Working Paper: NBER ID: w4355
Authors: Kenneth A. Froot
Abstract: This paper reexamines the widely-held wisdom that the currency exposure of international investments should be entirely hedged. It finds that the previously documented ability of hedges to reduce portfolio return variance holds at short horizons, but not at long horizons. At horizons of several years, complete hedging not only does not lower return variance, it actually increases the return variance of many portfolios. Hedge ratios chosen to minimize long-run return variance are not only low, they also have no perceptible impact on return variance. The paper reports and explores these results, their apparent causes, and investigates their implications for hedging practice.
Keywords: currency hedging; international investments; return variance
JEL Codes: G15; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| currency hedging (F31) | return variance (short horizon) (C29) |
| currency hedging (F31) | return variance (long horizon) (C29) |
| real exchange rate changes (F31) | return variance (long horizon) (C29) |
| inflation expectations (E31) | return variance (long horizon) (C29) |
| investment horizon (G11) | optimal hedging strategy (G13) |
| hedging policies (G52) | investment duration (C41) |