Once the investor has decided to hedge the foreign currency exposure, the next important question is which instruments to use. In this section, we look at the relative benefits of hedging with currency forwards and options, investigating their impact on hedge cash flows, effective hedge ratios, and total return.
Managing hedge cash flows has become increasingly important for investors because of both the increased volatility of currencies during the 2007–2008 credit crisis and the increased correlations between assets and currencies. The problem is particularly sensitive in the case of hedge losses, which generate negative cash flows against mark-to-market currency gains on underlying assets.
From the point of view of hedged asset indices, the concept of cash flows seems trivial—negative cash flows from currency hedges are covered by realizing the simultaneous currency gains on underlying assets, which is achieved by selling off some of the foreign assets (at zero cost). However, in practice, there are several reasons why investors may prefer to handle hedge cash flows separately from the asset.
First, selling assets to cover hedge losses may be costly and difficult, especially the hedge losses happen in a portfolio of illiquid assets or in times of reduced market liquidity. Second, selling assets makes the performance of the asset conditional on the performance of currency hedges and ...