Optimal Passive Currency Holdings: Equilibrium Currency Hedging Revisited

Abstract

We derive the optimal currency portfolio of an equity investor with no forecasting ability. This can be estimated based on observable parameters, including equity and currency covariances and the proportion of the investor's wealth held in risky assets. The currency position depends on the regression of a measure of home bias on currency returns and a measure of the relationship between currencies and inflation. This strategy differs significantly from commonly advocated currency strategies. In particular, for a typical US investor using data for the period 1900-2005 it should have been long foreign currencies. That would have resulted in a significantly improved Sharpe ratio.

Keywords: Currency Hedging, Equilibrium, Passive Management, Equity Portfolios, International Portfolios

JEL Classification: F30, F31, G11, G15