To Hedge or Not to Hedge: A Framework for Currency Hedging Decisions in Global Equity & Fixed Income Portfolios

Abstract

This paper develops a framework for evaluating the impact of currency hedging on expected returns and volatility and tests the implications for global equity and fixed income portfolios using data on 12 developed markets from 1985 to 2019. We show that the impact of currency hedging on overall portfolio volatility depends on the magnitude of asset volatility relative to that of currency volatility. We also find that currency returns cannot be reliably predicted using the prior month currency returns or interest rate differentials. The forward currency premium, however, contains reliable information about differences in expected returns between unhedged and hedged portfolios, and can be used to pursue higher expected returns through a selectively hedged strategy.

Keywords: currency, hedging, fixed income, equity, volatility, expected returns

JEL Classification: F31, G15