Many investors take a global perspective when building portfolios to achieve their investment goals. With the benefits of greater diversification and an expanded opportunity set come exposure to foreign currencies. For investors with unhedged foreign investments, when their home currency appreciates, it has a negative impact on returns; when it depreciates, the impact is positive. How can investors make an informed decision about whether and when to hedge currency exposures?
Using data on 12 developed markets from 1985 to 2019, recent research by Dimensional develops and tests a framework for evaluating the impact of currency hedging on expected returns and volatility for global equity and fixed income portfolios. An important takeaway for investors is that currency hedging decisions should depend on their asset allocations and investment goals.
The impact of currency hedging on volatility depends mostly on the magnitude of asset volatility relative to currency volatility. Stocks tend to be more volatile than currencies and drive the overall volatility of a global equity portfolio. Currencies, however, are more volatile than bonds and dominate the overall volatility of a global bond portfolio. Hence for investors with high allocations to stocks, hedging currencies does not meaningfully reduce return volatility. In contrast, for investors with high fixed income allocations, currency hedging is an effective way to reduce portfolio volatility.
The study also confirms that monthly currency returns are largely unpredictable and not reliably different from zero on average, so hedging decisions based on predictions of currency movements are unlikely to add value. Another implication is that forward currency premiums (discounts), which are based on observable currency spot and forward rates, contain reliable information about differences in expected return between unhedged and hedged securities. Therefore, a dynamic hedging strategy can increase expected returns by selectively hedging the currency exposure in markets where the forward currency premium is positive and leaving the currency exposure unhedged otherwise. This approach does not substantially increase portfolio volatility when the majority of investments are in equities and can be appropriate for fixed income investors who are willing to accept more volatility in pursuit of higher expected returns.
Currency hedging is among the many aspects to consider when building global portfolios. We believe a robust framework backed by rigorous research, like the one shown in this study, can help investors make well-informed decisions to better achieve their investment goals.
Currency hedging: Establishing a position that mitigates or decreases the risk associated with an existing currency position.
Currency forward rate: The exchange rate at which market participants agree today to exchange one currency for another at a future date.
Currency spot rate: The current exchange rate at which market participants can exchange one currency for another.
Forward currency premium (discount): The difference (often expressed as percentage difference) between the currency forward rate and the currency spot rate of a currency pair. It is referred to as a premium (discount) when the difference is positive (negative).
Volatility: A statistical measure of the dispersion, or variability, of returns for a given security, currency pair or portfolio. Volatility is often measured using standard deviation.
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