International Stock Portfolios and Optimal Currency Hedging with Regime Switching

Abstract

Despite the vast literature on optimal currency hedging, there still is considerable disagreement about how international investors should hedge their currency risk. One argument is that investors should fully hedge, since exchange-rate changes in excess of the forward discount rate average out. Therefore, hedging decreases the risk of foreign investment, but does not reduce its expected returns. In the words of Perold and Schulman (1988), currency hedging is a free lunch. However, there is a large branch of literature that does not agree with this viewpoint. As an early example, Froot (1993) argues that the free-lunch argument does not hold in the long run. If exchange rates and asset prices display mean reversion, the optimal hedging policy becomes time-varying. In particular, real exchange rates revert to their means according to the theory of purchasing power parity, and investors should maintain an unhedged foreign currency position. Therefore, for an investor with a long investment horizon, it becomes optimal not to hedge at all. Froot argues that real-exchange rates may deviate from their theoretical fair value over shorter horizons, and currency hedging in this context may become beneficial.KeywordsForeign InvestmentForeign MarketExcess ReturnSharpe RatioAsset AllocationThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.