Currency Risk Hedging: No Free Lunch

55 Pages Posted: 16 Feb 2009 Last revised: 29 Oct 2012

See all articles by Frans de Roon

Frans de Roon

Tilburg University - Department of Finance

Esther Eiling

University of Amsterdam - Amsterdam Business School

Bruno Gerard

BI Norwegian Business School - Department of Finance

Pierre Hillion

INSEAD - Finance

Date Written: October 17, 2012

Abstract

Currency risk hedging typically aims at minimizing portfolio volatility. We find that while hedging lowers the volatility of international equity and bond portfolios, it also lowers portfolio returns. Furthermore, Sharpe ratios often deteriorate, portfolio skewness worsens and its kurtosis increases. In a no-arbitrage model of interest rates and exchange rates with an equity component, currency expected returns are positively related to the covariance between currency and equity returns. Consequently, the hedge goes short in currencies with positive expected returns. The model also generates the observed negative effects of hedging on Sharpe ratios and skewness. In sum, currency hedging is no free lunch.

Keywords: Currency risk, Currency risk hedging

JEL Classification: G11, G15

Suggested Citation

de Roon, Frans A. and Eiling, Esther and Gerard, Bruno and Hillion, Pierre, Currency Risk Hedging: No Free Lunch (October 17, 2012). Available at SSRN: https://ssrn.com/abstract=1343644 or http://dx.doi.org/10.2139/ssrn.1343644

Frans A. De Roon (Contact Author)

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 1 3466 8361/3025 (Phone)
+31 1 3466 2875 (Fax)

Esther Eiling

University of Amsterdam - Amsterdam Business School ( email )

Plantage Muidergracht 12
Amsterdam, 1018 TV
Netherlands

Bruno Gerard

BI Norwegian Business School - Department of Finance ( email )

Nydalsveien 37
Oslo, N-0484
Norway
+4746410506 (Phone)

Pierre Hillion

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France
65 799 5388 (Phone)
65 799 5399 (Fax)

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