Preference-Based Strategic Currency Hedging

Abstract

This article considers the value to a given investor of volatility reduction through currency hedging relative to taking an unhedged position. Included is a decision framework to help international investors analyze how the potential risk reduction benefits of hedging interact with the investor's beliefs about the currency risk premium, risk aversion, and investment constraints to determine an optimal currency-hedging strategy. In our framework, investors choose from nine hedging strategies, each of which may be optimal under a specific set of assumptions. The article concludes that a unitary hedge strategy is best for investors who do not forecast currency returns. For those who make strategic currency-return forecasts, our aggregated results suggest an optimized hedge strategy using expected return inputs from an asset-pricing model.