Handbook of Exchange Rates

18.1 Introduction

The unprecedented volatility of exchange rates during the 2007–2008 credit crisis demonstrated that the decision to hedge or not to hedge exposure to currencies can significantly impact total portfolio return and volatility. In a period when equity prices dropped sharply, foreign investors in US equities with no currency hedges on average did better than their fully hedged counterparts. Unhedged Japanese investors, however, suffered sharp currency losses at times when global equities did badly, while hedged investors experienced smoother returns.

Experience from recent years shows that currency hedging may not always have the intended consequence of reducing portfolio volatility. The negative correlation between the US dollar and equities meant that investors who hedged their US equity exposures increased their losses via currency hedges, adding volatility to their returns.

In this chapter, we investigate the historical impact of currency hedging on the volatility and returns of foreign bond and equity investments. Our focus is entirely empirical and covers a period of several different market regimes. Relative to previous studies in the area, we expand our study to include investors with all 10 major base currencies. In addition to traditional government bond and equity index holdings, we also investigate the performance of hedging the Citi US High Yield corporate bond index.

Section 18.2 of this chapter outlines previous empirical findings on currency hedging. ...