Hedging Foreign Exchange Risks

Since foreign exchange risk does add to the dollar risk of holding foreign securities, it appears to pay for an investor in foreign markets to hedge against currency movements. Currency hedging means taking a position in a currency market that offsets unexpected changes in the foreign currency relative to the dollar. Stock market fluctuations can cause enough anxiety without worrying about whether a change in foreign exchange rates will reduce the value of your foreign portfolio.

Although hedging seems like an attractive way to offset exchange risk, in the long run it is often unnecessary. For example, in the United Kingdom from 1910 onward, the pound depreciated from $4.80 to about $1.50. It might seem obvious that an investor who hedged the fall of the pound would be better off than one who had not. But this is not the case. Since the interest rate was, on average, substantially higher in the United Kingdom than in the United States, the cost of hedging for a dollar-based investor, which depends on the relative interest rates between the two countries, was high. The unhedged returns for British stocks in U.S. dollars actually exceeded the hedged accumulation, despite the fall of the British pound.

For investors with long-term horizons, hedging currency risk in foreign stock markets is not important. In fact, there is recent evidence that in the long run currency hedges might actually increase the volatility of dollar returns.5 In the long run, exchange rate movements are determined primarily by changes in local prices. Equities are claims on

5 Kenneth A. Froot, ''Currency Hedging over Long Horizons," N.B.E.R. working paper no. 4355, May 1993.

real assets that compensate the stockholder for changes in the price level. To hedge such a long-run investment would be self-defeating since by buying a real asset you automatically hedge a depreciating currency.

Hedging currency movements is particularly counterproductive if there is a change in monetary policy. In that case, hedges might actually increase the volatility of your dollar returns. For example, if the Bundesbank, Germany's central bank, tightens credit and raises interest rates, this will cause the deutsche mark to rise. But German stock prices will fall, as rising interest rates lower the value of stocks.

If investors does not hedge, the downward movement in the stock market will be offset by the upward movement of the deutsche mark, thereby reducing fluctuations in the dollar returns on German stocks. On the other hand, if investors hedge, they forgo the appreciation of the deutsche mark that offsets the decline in the value of German stocks.

Although changes in exchange rates and stock prices often move in the opposite direction, this is not always so. An increase in optimism about the growth prospects in a country often increases both stock prices and currency values. When Vice President Al Gore won the debate with Ross Perot by supporting NAFTA in November 1993, both the Mexican peso and Mexican stocks rose. Optimism about economic growth drives up both the exchange rate and stock prices.

Since both monetary and real factors drive exchange rate and stock movements, it is not surprising that the stock and currency markets often move independently of one another. The inability to identify in advance the source of movement in these markets reduces the attractiveness of hedging foreign stock risk.

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