A pension fund that buys foreign assets acquires two exposures and needs only one. Managing the unwanted half is a continuous operational exercise rather than a single decision.
The mismatch that creates the problem
Pensions are promised and paid in the home currency. Assets bought abroad are denominated in others, so their value in home terms changes with the exchange rate.
A fund can be fully invested and well managed and still see its funding position move on currency alone. That volatility is unrelated to the assets chosen.
The purpose of a hedging programme is to remove that unintended variation. It does not aim to profit from currency movement.
How forward contracts do the work
The fund agrees to sell a quantity of foreign currency at a fixed rate on a future date. If the currency falls, the gain on the contract offsets the loss on the asset value.
Contracts are typically short-dated and rolled repeatedly, since a permanent hedge is not available. Each roll resets the rate to current market levels.
The forward rate reflects the interest rate difference between the currencies rather than any forecast. Hedging into a lower-rate currency therefore carries a persistent cost.
Why hedging consumes cash
When a hedge loses value because the foreign currency strengthened, the fund must settle that loss in cash at each roll. The offsetting gain sits in assets that have not been sold.
A large and sustained currency move can therefore create substantial cash demands while the fund is technically better off. Liquidity must be held against this.
Funds that underestimated this requirement have been forced to sell assets at inconvenient times. Managing hedge liquidity is a recognised risk in its own right.
Choosing the hedge ratio
Few funds hedge everything. Bonds are usually hedged close to fully, because unhedged currency movement would overwhelm their modest return.
Equities are often hedged less, since their own volatility is high and some currencies provide a natural offset during market stress. The ratio reflects that interaction.
Emerging market currencies are frequently left unhedged because forward markets are thin and costly. The exposure is accepted as part of the asset.
What the programme costs to run
Beyond the forward rate itself, there are trading spreads, collateral management and the operational cost of rolling contracts regularly. These are ongoing rather than one-off.
Accounting and regulatory treatment of derivative positions differs by jurisdiction and changes over time. Reporting requirements can influence how a programme is structured.
The judgement is whether reduced volatility is worth those costs. Funds reach different answers depending on how closely their liabilities are matched.