Currency Hedging for Global Equity Portfolios: Historical Performance

Abstract

Offshore assets present investors with an increased investment universe and additional opportunities for reward, but embedded exposure to exchange rates can result in additional risk. In this work, we consider a global equity portfolio of five equity indices (US, Japan, Europe, UK and Canada), and examine the historical performance of currency hedging strategies in the context of portfolio risk reduction. Two types of scenario are studied; namely, a holding in a single foreign equity index, and a model global equity portfolio. In the case of the global equity portfolio, it is assumed that the allocations to the equities are fixed and exposures to currencies are solved for in a single combined optimization, taking into account all interactions between the equity indices and currencies. We show that a theoretical minimum-risk currency exposure level can be calculated which results in less risk than portfolios featuring either full or zero currency exposure. Furthermore, we show that the risk reduction achieved historically by following an easily implementable dynamic currency hedging strategy is comparable to that given by the theoretical, perfect knowledge calculations. Given our focus on minimum-risk hedging strategies, we find that using certain hedging instruments can slightly reduce total portfolio returns. However, in all cases the significant reduction in volatility always leads to superior risk-adjusted returns for the global equity portfolios. Moreover, certain hedging instruments in our historical tests do actually provide both risk reduction and return enhancement.