What's the best strategic (or long-term) currency hedging policy? Our approach to this issue has focused on assessing the risk budget associated with alternative levels of currency hedging. Additionally, to make our advice as universal as possible, we've applied our analysis to euro-, sterling-, U.S. dollar-, and yen-based portfolios.
Our conclusions? First, currency hedging affects equity and fixed income assets differently. Since currency accounts for a disproportionate amount of the risk in unhedged foreign fixed income portfolios, we recommend a 100 percent currency hedge.
Second, the appropriate currency hedge level changes with the home bias level. Assuming you want currency to be the smallest source of portfolio risk, a currency hedge of 80 percent is appropriate for a global capitalization weighted portfolio. As home bias increases, the appropriate currency hedging level decreases (assuming you want currency exposure to be your portfolio's smallest source of risk).
Third, irrespective of base currency, investors achieve 75 percent of the potential Sharpe ratio improvement (based on equilibrium returns) when they move 60 percent of the way from a purely domestic portfolio toward a global capitalization weighted portfolio. This suggests appropriate currency hedge ratios of about 40 percent (again, assuming you want open currency positions to be your portfolio's smallest source of risk).
Finally, when a global capitalization weighted portfolio is 80 percent hedged, the implied currency excess returns approximate 50 basis points.
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