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.
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.
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
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. *