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The Fallacy of Currency Diversification: How Zero Correlation Can Still Add Risk

Robert Bush, Jason Chen and Eric Legunn
The Journal of Investing October 2019, joi.2019.1.097; DOI: https://doi.org/10.3905/joi.2019.1.097
Robert Bush
is a director and head of U.S. Product Strategy at DWS Group in New York City, NY
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Jason Chen
is a vice president for U.S. Product Strategy at DWS Group in New York City, NY
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Eric Legunn
is an assistant vice president in U.S. Product Strategy at DWS Group in New York City, NY
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Abstract

The empirical observation is well documented that currency exposure can add risk to an unhedged international equity portfolio. Extending that work, this article uses three manipulations of the standard portfolio risk equation to show (1) why currency acts as implicit leverage in a portfolio and can therefore increase risk, even under the assumption of zero correlation; (2) how, under an additional assumption, the portfolio risk equation reduces to the Pythagorean equation and that, by using that result, a simple proof can show that an unhedged international equity portfolio is always riskier than a hedged one; and (3) how the risk equation can be rearranged to give the “correlation breakeven” that an investor requires to be indifferent to hedging (or not hedging).

TOPICS: Currency, developed markets, portfolio construction, risk management

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The Fallacy of Currency Diversification: How Zero Correlation Can Still Add Risk
Robert Bush, Jason Chen, Eric Legunn
The Journal of Investing Aug 2019, joi.2019.1.097; DOI: 10.3905/joi.2019.1.097

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The Fallacy of Currency Diversification: How Zero Correlation Can Still Add Risk
Robert Bush, Jason Chen, Eric Legunn
The Journal of Investing Aug 2019, joi.2019.1.097; DOI: 10.3905/joi.2019.1.097
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  • Article
    • Abstract
    • LITERATURE REVIEW
    • CURRENCY AS IMPLICIT LEVERAGE
    • PYTHAGORAS AND HEDGING
    • CORRELATION BREAKEVEN EQUATION
    • CONCLUSIONS
    • ADDITIONAL READING
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