Currency Hedging Explained for Australian Investors

The decision is not straightforward. Hedging has costs, and it changes the pattern of returns in ways that matter differently depending on time horizon, portfolio purpose, and the particular behaviour of the Australian dollar.

This article explains how currency hedging works, what it costs, and how hedged, unhedged, and partially hedged approaches differ in practice.

What currency hedging actually does#

Currency hedging aims to neutralise exchange rate movements between the Australian dollar and a foreign currency. The goal is to make the AUD return on an overseas investment look more like the local currency return of that investment.

Without hedging, an Australian investor in US shares receives a return that combines two components: the US share market return (in USD) and the change in the AUD/USD exchange rate. If US shares rise 10% but the AUD also rises 10% against the USD, the return in AUD terms is roughly flat. If the AUD falls 10% instead, the AUD return is roughly 20%.

Currency movement can amplify or reduce the underlying investment return. Hedging is designed to strip out that currency layer, leaving only the asset return.

How hedging works in practice#

Forward contracts#

The most common hedging mechanism is the currency forward contract. A forward contract locks in an exchange rate for a future date. Fund managers use rolling forward contracts (typically one to three months) to continuously hedge the currency exposure of the underlying portfolio.^¹

The forward rate is not the same as the current spot rate. It reflects the interest rate differential between the two countries. This difference is the primary source of hedging cost (or benefit), discussed further below.

How hedged ETFs and funds manage this#

Australian-domiciled hedged funds and ETFs handle the mechanics on behalf of investors. A hedged international ETF holds the same underlying shares as its unhedged counterpart but layers on forward contracts to reduce AUD currency exposure.^²

The hedge is not perfect. It is typically reset monthly, so short-term currency movements within the month are not fully captured. Fund managers also face practical decisions about how much of the portfolio to hedge, as the portfolio value changes daily while the forward contracts are fixed at the reset date. This is sometimes called "hedge slippage" or "tracking difference."

The key point is that hedging is a continuous, managed process with small frictions, not a one-time lock.

The Australian dollar in context#

AUD/USD historical range#

The AUD/USD exchange rate has moved within a wide range over recent decades. It fell below 0.50 USD in 2001, rose above 1.10 USD in 2011, and has spent much of the period since trading between roughly 0.60 and 0.80 USD.^³

This range matters because it illustrates how large the currency component of international returns can be. A move from 0.75 to 0.65 (a roughly 13% fall in the AUD) would add approximately 13% to the AUD return of an unhedged overseas portfolio, even if the underlying assets did not move.

A commodity currency#

The Australian dollar is widely classified as a commodity currency. Australia's export base is heavily weighted toward iron ore, coal, natural gas, and other resources. When global commodity prices rise, the AUD tends to strengthen. When commodity demand falls, the AUD tends to weaken.^³

This creates a distinctive pattern: the AUD often falls during global economic slowdowns and financial crises, precisely when international share markets are also falling.

The "natural hedge" during downturns#

This pattern is sometimes described as a natural hedge for unhedged international investors. When global markets fall, the AUD often falls too. For an Australian investor holding unhedged international shares, the falling AUD partially cushions the loss in AUD terms. The shares lose value in their local currency, but the AUD buys fewer of those foreign currency units, which offsets some of the decline.^⁴

This effect appeared during the 2008 global financial crisis and the early 2020 COVID downturn. In both cases, the AUD fell sharply against the USD, reducing the AUD-denominated losses on unhedged international equity holdings compared to what the local currency returns alone would suggest.^⁴

There is something quietly useful about a currency that weakens at the moment a portfolio needs protection most, even if it was never designed to do so.

Hedged versus unhedged: a worked example#

Consider an Australian investor with $10,000 in a US share fund. The US market returns 8% over one year in USD terms. Two currency scenarios illustrate the difference:

The hedged return stays close to the underlying 8% regardless of currency movement (minus the cost of hedging). The unhedged return swings between approximately -2% and +20%, depending on what the AUD does.

Neither outcome is inherently better. The hedged investor gets more predictable returns relative to the underlying market. The unhedged investor accepts wider variability but also captures the diversification effect of holding foreign currency exposure.

The cost of hedging#

Hedging is not free. The cost is primarily determined by the interest rate differential between Australia and the foreign country.^¹

Interest rate differentials#

Forward contract pricing reflects the difference in short-term interest rates between two countries. When Australian interest rates are higher than US rates, hedging AUD/USD exposure has a cost (the hedge "costs carry"). When Australian rates are lower, hedging can provide a small benefit (the hedge "earns carry").

Over the past two decades, Australian rates have often been higher than US rates, meaning hedging AUD/USD exposure has typically carried a cost. This cost has varied from near zero to over 2% per annum, depending on the rate environment.^¹

Other hedging costs#

Beyond the interest rate differential, hedging involves:

• Transaction costs on rolling forward contracts
• Hedge slippage from portfolio value changes between reset dates
• Fund management overhead for operating the hedging programme

These additional costs are generally small (often a few basis points), but they are not zero. They are typically embedded in the fund's management expense ratio or tracking difference.

