Optimal Currency Hedging: Horizon Matters

Abstract

Investors have long debated what fraction of their portfolios’ currency exposure they should hedge, if any. The answers cover a broad range, often with dubious rationale. Yet most informed investors agree that the solution should use mean-variance optimization to maximize expected utility or, when the return means are assumed to equal zero, minimize risk. However, this approach presents a serious challenge because it depends on how currencies co-vary with each other and with the underlying portfolio, and these covariances, themselves, vary significantly with the return interval used to estimate them. The authors show that monthly covariances produce unreliable results for horizons that are longer than one month.

TOPICS: Currency, portfolio construction, quantitative methods, statistical methods, risk management, global markets

Key Findings

• ▪ Investors understand that currency exposure introduces unnecessary risk to globally diversified portfolios. In the absence of views about the direction of future currency returns, they recognize they should manage this risk by hedging some fraction of this currency exposure.

• ▪ Sophisticated investors rely on mean-variance optimization to determine the specific fraction of currency exposure to hedge to minimize risk. Still, they typically misestimate volatilities and correlations because they use the wrong return interval to estimate these values.

• ▪ Our research shows that the increase in risk resulting from using the wrong return interval to estimate hedge ratios is significant, about the same magnitude as misallocating a 50/50 stock/bond portfolio by 10% and without compensation of a higher expected return.