A hedge aims to reduce the currency effect on your holding
An asset is something you own with a value, such as stocks or bonds. A bond is money lent in exchange for promised interest and repayment. A fund pools assets, and an ETF share gives you a stake in that pool. If it holds dollar-valued investments and you measure your money in won, two things affect the result: the investments' dollar value and how many won each dollar buys.
A currency hedge adds a separate contract intended to offset some or most of the second movement. One method agrees today on a price for exchanging money later. Leaving the currency effect in place is the unhedged approach. A hedge need not change the investment itself; it adds a second gain or loss alongside it.
The currency being protected matters. Reducing European shares' euro movements against dollars does not fix their value in won. Someone spending won may still face a dollarβwon movement. Hedging only part of a holding also differs from targeting a full hedge.
A 10% gain in dollars can become a 1% loss in won
Start without the extra contract. You have β©1,300,000 and can exchange it at β©1,300 per US dollar. All figures are invented. There are no cash payments from the investment, called distributions, and no fees or taxes. Also assume no conversion spread, the gap between rates used to buy and sell a currency.
Follow the same money through three steps
- Start: β©1,300,000 β US$1,000
Exchange the money and invest the dollars in the asset.
- The asset gains 10%: US$1,000 β US$1,100
You have gained US$100 when counting in dollars.
- The ending rate is β©1,170: US$1,100 β β©1,287,000
Each dollar now buys fewer won. Compared with the original β©1,300,000, you have lost β©13,000, or 1%.
The rate's fall from 1,300 to 1,170 means one dollar's won value fell 10%; the won strengthened against the dollar. The new rate applies to the extra US$100 as well as the original US$1,000. That is why adding +10% and β10% does not give the right result.
On a narrow screen, scroll within the table to read the remaining columns.
| Ending rate, KRW per USD | Dollar's change in won | Ending value | Return in won |
|---|---|---|---|
| 1,170 | β10% | β©1,287,000 | β1% |
| 1,300 | 0% | β©1,430,000 | +10% |
| 1,430 | +10% | β©1,573,000 | +21% |
The dollar asset ends at US$1,100 in every row; only the ending exchange rate changes. An unchanged 1,300 rate leaves a 10% won return; 1,430 produces 21%. All rates mean won per US dollar. The return is the gain or loss relative to the starting investment over this one assumed period, rather than a yearly rate or forecast.
Check the formula
With no costs or distributions, the compact calculation is (1 + dollar asset return) Γ (ending exchange rate Γ· opening exchange rate) β 1. Enter 10% as 0.10.
The first row is 1.10 Γ 0.90 β 1 = β0.01. The last is 1.10 Γ 1.10 β 1 = 0.21. Following the final dollar amount back into won gives the same answers.
We choose the exchange rate independently here; it is not calculated from a change in a central bank's policy interest rate. Our interest rates and exchange rates guide explains why a rate gap cannot by itself predict a currency.
What if you agree in advance to sell the first US$1,000 at 1,300?
Keep the same asset and add one agreement: at the end, sell US$1,000 at β©1,300 per dollar. This is a dollar-selling forward contract. It is intended to keep the contracted portion's exchange value from falling with the dollar.
The US$1,000 contract amount stays unchanged. Assume no fees, zero difference between the two currencies' interest rates and zero forward points, the gap between the current rate and the contract's future exchange rate. At the end, the parties pay the difference in cash instead of exchanging the dollars themselves. That final payment is the contract settlement.
If the final rate is 1,170, the agreement is 130 won per dollar better than exchanging then. It pays US$1,000 Γ (1,300 β 1,170) = β©130,000. Add that to the asset's β©1,287,000 value to get β©1,417,000, a 9% return, instead of the unhedged 1% loss.
Why does it not preserve exactly 10%? Only the starting US$1,000 was covered. Its value plus the contract payment is β©1,300,000, but the extra US$100 was never hedged. At the final rate it adds β©117,000. The investment grew while the contract amount did not.
| Ending KRW per USD | Assets in won | Forward settlement | Combined value | Return |
|---|---|---|---|---|
| 1,170 | β©1,287,000 | +β©130,000 | β©1,417,000 | +9% |
| 1,300 | β©1,430,000 | β©0 | β©1,430,000 | +10% |
| 1,430 | β©1,573,000 | ββ©130,000 | β©1,443,000 | +11% |
At 1,430, you instead pay β©130,000 on the contract. Combine that with β©1,573,000 in assets and you have β©1,443,000, an 11% return instead of the unhedged 21%. At an unchanged 1,300 rate, the payment is zero and the total is β©1,430,000, a 10% return. The hedge reduced the currency effect in both directions.
