The Best Strategies for FX Hedging

Abstract

The question of whether, when, and how to hedge foreign exchange risk has been a vexing one for investors since the end of the Bretton Woods system in 1973. Our study provides a comprehensive empirical analysis of dynamic FX hedging strategies over several decades, examining various domestic and foreign currency pairs. While traditional approaches often focus on risk mitigation, we explore the broader implications for expected returns, highlighting the interplay between hedging and strategies such as the carry trade. Our findings reveal that incorporating additional factors-such as trend (12-month FX return), value (deviation from purchasing power parity), and carry (interest rate differential) - into hedging decisions delivers significant portfolio benefits. By adopting a dynamic, active approach to FX hedging, investors can enhance returns and manage risk more effectively than with static hedged or unhedged strategies.

Keywords: FX, Hedging, Carry, Value, Momentum, Trend, Purchasing Power Parity, Active Investing, Dynamic Hedging

JEL Classification: G11, G12, G15, G32, F31