Strategic Currency Hedging in Multi-Asset Portfolios

Abstract

The authors provide a strategic currency hedging framework for multi-asset portfolios, helping global investors better manage foreign currency exposures by balancing hedging costs and risk. The authors focus primarily on G4 currencies—US dollar (USD), Euro (EUR), Pound sterling (GBP), and Japanese yen (JPY)—but also provide some insights for other G7 currencies. Starting from a single-asset-class perspective, the framework shows that developed market fixed-income instruments should generally be fully hedged back to the investor currency. US investors should fully hedge foreign exchange risk when buying European equities. Japanese equities should be left unhedged for all investors due to the Japanese yen’s value as a safe haven during market panics. Conversely, Japanese investors buying international equities should fully hedge currency risk but may find it optimal to leave some of their US bond exposures unhedged to minimize hedging costs while retaining some diversification benefits. The picture is also nuanced for European investors where the cost-benefit trade-off points to partial hedging as the optimal approach. When it comes to multi-asset investing, hedge ratio optimality also becomes a function of cross-asset correlations, which leads to interesting nuances of approach across domiciles. The authors believe their research provides global investors with useful information to calibrate strategic hedge ratios.

TOPICS: Currency, portfolio management/multi-asset allocation

Key Findings

• • We find the optimal hedge ratio dynamically derived from exploring the trade-off between hedging costs and risk minimization generally leads to superior risk adjusted returns than a static approach to currency hedging.

• • Our Mean Variance Optimization (MVO) framework allows practitioners to set a flexible currency hedging policy based on their own risk preference and is applicable to single asset and multi asset portfolios. The hedge ratio decomposition we propose sheds light on the drivers of the optimal hedge ratio and gives investors the ability to further calibrate their currency hedging policy by putting more emphasis on the driver they deem the most important.

• • We find developed markets (DM) fixed-income instruments should generally be fully FX hedged. US investors should fully hedge foreign exchange (FX) risk when buying European equities. Japanese equities should be left unhedged for all investors due to the Japanese yen’s risk-off characteristics. Conversely, Japanese investors buying international equities should fully hedge currency risk but may find it optimal to leave some of their US bond exposures unhedged to minimize hedging costs while retaining some diversification benefits. The picture is also nuanced for European investors where the cost-benefit trade-off points to partial hedging as the optimal approach. When it comes to multi-asset investing, hedge ratio optimality also becomes a function of cross-asset correlations, which leads to interesting trade-offs.