A fund adjusting the contract during the period needs a calculation for every new amount and rate. These 9%, 10% and 11% results cover the initial amount once; they do not predict a particular hedged ETF's return.
The currency you pay in does not tell you what the fund holds
An overseas ETF bought with won can still be exposed to exchange rates. Your order is paid in won, but the fund's holdings must still be valued across currencies. Not exchanging money yourself does not remove that step.
The reverse also applies. Buying a global stock ETF with a share price quoted in dollars does not make every holding a dollar asset. Keep the trading currency, the currency used in the fund's accounts and the exposures arising from its holdings separate.
A suffix such as βHβ or βUβ is a clue to investigate, not a universal rule. Check which currency, how much and how often the fund hedges in its investment policy. This guide uses one dollar-valued asset and won as the investor's home currency; a multi-currency fund needs more detail.
Net asset value, or NAV, is based on the assets a fund owns minus what it owes. Currency exposure is separate from an ETF share trading above or below that value. Our ETF price and NAV example follows that price difference.
Hedging does not always mean the same annual charge
Our example used 1,300 both for exchanging today and for the future agreement. An actual forward rate can differ from today's rate, called the spot rate. The gap, forward points, reflects factors including how long the contract runs and the difference between the currencies' interest rates. The BIS explanation describes that relationship.
The contract price can work in your favour or against you, depending on market conditions and the trade's direction. Replacing an expiring contract with a new one is called rolling the hedge. Buying and selling those contracts can bring trading spreads and other costs too.
An expense ratio reports the fund's operating expenses as a proportion of its assets. It does not by itself reveal every contract gain, loss or trading cost. Read which costs it includes and where the other effects enter the reported return.
To practise deducting a cost separately, take an invented β©6,500 charge once at the end. The first hedged result falls from β©1,417,000 to β©1,410,500, an 8.5% return. This is not an estimate of a real ETF's costs.
Published returns can already include costs in net asset value, the value based on what the fund owns minus what it owes. Deducting the same expense again would count it twice. Match this treatment when comparing returns.
A currency hedge does not protect against a fall in the investments
The fund can still lose money if its shares or bonds fall. A currency contract does not promise to make up that loss or protect the principal.
Changes in asset values and money entering or leaving the fund can make the contract amount larger or smaller than the exposure. Trading may become difficult, and the other party to a contract, called the counterparty, may fail to pay. A portfolio-level hedge also leaves currency effects on a company's overseas sales and costs.
A long holding period does not guarantee that exchange-rate changes will cancel out. The currency you will eventually spend matters to the risk you are trying to manage. Buying both fund versions also does not necessarily diversify the investments inside them; check their combined holdings separately.
Match four things before comparing the returns
- Holdings: compare similar assets and benchmarks. A US large-company fund and a global equity fund differ in more than hedging.
- Hedge target: check the target currency, percentage and rules for adjusting the amount.
- Costs: separate the reported expense ratio, contract gains or losses and other trading costs.
- Return basis: use the same dates, reporting currency, distribution treatment and price basis.
Net asset value, or NAV, is based on the fund's assets less its liabilities. The market price comes from exchange orders. Comparing one fund's NAV return with another fund's exchange-price return can mix a trading-price difference into the currency comparison.
When the hedged version does better, check which exchange-rate move it offset. When the unhedged version leads, separate asset gains from the currency effect. The ETF comparison guide covers other differences worth checking, and portfolio rebalancing explains changes in holding weights. Neither comparison predicts the next currency move.
Sources and assumptions
The BIS reference explains the relationship between forward prices and interest-rate differentials. This guide is not an official BIS publication or translation; the BIS does not guarantee its accuracy or completeness. The original content is available on the BIS website through the source link above.
The model assumes a single period, US$1,000 initially invested, a 10% dollar asset gain, no distributions or taxes, and no costs except in the separately labelled charge example. The static forward covers the initial US$1,000 only, with zero forward points and settlement at the ending spot rate. It does not replicate a particular fund. The explanations are written for this guide; source charts and performance tables are not reproduced. See our editorial policy.