Strategic currency hedging
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Andrew Dales* is a currency researcher and strategist at Barclays Global Investors in London. Andrew has an MA in Mathematics and a Diploma in Statistics from Cambridge University.
Richard Meese oversees research on currencies and real estate investment trusts (REITS) in the Advanced Strategies & Research Group at Barclays Global Investors. Prior to joining BGI, Dick was a professor at the Haas School of Business at UC Berkeley from 1982, and he served as Associate Dean for Academic Affairs from 1996. *Barclays Global Investors, Murray House, 1 Royal Mint Court, London EC3N 4HH, UK. Tel: ⫹44 (0)20 7688 8957; Fax: ⫹44 (0)20 7668 8910; e-mail: [email protected]
Abstract This paper examines the rationale for strategic hedging policy, whereby some fixed proportion of the currency exposure associated with international assets is hedged. We begin with a review of both the theoretical and empirical literature on hedging policy. This literature provides a strong case for hedging some portion of the currency exposure associated with international investing. Differences in opinion remain, however, as to the appropriate methodology to use when constructing hedge ratios in practice. We advocate the use of portfolio optimisation methods and provide examples, along with caveats and guidelines, for the calculation of hedge ratios from a number of different currency perspectives. Keywords: currency hedging; currency risk; hedge ratio; portfolio optimisation
International investing and currency exposure Most investors have two key goals: to maximise the expected return of their investments and to minimise the risk that something will go wrong. These two goals are neatly summarised by William Sharpe’s famous ratio, where portfolio risk is measured by the standard deviation of asset return. These two goals are also the motivation behind the decision to invest internationally. Investors either believe that they can expect to receive extra returns from investing in non-domestic assets, or that by doing so they can reduce the risk of their overall portfolio.
䉷 Henry Stewart Publications 1470-8272 (2001)
There is, however, an interesting divergence in investment practice between investing in domestic assets and in investing internationally. In domestic investing, the ideas underlying the capital asset pricing model (CAPM) have had an enormous impact on investment practice. Many investors choose to apply CAPM to its final conclusion and invest in index funds. But even active funds follow many of the lessons of CAPM. Typical institutional active equity portfolios will hold a large number of stocks, and ensure that their exposures to various risk themes, such as market capitalisation, sectors and growth versus
Vol. 2, 1, 9-21
Journal of Asset Management
9
Dales and Meese
Table 1
Examples of typical strategic asset allocations for international investors
European Equity Japanese Equity Pacific Rim Equity UK Equity US Equity European Bonds Japanese Bonds UK Bonds US Bonds Cash Other
US %
Japan %
UK %
Index %
10
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