Risk Management: Foundations for a Changing Financial World

CHAPTER 37

HEDGING: OPTIMIZING CURRENCY RISK AND REWARD IN INTERNATIONAL EQUITY PORTFOLIOS^ak

Fischer Black

 

 

In a world where everyone can hedge against changes in the value of real exchange rates (the relative values of domestic and foreign goods), and where no barriers limit international investment, there is a universal constant that gives the optimal hedge ratio—the fraction of your foreign investments you should hedge. The formula for this optimal hedge ratio depends on just three inputs:

• The expected return on the world market portfolio.

• The volatility of the world market portfolio.

• Average exchange rate volatility.

The formula in turn yields three rules:

• Hedge your foreign equities.

• Hedge equities equally for all countries.

• Don’t hedge 100 percent of your foreign equities.

This formula applies to every investor who holds foreign securities. It applies equally to a U.S. investor holding Japanese assets, a Japanese investor holding British assets, and a British investor holding U.S. assets. That’s why we call this method “universal hedging.”

WHY HEDGE AT ALL?

You may consider hedging a “zero-sum game.” After all, if U.S. investors hedge their Japanese investments, and Japanese investors hedge their U.S. investments, then when U.S. investors gain on their hedges, Japanese investors lose, and vice versa. But even though one side always wins and the other side always loses, hedging reduces risk for both sides.

More often than not, when performance is measured in local ...