Currency Risk Hedging: No Free Lunch

Posted: 2 Oct 2012 Last revised: 5 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 2, 2012

Abstract

Currency risk hedging in international portfolios typically aims at minimizing portfolio volatility. In a purely out-of-sample context, this paper looks beyond the effect on portfolio risk and fi…nds that currency hedging comes at a serious cost. While hedging lowers volatility of international equity and bond portfolios, it also lowers portfolio returns. The reduction in average returns more than offsets the decrease in variance and as a result, Sharpe ratios often deteriorate. In addition, hedging induces more negative skewness and signifi…cantly higher kurtosis in portfolio returns. We extend a no-arbitrage model of interest rates and exchange rates with an equity component and show that, in the model, hedging indeed lowers returns. Currency expected returns are positively related to the covariance between currency and equity returns. Consequently, the hedging portfolio takes short positions in currencies with positive expected returns, thereby lowering overall portfolio returns. The model also generates the observed negative effects of hedging on Sharpe ratios and skewness.

Keywords: currency risk, currency 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 2, 2012). INSEAD Working Paper No. 2012/87/FIN, Available at SSRN: https://ssrn.com/abstract=2156802

Frans A. De Roon

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 (Contact Author)

INSEAD - Finance ( email )

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

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