Is Complete Hedging Optimal for International Bond Portfolios?

• Published in: Financial analysts journal Vol. 48; no. 4; pp. 37 - 47
• Main Authors: Victor S. Filatov, Rappoport, Peter
• Format: Journal Article
• Language: English
• Published: Charlottesville The Association for Investment Management and Research 01.07.1992; National Federation of Financial Analysts Societies; Taylor & Francis Ltd
• Subjects: American dollar; Asset management; Bond portfolios; Covariance; Currency; Diversification; Financial portfolios; Foreign assets; Foreign exchange rate risk; Foreign exchange rates; Foreign investment; Forward exchange; Hedging; International bonds; International markets; Investment policy; Investment risk; Investors; Mathematical models; Portfolio diversification; Portfolio management; Portfolio performance; Risk assessment; Standard deviation; Volatility; United States > US
• ISSN: 0015-198X; 1938-3312
• DOI: 10.2469/faj.v48.n4.37

International investments offer diversification benefits for investors, but they also expose portfolios to highly volatile currency movements. Some have argued that hedging currency exposure completely offers investors a free lunch--lower risk with no sacrifice of expected return. Complete hedging did turn out to be a sound strategic position for U.S.-dollar-based investors in the 1980s. Over the 1980s, however, non-U.S. investors could have lowered their international portfolios' risks by taking on some currency exposure. For these investors, the benefits of diversification across currencies more than offset the cost of the currencies' volatilities. Evidently the free-lunch argument misses something, and investors should be concerned that the missing link might change across countries or over time. The conditions under which currency hedging does or does not contribute to diversification turn on the correlations between asset and currency returns--standard parameters in optimal portfolio selection. Investors need to take care in estimating these parameters, given their importance to the hedging decision. On the other hand, investors need have no strong views about or special expertise in forecasting exchange rate movements in order to avail themselves of the diversification benefits of currency exposure.