This is consistent with the role of the U.S. dollar and the euro as reserve currencies in the international financial system. The finding that the risk-minimizing demand for euros had increased over time leading up to 2008 suggests that the euro had partially displaced the dollar as a reserve currency.
Consistent with this story, the authors found that the correlation of the euro and Swiss franc with world equity markets had become more negative in the second half of the sample, as the euro had come to play a more important role in the international financial system.
Since the financial crisis and the subsequent recession during the 2008-2009 time period, key findings show that correlations have become increasingly negative since the introduction of QE.
Reserve currencies, particularly the U.S. dollar, have tended to strengthen against other currencies during the stock market declines. There are a series of similar observations over periods including the market crash of 1987, the Russian financial crisis of 1998 and the most recent financial crisis of 2008.
The implication of negative correlations is that holding exposures to such currencies may dampen portfolio volatility, due to the offsetting nature of the asset and currency returns.
To the extent that the U.S. dollar continues to maintain its safe-haven status and the risk-on/risk-off regime persists in the future, a non-U.S. investor investing in the U.S. would be prudent to have foreign currencies unhedged.
Canadian Dollar Example
The recent example of a Canadian investor investing in the U.S. equity market is a good case in point.
During the period spanning Sept. 30, 2008 to Oct. 31, 2008, the S&P 500 Index returned -16.79 percent in local terms, while the Canadian dollar depreciated from 1.063 to 1.216 over the same period. Canadian investors with exposure to the S&P 500 Index would have potentially realized an unhedged return of -4.85 percent, while the hedged return over this period would potentially have been -19.38 percent.
As the U.S. dollar has continued to strengthen relative to the Canadian dollar since then, investment flows have supported this point.
Most of the increase in Canada's direct investment asset position in 2013 occurred in the U.S., increasing by $28.6 billion to $317.7 billion. Aside from investment, generally stronger foreign currencies relative to the Canadian dollar supported the growth of Canadian direct investment assets abroad.