Currency: To Hedge or Not to Hedge

Researchers test the most popular strategies.

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According to the Top 100 Pension Funds Report published in the May 2006 issue of Benefits Canada (Cakebread, 2006), Canadian pension funds invest significantly in non- Canadian equities, with on average 11.9% of their portfolio directed toward U.S. equities and 11.4% directed toward the other developed markets’ equities (data for the year 2005). One inevitable consequence of being exposed to foreign equities is the need to address the resulting currency exposure issue. Institutional investors exposed to foreign currencies have to decide whether to fully hedge this exposure, to leave it completely unhedged, or to settle in the middle of these two extremes.

There is no consensus among institutional investors around the world regarding the best policy to adopt when confronted with currency hedging decisions. Indeed, a survey conducted in 2004 by Mellon/Russell and reported in Michenaud and Solnik (2005) gave the following results: 39% of investors adopt a no-hedging policy, 34% of investors choose a 50% hedging policy, 14% of investors settle for a 100% hedging policy and 13% embrace other hedge ratios.

Beyond these passive strategic approaches, some investors might see the currency exposure as a potential avenue to further add value. They could rely on active strategies that choose to hedge or not at the beginning of each period, depending on some empirical models or rules.

In this paper, we examine different options available for an institutional investor when it comes to dealing with the currency exposure of the foreign equity portion of its portfolio. More specifically, we adopt the perspective of a Canadian institutional investor who is anchored to the MSCI World ex-Canada equity index. We examine the performance of a conditional currency hedging strategy, namely the forward hedge rule (FHR), compared to the three currency benchmarks institutional investors use most: 100% unhedged, 50%/50%, and 100% hedged. Read the full paper here…

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