Handbook of Exchange Rates

18.2 Overview of Empirical Hedging Studies

Empirical studies on currency hedging typically find that while arguments for the volatility benefit of hedging are compelling in government bond portfolios, evidence for other asset classes is more mixed. There is also strong evidence that conditional hedging based on the forward premium (i.e., hedging currencies with low yield and leaving currencies with high yield unhedged) has improved total returns in the past. At the same time, there appears to be no agreement on whether currency hedging has reduced the volatility of international equity portfolios.

The arguments for a high degree of currency hedging tend to be more concentrated in early studies. Eun and Resnick (1988) show that exchange rate uncertainty is a largely nondiversifiable factor, which adversely affects the performance of foreign portfolios. Using a sample of weekly data from December 1979 to 1985, they find that currency hedging significantly improved risk-adjusted returns from foreign equity holdings for a US-dollar-based investor. Similarly, Perold and Schulman (1988) argue that the risk premium in currencies will not persist over time; with the expected long-term return from currencies zero, hedging can reduce volatility without affecting returns, giving the investor a “free lunch”.

Eaker and Grant (1990) find in what was probably one of the earliest carry trade papers that hedging US dollar only when there is a forward premium outperformed both fully hedged and unhedged ...