Asset Allocation

CHAPTER 18Currency Risk

THE CHALLENGE

Most investors recognize that it is possible to reduce the risk of a global portfolio by hedging some portion of its foreign currency exposure, but they face the challenge of determining which currencies to hedge, how much to hedge, and what instruments to use. Some investors choose not to hedge at all. In this chapter, we evaluate the prevailing arguments for and against currency hedging. We show how to derive a range of linear and nonlinear hedging strategies, and we evaluate their impact on expected portfolio performance. Finally, we review the economic rationale that explains why the risk-minimizing currency-hedging policy varies across currencies and home countries.

WHY HEDGE?

Investors who chose not to hedge foreign currency exposure typically rationalize their decision by making one or both of the following assertions:

• In the long run, currencies revert to the mean, and their returns wash out. We have a long investment horizon. So why bother?
• Currencies introduce diversification to the portfolio. We want to retain this diversification rather than hedge it away.

There is ample evidence to contradict the first assertion. For example, the British pound declined from USD 4.96 in 1850 to approximately USD 1.30 in September 2016. As we write this chapter, in the wake of the UK's historic “Brexit” vote to leave the European Union, we do not know any investors who are forecasting that the pound will revert to its mid-nineteenth-century ...