The New Neutral: The Long-Term Case for Currency Hedging

Abstract

The foreign exchange component of international equity investing is key to the experience that investors will have when they buy assets in denominations other than their base currency. Indeed a traditional, un-hedged international investment, with full foreign currency exposure, can in fact be thought of as a long position, of equal magnitude, in both the foreign equity and the foreign currency. In this article, the authors use traditional portfolio metrics to address the question of whether exposure to foreign currency is likely to help, or hinder, investors over the long run. They argue that the portfolio approach is a helpful but underutilized framework that requires the careful consideration of six elements; the returns of equities and currencies, their risks, the correlation between equity and currency, and the costs to hedge. The authors find that, under certain empirically justified assumptions, currency is rarely sufficiently negatively correlated to justify its place in strategic international allocations. They conclude that the “new neutral” for long-term international investors should be to remove foreign currency exposure from their portfolios.

TOPICS: Real assets/alternative investments/private equity, portfolio management/multi-asset allocation, emerging