The effectiveness of global currency hedging after the Asian crisis

Abstract

Global equity portfolio managers employ a variety of approaches to currency hedging either hedging all of their currency risk, hedging only a portion of their currency risk, or simply not hedging at all. This paper considers a hypothetical US-based global portfolio invested in Europe, Asia, Latin America, and the US and looks at how various passive hedging strategies would have performed over the post-Asian crisis period from 1999 to 2006, while also looking at individual currency hedges in isolation over a longer time period (from 1984 to 2006). Although it is well known that currency hedging reduces the volatility of dollar returns, some recent studies have argued that hedging is less important in emerging markets due to the negative correlation between currency returns and local equity returns. The Sharpe ratio of this hypothetical global portfolio is examined to determine which currency hedging approach did the best on a risk-adjusted basis from 1999 to 2006. Five hypothetical global portfolios are considered. The benchmark portfolio is market-capitalisation weighted, while the others are more European weighted, equal weighted among regions of the world, and with large investments in emerging markets, like Asia and Latin America. As in other studies, it is found that currency hedging reduces portfolio risk and improves the performance of most portfolios on a risk-adjusted basis for managers with exposures to single foreign countries. For global investment managers with exposure to many countries and using simple, yet very common hedging techniques, currency hedging did not improve the risk-adjusted returns of the portfolio in most cases compared to a policy of no currency hedging. This was primarily due to the consistent depreciation of the US dollar versus most currencies in the world during this period of time. Even though it did not improve the risk-adjusted returns of the portfolio, currency hedging reduced the overall volatility of the portfolio marginally compared to the unhedged case. As expected, the hedging return volatility matched more closely with the local equity return volatility. The only global portfolio for which hedging improved the risk-adjusted returns was for the global portfolio that was heavily invested in South American equities. The results of this paper also indicate that using a hedging strategy that employs only three optimally weighted currencies performed equally well when compared with a strategy using all currencies to hedge the global portfolio.