The cost is not always visible#

In a hedged ETF, the cost of hedging does not appear as a separate line item. It shows up as a difference in return between the hedged and unhedged versions of the same fund, adjusted for currency movement. This makes hedging costs easy to overlook.

When hedging tends to reduce volatility#

Shorter time horizons#

Over periods of one to five years, currency movements can represent a large portion of total return variability on international holdings. For portfolios with shorter time horizons or near-term spending needs, hedging can reduce the range of likely outcomes in AUD terms.^⁵

Defensive allocations#

International fixed income (bonds) is a common example where hedging is widely used. Bond returns are relatively low and stable. Adding unhedged currency volatility on top can overwhelm the underlying bond return, making the allocation behave more like a currency position than a defensive holding.^²

When currency adds unwanted volatility#

If the purpose of an allocation is to provide stability (for example, a capital preservation bucket within a goals-based plan), currency movement may work against that purpose. Hedging keeps the return profile closer to the underlying asset's risk characteristics.

When leaving currency unhedged tends to add value#

Longer time horizons#

Over longer periods (ten years and beyond), currency movements have historically tended to contribute less to total return variability as a proportion of the overall outcome. The underlying asset return becomes the dominant driver. Research from Vanguard and others suggests that the diversification benefit of currency exposure increases with time horizon.^⁵

Diversification of risk sources#

Holding foreign currency exposure adds a source of return that is not perfectly correlated with Australian economic conditions. For an Australian investor whose income, property, and superannuation are all tied to the Australian economy, unhedged international exposure provides a form of diversification that hedging removes.^⁴

The crisis cushion#

As discussed above, the AUD's tendency to weaken during global downturns means unhedged international holdings may lose less in AUD terms during the periods that matter most. Hedging removes this effect. A fully hedged international equity portfolio will capture the full local currency drawdown during a crisis, with no AUD offset.

Most of investing is lived during ordinary years. But portfolios are often judged by how they perform during the difficult ones.

Partial hedging as a middle ground#

Partial hedging (for example, hedging 50% of currency exposure) is a common approach that accepts some currency movement while reducing the extremes.

Partial hedging does not optimise for any single scenario. It reduces the impact of being wrong about currency direction. For investors who find the fully hedged and fully unhedged cases each uncomfortable for different reasons, a partial hedge narrows the range of outcomes in both directions.^⁵

How hedging decisions relate to time horizon#

The relationship between hedging and time horizon is one of the more consistent findings in the research literature on currency management for investors.

Over short periods, currency movements are large relative to asset returns and difficult to predict. Hedging reduces this uncertainty. Over long periods, currency movements tend to mean-revert (the AUD does not trend to zero or to infinity), and the underlying asset return dominates the outcome.^⁵

This does not mean short-horizon investors must hedge or long-horizon investors must leave currency unhedged. It means the relative importance of currency volatility changes with the time frame, and the hedging decision can reasonably reflect that.

A portfolio designed to fund expenses in three years faces a different currency question than one designed to compound over thirty years. The mechanics are the same. The weight given to currency variability is not.

Closing#

Currency hedging is a structural decision about how much exchange rate movement to accept in a portfolio's international holdings. For Australian investors, the AUD's commodity-linked behaviour adds a distinctive wrinkle: the same currency exposure that adds volatility in normal times can provide a cushion during global downturns.

Hedging reduces that volatility and removes that cushion, at a cost determined largely by interest rate differentials. Leaving currency unhedged preserves both the volatility and the diversification benefit. Partial hedging sits between the two.

None of these approaches is universally correct. The trade-offs shift with time horizon, portfolio purpose, and the role each allocation plays within a broader plan.

Summary#

Currency hedging removes or reduces the impact of AUD exchange rate movements on international investment returns, using forward contracts that carry a cost driven primarily by interest rate differentials between countries. The Australian dollar's tendency to fall during global downturns creates a natural cushion for unhedged international holdings, an effect that hedging eliminates. Shorter time horizons and defensive allocations tend to benefit more from hedging, while longer horizons and growth-oriented allocations may benefit from the diversification that unhedged currency exposure provides. Partial hedging reduces extreme outcomes in both directions without requiring a view on future currency movements.

Sources#

1. Campbell, J. Y., Serfaty-de Medeiros, K., & Viceira, L. M. (2010). Global currency hedging. The Journal of Finance, 65(1), 87–121. https://doi.org/10.1111/j.1540-6261.2009.01524.x

1. Vanguard. (2014). Currency hedging: Separating the wheat from the chaff. https://corporate.vanguard.com/content/dam/corp/research/pdf/currency_hedging.pdf

1. Reserve Bank of Australia. (n.d.). Exchange rates. https://www.rba.gov.au/statistics/frequency/exchange-rates.html

1. Philips, C. B., Walker, D. J., & Kinniry, F. M. (2014). Dynamic currency hedging for international equity portfolios. Vanguard Research. https://corporate.vanguard.com/content/dam/corp/research/pdf/Dynamic-Currency-Hedging.pdf

1. Vanguard. (2023). The role of currency in portfolio construction for Australian investors. https://www.vanguard.com.au/adviser/en/article/portfolio-construction/the-role-of-currency