Foreign Currency for Long-Term Investors

Abstract

Conventional wisdom holds that conservative investors should avoid exposure to foreign currency risk. Even if they hold foreign equities, they should hedge the currency exposure of these positions and should hold only domestic Treasury bills. This paper argues that the conventional wisdom may be wrong for long-term investors. Domestic bills are risky for long-term investors because real interest rates vary over time, and bills must be rolled over at uncertain future interest rates. This risk can be hedged by holding foreign currency if the domestic currency tends to depreciate when the domestic real interest rate falls, as implied by the theory of uncovered interest parity. Empirically, this effect is important and can lead conservative long-term investors to hold more than half their wealth in foreign currency.

Keywords: Foreign Exchange Rates, Home Bias, Intertemporal Hedging Demand, Portfolio Choice, Uncovered Interest Parity

JEL Classification: G12