Monday, October 1, 2012

De ROON Frans, EILING Esther, GERARD Bruno, HILLION Pierre
Currency Risk Hedging: No Free Lunch
INSEAD Working Paper 2012/87/FIN

Currency risk hedging in international portfolios typically aims at minimizing portfolio volatility. In a purely out-of-sample context, this paper looks beyond the e¤ect on portfolio risk and …nds that currency hedging comes at a serious cost. While hedging lowers volatility of international equity and bond portfolios, it also lowers portfolio returns. The reduction in average returns more than offsets the decrease in variance and as a result, Sharpe ratios often deteriorate. In addition, hedging induces more negative skewness and signi…cantly higher kurtosis in portfolio returns. We extend a no-arbitrage model of interest rates and exchange rates with an equity component and show that, in the model, hedging indeed lowers returns. Currency expected returns are positively related to the covariance between currency and equity returns. Consequently, the hedging portfolio takes short positions in currencies with positive expected returns, thereby lowering overall portfolio returns. The model also generates the observed negative effects of hedging on Sharpe ratios and skewness.