Currency Risk Hedging: No Free Lunch

Currency risk hedging in international portfolios typically aims at minimizing portfolio volatility. In a purely out-of-sample context, this paper looks beyond the effect on portfolio risk and finds that currency hedging comes at a serious cost. While hedging lowers volatility of international equity and bond portfolios, it also lowers portfolio returns. The reduction in average returns more than offsets the decrease in variance and as a result, Sharpe ratios often deteriorate. In addition, hedging induces more negative skewness and significantly higher kurtosis in portfolio returns. The authors extend a no-arbitrage model of interest rates and exchange rates with an equity component and show that, in the model, hedging indeed lowers returns. Currency expected returns are positively related to the covariance between currency and equity returns. Consequently, the hedging portfolio takes short positions in currencies with positive expected returns, thereby lowering overall portfolio returns. The model also generates the observed negative effects of hedging on Sharpe ratios and skewness.