Optimal Currency Hedging for International Equity Portfolios

Abstract

T he currency-hedging policies of international equity portfolios have been subject to much debate by academics and practitioners, yet a consensus has failed to emerge on an optimal approach. 1 Many investors choose simply to ignore the currency component of these portfolios-in an eVestment universe of 104 MSCI EAFE Index managers totaling $419 billion of assets, as of June 2018, only 18.3% pursued active currency management. 2 Perhaps this inaction stems from uncertainty about whether hedging can truly offset risk or from concerns that hedging programs that reduce risk may also create a drag on returns. Although academics and theorists have pointed to mean-variance optimization (MVO) as a potential framework for combining risk-andreturn considerations, its practical relevance has remained questionable because of its opacity and tendency to generate unrealistic portfolios with high leverage, turnover, and tail risk. We attempt to bridge the gap between theory and practice by presenting a "modified portfolio mean-variance optimization" (MPMVO) framework that is specifically adapted to improve the practical relevance of a meanvariance approach. The result of our work is a transparent and robust hedging solution, one that both lowers portfolio risk and raises realized returns, with manageable turnover, leverage, and tail properties. MPMVO decomposes the MVO portfolio into three distinct components: (1) a pure equity piece, taken as given, (2) a "hedging" portfolio designed to minimize equity volatility, and (3) a currency "alpha" portfolio that is focused on generating high standalone riskadjusted returns. The underlying theory determines the optimal mix This study explores optimal currency exposures in international equity portfolios through the lens of a modified mean-variance optimization framework. We decomposed the optimal currency portfolio into a "hedge portfolio" that uses a dynamic risk model to minimize equity volatility and an "alpha-seeking portfolio" based on the well-documented currency styles of value, momentum, fundamental momentum, and carry. This method is an integrated and economically intuitive approach to currency management that simultaneously provides lower risk and higher returns than either hedged or unhedged benchmarks. Crucially, the solution is practical, with realistic and implementable leverage, turnover, and tail-risk characteristics.

Sparse and Stable International Portfolio Optimization and Currency Risk Management

“…Dynamic currency hedging strategies have been shown to outperform the static approaches by providing significant improvements in portfolio performance. 1 On a more recent note, Boudoukh et al (2019) derive a decomposition of a currency overlay to a riskminimizing hedge part and an alpha-generating part. Ulrych and Vasiljević (2020) extend this approach by deriving closed-form expressions for optimal currency allocation under risk and ambiguity aversion.…”

Dynamic currency hedging with non-Gaussianity and ambiguity

“…Moreover, Cho et al (2016) showed that capital tends to move out of emerging into developed countries in global down markets, leading to depreciation (appreciation) of emerging (developed) currencies. Boudoukh et al (2019) provided a decomposition of a currency overlay portfolio in a mean-variance framework consisting of a hedge sub-portfolio and an alpha-seeking currency sub-portfolio. Ulrych and Vasiljević (2020) generalized this concept to the risk and ambiguity aversion and showed that investors' dislike for model uncertainty induces stronger currency hedging demand.…”

Hedging Effectiveness as an International Financial Risk Management Strategy

“…and Glen & Jorion (1993) further explore the use of foreign currency derivatives for hedging and the benefits of currency hedging in international portfolios. Black (1989) and Boudoukh et al, (2019) provide specific models for optimizing currency risk and reward in international equity portfolios, with proposing a practical and integrated approach. Dales & Meese (2001) emphasizes the importance of strategic currency hedging, advocating for the use of portfolio optimization methods.…”