple, practical hedging options for private investors.
Explanation
Currency risk (exchange-rate risk) is the chance that your result in euros changes because an exchange rate moves, even if the investment itself performs as expected. It affects anyone in Germany who holds US shares, global equity ETFs or foreign bonds. Diversification and ETF share classes were covered in the course "ETFs, Funds & Long-Term Investing"; here we look at the currency mechanics.
Return decomposition
Euro return = (1 + local return) × (1 + currency return) − 1. For US assets quoted against EUR/USD, the currency return = EUR/USD at purchase ÷ EUR/USD at sale − 1. If EUR/USD rises, the dollar has weakened and a euro investor loses on the currency.
Where the exposure really sits
The listing currency is not always the economic exposure. A European company listed in euros that earns most revenue in dollars still carries dollar risk inside its profits. A hedge on the ETF's currency removes the translation effect of the listing currencies, not every business effect.
Forward hedge
A forward contract fixes today an exchange rate for a future date. A euro investor who holds US assets hedges by selling dollars forward. The forward rate follows covered interest parity (introduced in the swap lesson of this course): forward EUR/USD = spot × (1 + USD rate) ÷ (1 + EUR rate). If US rates are higher than euro rates, the forward EUR/USD is above spot, so selling dollars forward locks in fewer euros per dollar: this is the hedging cost, roughly the interest-rate difference per year. If euro rates are higher, hedging earns a small amount instead.
Practical options
- Currency-hedged ETF share classes (often marked "EUR Hedged"): the fund rolls monthly forwards. Costs show up in a higher TER (total expense ratio) and in the interest difference.
- Partial hedge: hedging 50% halves the currency effect in both directions and reduces regret either way.
- Natural hedge: matching assets to future spending in the same currency, for example if you will pay costs in dollars later.
- Bonds versus equities: a common rule of thumb is to hedge foreign bonds, because currency swings can be larger than the bond's own price swings, and to leave long-term equity exposure more often unhedged. This is a convention, not a law; your own goals decide.
Hedging with leveraged forex CFDs is possible but adds margin calls, swaps and close-out risk; for long-term investors it is usually more complex than a hedged share class.
Worked example
Hypothetical example: you invest €50,000 in US shares at EUR/USD = 1.10, receiving $55,000. Over one year the shares rise 8% in dollars to $59,400. Assumed rates: USD 4%, EUR 2%. Fees, dividends and taxes are excluded.
One-year forward: 1.10 × 1.04 ÷ 1.02 ≈ 1.1216 (a hedging cost of about 1.96%).
| Scenario | Unhedged | Hedged ($55,000 sold forward at 1.1216) |
|---|---|---|
| EUR/USD ends at 1.20 (dollar weaker) | 59,400 ÷ 1.20 = €49,500 (−1.0%) | 55,000 ÷ 1.1216 = €49,037, plus 4,400 ÷ 1.20 = €3,667; total €52,704 (+5.4%) |
| EUR/USD ends at 1.00 (dollar stronger) | 59,400 ÷ 1.00 = €59,400 (+18.8%) | €49,037 + 4,400 ÷ 1.00 = €53,437 (+6.9%) |
The hedge narrowed the range of outcomes from −1.0%…+18.8% to +5.4%…+6.9%. It removed the downside from a weaker dollar and gave up the upside from a stronger one. The $4,400 gain was not hedged, which is why the two hedged results still differ.
Common mistake
Practice activity
A euro investor buys €20,000 of UK shares at EUR/GBP = 0.85. The shares rise 5% in pounds. At the sale EUR/GBP is 0.90. Calculate the pound amounts, the final euro value and the euro return (unhedged).
Show solution
Purchase: 20,000 × 0.85 = £17,000. After +5%: £17,850. Sale: 17,850 ÷ 0.90 = €19,833. Return: 19,833 ÷ 20,000 − 1 = −0.83%. A 5% local gain became a small loss because the pound weakened about 5.6%.
Limitations: EUR/GBP is quoted with the euro as base currency, so here you divide by the rate to get euros; always check the quote direction.
Key takeaways
- Euro return = (1 + local return) × (1 + currency return) − 1.
- A forward hedge locks in a rate; its cost or gain is roughly the interest-rate difference.
- Hedging narrows the range of outcomes; it does not increase expected return.
- Set a hedge ratio (0%, 50% or 100%) in writing and do not change it after each move.
Next step
In the next lesson you will switch back to the trader's view and study a session-based technical setup: the Asian range and the London open.
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