Some Like it Hedged
26 Pages Posted: 8 Nov 2019
Date Written: November 2018
Foreign currency exposure is a by-product of international investing. When obtaining global asset exposure, investors also obtain the embedded foreign currency exposure. The impact of this foreign currency exposure on the return and the volatility of the institutional investor’s portfolio can be quite meaningful. For example, according to a Reuters’ article, the rise in the US dollar wiped out about $1 trillion in US pension fund assets (i.e., in the dollar value of the funds’ non-dollar-denominated assets) between mid-2014 and March 2015 (Chavez-Dreyfuss 2015).
How to address this exposure has been a subject of much debate over the years. The seminal paper by Black (1989) argued for a “universal” hedge ratio for all investors. Perold and Schulman (1988) argued that US investors should completely hedge foreign currency exposure; another school of thought is that foreign currency exposure provides diversification benefits and should be left unhedged. Recently, Chen, Kritzman, and Turkington (2015) evaluated the impact of various currency-hedging strategies on a typical institutional investor portfolio. As expected, more-flexible strategies provide greater risk reduction, but there is no single best strategy ex ante, leaving investors to consider different risk–return trade-offs.
Although no single best-practice solution exists for addressing foreign currency exposures, institutional investors have three main choices:
1. Do nothing (i.e., maintain unhedged foreign currency exposure).
2. Hedge passively (i.e., maintain a constant hedge ratio).
3. Hedge actively (i.e., vary the hedge ratio).
The best solution will differ from institution to institution, but it comes down to two fundamental factors. First, the optimal solution depends on the importance of risk versus return and the institution’s tolerance for negative cash flow. Second, investors must decide whether they believe that currency managers are able to achieve a positive information ratio over the long term after fees and, importantly, whether they will be able to identify these currency managers.
Before I address the available choices, I present the estimated impact of foreign currency exposure on institutional portfolios. In the following sections, I consider four different base currencies: the US dollar, Canadian dollar, euro, and Japanese yen.
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