Country and currency diversification of bond investments: do they really make sense for Swiss investors?

Abstract

The inclusion of hedged or unhedged foreign currency bonds within a strategic asset allocation is a crucial decision which should be analyzed carefully. The goal of this paper is to provide a contribution to this analysis by focusing particularly on the time horizon of the investment. Results are analyzed from the perspective of a Swiss investor. We find that over the last 21 years, investing in bonds denominated in Swiss Francs has been clearly less efficient in terms of risk-adjusted returns than investing in a hedged global bond portfolio. For short-term investors, we find robust evidence against the hypothesis of investing in unhedged foreign currency bonds. The picture changes dramatically, however, when we consider an investment horizon of 6 years and the normal case of balanced portfolios including also equities and domestic bonds. In this case, the optimal strategy for the period we analyzed would have been to hedge only the exposure to US dollar bonds. Copyright Swiss Society for Financial Market Research 2007Bonds, Currency risk, Hedging, International diversification, Optimal portfolios, F31, G11,

Optimal currency hedge and the carry trade

“…We show that portfolios of foreign bond investments are sensitive to foreign currency risk and these risks can only be partially mitigated in multiple asset portfolios. In line with the previous literature on international-fixed income portfolios, such as Carcano (2007), Campbell et al (2010), Schmittmann (2010), de Roon et al (2012) and Caporin et al (2014), we find that different kinds of hedging strategies improve the return/risk profiles in our sample significantly. Unhedged positions perform the worst in terms of the volatility of the portfolios.…”

“…If exchange rates are mean reverting, hedging in theory should improve the risk/return profile of the portfolio in the short term by reducing volatility, but not in the long term, because the reduction in volatility will not compensate for the cost of hedging, which increases with the investment horizon. This problem has been analysed by Froot (1993) and Carcano (2007), and their studies confirm the hypothesis of hedging only being efficient in the short horizon. Campbell et al (2010) and Schmittmann (2010) combine the question of volatility and cross-correlation with the time horizon question, and reach the conclusion that some hedging can be optimal in the long term as well.…”

“…The literature review covers the literature since the 1980s and is organised along three dimensions that the literature has centred on when analysing whether, how and how much currency risk should be hedged. The first of these lines looks at the composition of the portfolio and whether a single strategy could work for all investors (Perold and Schulman, 1988; Black, 1989); the second looks at whether the investment horizon of the investors is short or long (Froot, 1993; Carcano, 2007; Campbell et al , 2010; Schmittmann, 2010); and the third considers the complexity of the hedging strategy and whether it is static or dynamic (Kroner and Sultan, 1993; Ku et al , 2007; Schmittmann, 2010; Caporin et al , 2014; Cho et al , 2019). The main question is the same in all cases, i.e.…”

“…Firstly, while there is a strong indication that hedging either optimally or fully reduces the volatility of bond portfolios, there is no clear answer as to what the optimal level of hedge should be for bond portfolios, nor to the question of how to determine the optimal level of hedge. Most earlier studies analyse the issue by looking at single assets without addressing the construction of portfolios (Choudhry, 2004; Ku et al , 2007; Chang et al , 2013; Lai, 2019), or by considering only stocks or stocks and bonds in conjunction when the portfolio problem is approached (Carcano, 2007; Caporin et al , 2014). The dynamic hedging of bond portfolios is not addressed in detail, as studies such as Choudhry (2004), Ku et al (2007) and Lien (2009) focus on stocks and foreign currency and on the use of futures as hedging instruments.…”