Many investors take a global perspective when building portfolios to achieve their investment goals. With the benefits of greater diversification and an expanded opportunity set come exposure to foreign currencies. For investors with unhedged foreign investments, when their home currency appreciates, it has a negative impact on returns; when it depreciates, the impact is positive. How can investors make an informed decision about whether and when to hedge currency exposures?
Using data on 12 developed markets from 1985 to 2019, recent research by Dimensional develops and tests a framework for evaluating the impact of currency hedging on expected returns and volatility for global equity and fixed income portfolios. An important takeaway for investors is that currency hedging decisions should depend on their asset allocations and investment goals.
The impact of currency hedging on volatility depends mostly on the magnitude of asset volatility relative to currency volatility. Stocks tend to be more volatile than currencies and drive the overall volatility of a global equity portfolio. Currencies, however, are more volatile than bonds and dominate the overall volatility of a global bond portfolio. Hence for investors with high allocations to stocks, hedging currencies does not meaningfully reduce return volatility. In contrast, for investors with high fixed income allocations, currency hedging is an effective way to reduce portfolio volatility.
The study also confirms that monthly currency returns are largely unpredictable and not reliably different from zero on average, so hedging decisions based on predictions of currency movements are unlikely to add value. Another implication is that forward currency premiums (discounts), which are based on observable currency spot and forward rates, contain reliable information about differences in expected return between unhedged and hedged securities. Therefore, a dynamic hedging strategy can increase expected returns by selectively hedging the currency exposure in markets where the forward currency premium is positive and leaving the currency exposure unhedged otherwise. This approach does not substantially increase portfolio volatility when the majority of investments are in equities and can be appropriate for fixed income investors who are willing to accept more volatility in pursuit of higher expected returns.
Currency hedging is among the many aspects to consider when building global portfolios. We believe a robust framework backed by rigorous research, like the one shown in this study, can help investors make well-informed decisions to better achieve their investment goals.
Currency hedging: Establishing a position that mitigates or decreases the risk associated with an existing currency position. Currency forward rate: The exchange rate at which market participants agree today to exchange one currency for another at a future date. Currency spot rate: The current exchange rate at which market participants can exchange one currency for another. Forward currency premium (discount): The difference (often expressed as percentage difference) between the currency forward rate and the currency spot rate of a currency pair. It is referred to as a premium (discount) when the difference is positive (negative). Volatility: A statistical measure of the dispersion, or variability, of returns for a given security, currency pair or portfolio. Volatility is often measured using standard deviation.
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd, Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
AUSTRALIA and NEW ZEALAND: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.
JAPAN Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.
Dimensional Japan Ltd. Director of Kanto Local Finance Bureau (FIBO) No. 2683 Membership: Japan Investment Advisers Association
FOR PROFESSIONAL INVESTORS IN HONG KONG. This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this materiel, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice.
Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.
SINGAPORE This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.
This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this materiel, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.
To Hedge or Not to Hedge?
Many investors take a global perspective when building portfolios to achieve their investment goals. With the benefits of greater diversification and an expanded opportunity set come exposure to foreign currencies. For investors with unhedged foreign investments, when their home currency appreciates, it has a negative impact on returns; when it depreciates, the impact is positive. How can investors make an informed decision about whether and when to hedge currency exposures?
Using data on 12 developed markets from 1985 to 2019, recent research by Dimensional develops and tests a framework for evaluating the impact of currency hedging on expected returns and volatility for global equity and fixed income portfolios. An important takeaway for investors is that currency hedging decisions should depend on their asset allocations and investment goals.
The impact of currency hedging on volatility depends mostly on the magnitude of asset volatility relative to currency volatility. Stocks tend to be more volatile than currencies and drive the overall volatility of a global equity portfolio. Currencies, however, are more volatile than bonds and dominate the overall volatility of a global bond portfolio. Hence for investors with high allocations to stocks, hedging currencies does not meaningfully reduce return volatility. In contrast, for investors with high fixed income allocations, currency hedging is an effective way to reduce portfolio volatility.
The study also confirms that monthly currency returns are largely unpredictable and not reliably different from zero on average, so hedging decisions based on predictions of currency movements are unlikely to add value. Another implication is that forward currency premiums (discounts), which are based on observable currency spot and forward rates, contain reliable information about differences in expected return between unhedged and hedged securities. Therefore, a dynamic hedging strategy can increase expected returns by selectively hedging the currency exposure in markets where the forward currency premium is positive and leaving the currency exposure unhedged otherwise. This approach does not substantially increase portfolio volatility when the majority of investments are in equities and can be appropriate for fixed income investors who are willing to accept more volatility in pursuit of higher expected returns.
Currency hedging is among the many aspects to consider when building global portfolios. We believe a robust framework backed by rigorous research, like the one shown in this study, can help investors make well-informed decisions to better achieve their investment goals.
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GLOSSARY
Currency hedging: Establishing a position that mitigates or decreases the risk associated with an existing currency position.
Currency forward rate: The exchange rate at which market participants agree today to exchange one currency for another at a future date.
Currency spot rate: The current exchange rate at which market participants can exchange one currency for another.
Forward currency premium (discount): The difference (often expressed as percentage difference) between the currency forward rate and the currency spot rate of a currency pair. It is referred to as a premium (discount) when the difference is positive (negative).
Volatility: A statistical measure of the dispersion, or variability, of returns for a given security, currency pair or portfolio. Volatility is often measured using standard deviation.
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd, Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
AUSTRALIA and NEW ZEALAND: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.
JAPAN Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.
Dimensional Japan Ltd.
Director of Kanto Local Finance Bureau (FIBO) No. 2683
Membership: Japan Investment Advisers Association
FOR PROFESSIONAL INVESTORS IN HONG KONG. This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this materiel, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice.
Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.
SINGAPORE
This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.
This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this materiel, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.
11/19/2020
https://www.mydimensional.com/to-hedge-or-not-to-hedge
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