Making Wise Currency Hedging Decisions

December 03, 2014

But for equity investments, the risk case is more complex because co-variances of equities and currencies contribute much more to the overall foreign investment risk than in the case of bonds.

A study titled “Global Currency Hedging” by Campbell, Serfaty de Medeiros and Viceira that was published in October 2008 looked at risk management of an investor who holds a diversified portfolio of global equities or bonds and chooses long or short positions in currencies to manage the risk of the total portfolio.

Over the 30-year period from 1975-2005, they found that a risk-minimizing global equity investor with a quarterly horizon should short the Australian dollar, Canadian dollar, the yen and the British pound, but should hold long positions in the U.S. dollar, the euro and the Swiss franc.

Why The Differences?

The study observed that at one extreme, the Australian dollar and the Canadian dollar are positively correlated with local-currency returns in equity markets around the world, including their own domestic markets.

The Australian and Canadian economies, being highly commodity-dependent, have positive correlations between their currencies and world stock markets, consistent with the idea that fluctuation in world economic growth is driving equity and commodity prices in the same direction.

At the other extreme, the euro and the Swiss franc are negatively correlated with world stock returns and their own domestic stock returns.

The Japanese yen, the British pound, and the U.S. dollar are in the middle, with the yen and the pound having more similarity with the Australian and Canadian dollars, and the U.S. dollar having more similarity with the euro and the Swiss franc.

Flight To Quality

The U.S. dollar, the Swiss franc and the euro are widely used as reserve currencies by central banks, and, more generally, as stores of value by corporations and individuals around the world. Their negative correlations with equity prices are consistent with the idea that shocks to risk aversion drive down equity prices and drive up the values of the major reserve currencies as investors “flee to quality.”

This “flight to quality” drives up the dollar, euro and Swiss franc at times when the prices of risky financial assets decline. This explanation takes as given that these currencies are regarded as safe assets and therefore benefit from a flight to quality.

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