As international investments are becoming an increasingly significant part of institutional investment port-folios, the currency impact on these portfolios' return and risk dynamics can be felt more and more. As a result, the currency hedging decision is becoming an increasingly important piece of the investment puzzle. There are several key questions to consider.

Why Hedge Currencies?
Much of the recent research on currency hedging for investment portfolios has argued for a minimum threshold (e.g. 20 per cent, 30 per cent) of a given portfolio's allocation to foreign assets, thus to foreign currencies, for which currency management starts to become worthwhile. I would certainly say that, at the current levels of foreign investing in most Canadian pension fund portfolios, the impact of currencies and of the hedging policy are significant. I would also add that, regardless of foreign content levels, international investment decisions based on the underlying asset and the currency together lead to sub-optimal port-folio decisions. Moreover, currencies offer zero expected returns and, therefore, introduce uncompensated risk. The solution is to separate the underlying asset and currency decisions by hedging some portion of the currency risk.

The Diversification Argument
One crucial point that must be made regarding this issue of diversification is that many investors under-estimate the correlations between the currencies and the underlying assets in the portfolio through a failure to measure risk and returns from a base currency perspective. But a true measure of these correlations is obtained when we translate local returns and standard deviations to our base currency. By doing so, correlations of 0 based on local returns look more like 0.7 when we correctly analyze the portfolio components from a Canadian dollar perspective. Therefore, we can see how the diversification argument may be erroneously overemphasized.

Do Currencies Wash Out In The Long Run?
This is indeed a common retort to the currency hedging debate. But let us only look at the Canada-U.S. exchange rate between 1991 and today as the Canadian dollar gradually slipped from 1.1190 to 1.5750. Any investment manager waiting for a reversion had better be armed with a fair amount of patience. And if that doesn't correspond to your idea of the long run, look at the depreciation of the British pound against the U.S. dollar over the past century and a half: in 1860 a British Pound bought you US$7.39, today it would merely get you US$1.45.

Currency Hedging and the Risk of Loss
Finally let us look at the traditional measures of risk such as Value-at-Risk (VaR) and their ability to help us assess the risk of loss in a portfolio. The traditional VaR measure helps us quantify the risk of losing a given proportion of our portfolio at the end of a given investment horizon. But what does that say about the potential gyrations of our portfolio within that horizon? Unfortunately, the traditional VaR does not allow us to shed much light on that important window of time. This is why a measure of Continuous Value at Risk looks at the behaviour of a portfolio during the investment horizon and thus helps us get a much more realistic assessment of portfolio risks.

Finally, as we move forward with even greater shares of our portfolios invested abroad, we must be certain to fully appreciate the true impact of currencies and take a close look at currency management decisions. *