Currency Hedging for International Investment Portfolios Open Access

Abstract

Currency Hedging for International Investment Portfolios

By
Jochen M. Schmittmann

This paper examines the benefits from hedging the currency exposure of international
investments in single country equity and bond portfolios from the perspectives of
German, Japanese, British and American investors. Over the period 1975 to 2009,
currency risk constituted about a quarter of the risk of foreign equity investments and
about 90 percent of the risk of foreign bond investments. Hedging currency risk
substantially reduces the volatility of foreign investments at a quarterly investment
horizon but also affects returns in economically meaningful magnitudes in some cases.
Particularly Japanese investors would have benefited from the carry associated with
exposure to currencies with higher yields than the Yen. Contrary to previous studies, we
find that at investment horizons of up to five years the case for hedging for risk reduction
purposes remains strong.

Table of Contents

I. Introduction ..................................................................................................................... 1
II. Data ................................................................................................................................ 5
III. Components of International Investment Returns ........................................................ 7
IV. Hedging Currency Risk .............................................................................................. 12
A. Hedging Methodology and Notation........................................................................ 13
B. Impact of Hedging on Returns ................................................................................. 17
C. Impact of Hedging on Volatility .............................................................................. 18
D. Calculating the Forward Premium in Practice ......................................................... 19
E. Empirical ex post Analysis of Currency Hedging .................................................... 21
V. Optimal Hedge Ratios .................................................................................................. 23
VI. Hedging and the Investment Horizon ......................................................................... 26
VII. Conclusion ................................................................................................................. 32
References ......................................................................................................................... 35
Tables ................................................................................................................................ 41

List of Tables

Table 1. Summary Statistics ............................................................................................. 41
Table 2. Quarterly Returns to International Investments .................................................. 42
Table 3. Decomposition of the Volatility of Quarterly Stock and Bond Market Returns 43
Table 4. Forward Premia versus the U.S. dollar ............................................................... 46
Table 5. Returns on Hedged and Unhedged Equity and Bond Portfolios ........................ 47
Table 6. Quarterly Standard Deviations of Hedged and Unhedged Equity and Bond
Portfolios ........................................................................................................................... 49
Table 7. Estimated Minimum Variance Hedge Ratios ..................................................... 51
Table 8. Variance Ratios of Unhedged and Fully Hedged Returns over Different
Horizons ............................................................................................................................ 52
Table 9. Estimated Minimum Variance Hedge Ratios over Different Horizons .............. 54

About this Master's Thesis

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School	Laney Graduate School
Department	Business
Degree	MS
Submission	Master's Thesis
Language	English
Research Field	Business Administration, General
Keyword	International Investments Hedging Currency
Committee Chair / Thesis Advisor	Jegadeesh, Narasimhan, Emory University
Committee Members	Shanken, Jay, Emory University

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