AQR White Paper
Sharp losses associated with the rapidly rising value of the U.S. dollar — over $1 trillion for U.S. pension plans in unhedged portfolios between July 2014 and March 2015, according to Reuters — has sparked renewed interest in the question of optimal foreign currency hedging. While hedging would clearly have been beneficial for U.S. investors recently, what is the long term case for strategic currency hedging?
The analysis presented in this paper shows that:
- In the long term, foreign currencies have earned a very low level of return, consistent with economic intuition.
- The standalone risk of foreign currencies is not trivial, and typically about half that of domestic equities.
- The correlation between foreign currencies and domestic equity returns varies over time, but is positive on average and rarely significantly negative.
Given this, a volatility minimizing, or mean-variance optimizing investor would not favor an unhedged portfolio. While some amounts of currency risk can provide diversification benefits during certain time periods, the amount found in an unhedged portfolio is too great.
A more optimal allocation, achieved via a currency hedging program, would allow them to achieve a more desirable risk profile without a meaningful sacrifice in terms of expected returns.