When investing in foreign assets, managing currency risk is a key investment decision. For Canadian institutional investors, the currency hedging decision depends on the type of asset, with less risky assets generally requiring higher hedge ratios. For assets with higher risk, how the asset and currency risks are correlated matters. Not hedging currency risk is an investment decision that impacts the domestic risk-andreturn profile of a foreign asset for a Canadian investor. 

This article reviews the rationale for making an optimal currency hedging decision, taking as an example the three main families of foreign equity investments relevant to most Canadian portfolios – stocks from Europe, Australasia and the Far East (EAFE), Emerging Market (EM) stocks and U.S. stocks. For Canadian investors, it has historically paid off to currency-hedge EAFE equities, while leaving exposure to EM and U.S. equities unhedged. However, U.S. equities may benefit from a dynamic currency hedging strategy which is underpinned by the assumption that the U.S. and Canadian dollar pair will continue to maintain the broad price range from the past 54 years.

Currency hedging can serve two purposes: enhancing returns or reducing risk. Not hedging currency risk means implicitly making an investment decision to be long foreign currency exposure. Staying unhedged during sustained episodes of foreign currency weakness may suppress the return of the investment. A portfolio manager’s expertise in foreign asset investment doesn’t always translate into an ability to assess the economic merits of currencies. Hedging away the currency risk potentially allows the manager to realize the return of the foreign investment. However, currency hedging comes with explicit costs (the cost of carry and the transaction cost) that will need to be part of the decision process.

Four criteria generally play a role when designing an optimal currency hedging policy with the stated objective of risk reduction. The first one is the volatility of the underlying asset and currency pair. The second criterion is the cost of currency hedging. The third one is the expected correlation between the foreign asset and the currency pair. The fourth criterion is the currency pair’s expected range boundedness and mean-reversion properties.

Currency forwards and futures are the commonly used financial instruments to hedge currency risk. Each comes with its pros and cons. Currency forwards are generally considered the better alternative thanks to their combination of higher liquidity, better customization and capital efficiency advantage. Figure 2 summarizes the main features of currency forwards and futures.

A currency forward is an OTC derivative instrument. At inception, the market value of the forward is set to zero. Over time, the value of the forward will move with the fluctuations in currency value and interest rates. Mark-to-market exposure (MTM) may or may not be collateralized. Developed market foreign exchange forwards are usually not collateralized, but non-deliverable forward currencies are. The terms of the forward contract are flexible. The biggest advantage of currency forwards is the ability to completely customize the position (notional and maturity date) based on an investor’s preference. Generally, no upfront margin or MTM collateral is required for G7 currencies on short tenors. At inception, counterparties mutually determine the notional, maturity date and collateralization rules. 

When considering whether to hedge or not to hedge currency risk, it can be helpful to look at the historical domestic Canadian dollar returns of unhedged and fully hedged investments in three major equity indices: EAFE, EM and S&P 500. Let’s first look at EAFE and EM equities; the next section will focus on the S&P 500.

Counterintuitively enough, not hedging currency risk for U.S. equities has historically produced better returns, both on an absolute and risk-adjusted basis. This is due to a stronger U.S. dollar during periods of equity market weakness, when investors worldwide tend to flock to the U.S. dollar because of its status as reserve currency of the world. By staying unhedged, the negative correlation between S&P 500 and the USD-CAD pair has historically provided a natural hedge to Canadian investors exposed to U.S. equities. This is because weakness in the equity market has historically occurred at times of a stronger U.S. dollar and vice versa. 

Investors who expect this negative correlation to continue going forward could leave unhedged most of their currency exposure to U.S. equities, thus organically benefitting from risk reduction in weak equity markets. However, it’s important to note that the historically positive long-term correlation between the S&P 500 and the USD-CAD pair may not always hold. 

Take early 2025 as a recent example: in the wake of the Trump administration’s tariff policies, the U.S. dollar weakened during a U.S. equities sell-off. The U.S. dollar’s track record of being the world’s reserve and safe-haven currency is unlikely to change in the long run, as long as America’s status as an economic and innovative technological powerhouse persists. However, some periods of breakdown in the negative correlation between the U.S. dollar and the U.S. stock market may be expected in the future. In the long term, short of the U.S. economy underperforming massively compared to the rest of the world, the case for the continued negative correlation between the S&P 500 and the USD-CAD pair cannot be easily dismissed.

For investors unwilling to bear the historical correlation breakdown risk over the short run, a higher currency hedge ratio for U.S. equities will likely be more appropriate. 

Source: Bloomberg finance L.P., TDAM calculations. As of May 31, 2025.

For Canadian investors, relying on the negative correlation between the S&P 500 and the USD-CAD pair could generally be expected to provide strong risk-adjusted performance for an unhedged U.S. equity portfolio. However, the risk of correlation breakdown exists. This is why another hedging strategy can be explored, which relies on the USD-CAD pair to maintain the broad range it has held since 1971.

Source: Bloomberg Finance L.P. As of May 31, 2025.

Investors can benefit from currency hedging to better control foreign investment risk. TDAM’s proposed approach to mitigating currency risk is to overlay the equity exposure with a currency forward. The amount of currency forward hedge is periodically rebalanced according to the fluctuating market value of the asset. A personalized approach is optimal when it comes to determining the best currency hedging strategy. Choosing to hedge a foreign asset investment actively, passively or not at all requires thoughtful analysis. This analysis should take into account investment objectives, risk tolerance and the macroeconomic environment - as well as the volatility and correlation dynamic of the portfolio’s assets and currencies.