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Why Currency Hedging is Hard (and Getting Harder)

Asset pricing theory suggests that investors can improve the risk-adjusted performance of their portfolios by investing internationally. But foreign assets are denominated in foreign currency, so investors must decide whether to retain or hedge the implied exposure to currency risk.

This has never been an easy decision—in theory or in practice.

  • If foreign currencies are uncorrelated with other assets and there is no speculative demand for currency, then full hedging of currency risk is optimal.[1] Under these conditions, currency hedging is a “free lunch” that reduces risk at no cost to expected return.[2]
  • When foreign currency is correlated with other assets, however, full hedging may not be optimal; a foreign currency that appreciates relative to the investor’s domestic currency when the foreign asset market falls may offset some of the risks of the foreign investment.

Mean-variance analysis based on historical data can be used to find optimal currency hedges that minimize portfolio risk,[3],[4] but correlations between equity markets and currencies vary widely over time, which can make optimal hedge ratios unstable.[5] One influential early study argued that investors with long horizons should not hedge currency risk because the mean reversion of real exchange rates to purchasing power parity (PPP) acts as an automatic hedge, but this horizon effect is not found in more recent data.[6]

There may also be speculative demand for currency due to expected excess returns on some currencies in the short term; this is what motivates the “carry trade,” in which investors borrow in low-interest-rate currencies and lend in high-interest-rate currencies to profit from persistent deviations from uncovered interest parity.[7] Hedging may therefore affect return as well as risk.

In the face of this complexity, it is unsurprising that most investors opt for simple, fixed-currency hedge ratios of 0%, 50%, or 100%.[8] Similarly, standard currency-hedged equity indices are constructed by hedging 100%of the index value at the start of each month with one-month forward foreign exchange (FX) contracts and rolling those contracts every month.

But even simple hedges can leave investors with tough choices. Consider an investor based outside the US who must decide between hedged and unhedged versions of a US equity index. The performance she achieves will depend on how the exchange rate between her currency and the US dollar moves relative to US equity markets.

Unfortunately, those movements are hard to forecast, so the best choice may not be obvious. During the Great Financial Crisis (GFC), for example, the South Korean won and the Australian dollar depreciated significantly against the US dollar, cushioning losses for investors in those countries who held US equities. But the yen appreciated against the US dollar, increasing losses for Japanese investors. Currency hedging would have protected Japanese investors, but South Korean and Australian investors might have preferred to remain unhedged. In other periods, different decisions may have been optimal.[9]

Another critical factor is hedging costs. An investor who hedges currency risk using one-month forward contracts buys the foreign currency spot and sells it one month forward each month, a structure called an FX swap. The difference between the forward and spot exchange rates is the carry on the hedge, which reflects hedging costs. Prior to the GFC, spot and forward exchange rates for major currency pairs mostly satisfied covered interest parity (CIP). That is, the difference between the logarithms of the forward and spot exchange rates was equal to the difference between the interest rates on the quote and base currencies. Carry on currency hedges were therefore almost entirely driven by differences in short-term interest rates. Similarly, the cross-currency basis (i.e., the spread in a cross-currency basis swap, or CCBS) was near zero for most currency pairs.

Since the GFC, however, these relationships have broken down. Carry on forward FX hedges are no longer well explained by interest rate differentials, and the cross-currency basis in CCBS has become much larger and more variable. In many cases, a negative cross-currency basis has increased hedging costs for non-US investors in US-dollar-denominated assets, and in all cases, hedging costs have become more variable and less predictable. Why has this happened?

Part of the explanation is that the US dollar is a global funding currency. Increased counterparty risk in the GFC led to a US dollar shortage for global banks, forcing them to turn to FX swaps and CCBS as synthetic forms of US funding. The imbalance of supply and demand in these markets led to deviations from CIP and wider CCBS spreads or, essentially, banks paying a premium to borrow US dollars synthetically that they could not obtain directly.[10]

More recently, post-GFC changes in banking regulation may have increased the balance sheet costs to financial intermediaries by exploiting the arbitrage opportunities offered by deviations from CIP; the Basel III leverage ratio is a notable example.[11]

Finally, deviations from CIP may simply reflect the transition from LIBOR to risk-free rate (RFR) benchmarks such as SOFR. LIBOR rates are based on unsecured lending for a given term, so they contain credit and liquidity risk premiums. RFRs do not. FX swaps and CCBS are collateralized, so dealers will discount cash flows in those markets at rates that do not contain a credit risk premium. But principal amounts are exchanged at the beginning and end of FX swaps and CCBS, so there is liquidity risk. The appropriate rate at which to discount cash flows in each currency is therefore the RFR plus a liquidity risk premium. But this leads to a violation of CIP and a non-zero cross-currency basis since the forward FX price must reflect the relative liquidity risk of the two currencies.[12] Perhaps deviations from CIP are not arbitrage opportunities at all.

Whatever the explanation, persistent deviations from CIP and a larger and more variable cross-currency basis have made the hard problem of currency hedging even harder. Still, who said that investing should be easy?

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[1] B. Solnik, “An Equilibrium Model of the International Capital Market” Journal of Economic Theory 8 (August 1974): 500-524.

[2] A. Perold and E. Schulman, “The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards,” Financial Analysts Journal 44, no. 3 (May-June 1988): 45-50.

[3] J. Glen and P. Jorion, “Currency Hedging for International Portfolios,” Journal of Finance 48, no. 5 (December 1993): 1865-1886.

[4] J. Campbell, K. Serfaty-De Medeiros, and L. Viceira, “Global Currency Hedging,” Journal of Finance 65, no. 1 (February 2010): 87-121.

[5] J. Schmittmann, “Currency Hedging for International Portfolios.” IMF Working Paper 10/151, International Monetary Fund, June 2010.

[6] K. Froot, “Currency Hedging Over Long Horizons,” NBER Working Paper 4355, National Bureau of Economic Research, May 1993.

[7] C. Burnside, M. Eichenbaum, I. Kleshchelski, and S. Rebelo, “The Returns to Currency Speculation.” NBER Working Paper 12489, National Bureau of Economic Research, August 2006.

[8] L. Harris, “Is There Still Alpha to Be Gained in Active Currency Management,” Russell/Mellon (2004). Cited in S. Michenaud and B. Solnik, “Applying Regret Theory to Investment Choices: Currency Hedging Decisions,” Journal of International Money and Finance 27 (September 2008): 677-694.

[9] S&P Dow Jones Indices, “Currency Hedging US Equities: A Practical Tool for Global Investing,” September 2020.

[10] C.-H. Hui, H. Genberg, and T.-K. Chung, “Funding Liquidity Risk and Deviations from Interest-Rate Parity During the Financial Crisis of 2007-2009,” International Journal of Finance & Economics 16, no. 4 (October 2011):307-323.

[11] W. Du, A. Tepper, and A. Verdelhan, “Deviations from Covered Interest Rate Parity,” Journal of Finance 73, no.3 (June 2018): 915-957.

[12] A. Wong and J. Zhang, “Breakdown of Covered Interest Parity: Mystery or Myth?” BIS Papers no. 96, Bank for International Settlements, March 23, 2018.

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