05 Sep 2007Working Paper Summaries

Global Currency Hedging

by John Y. Campbell, Karine Serfaty-de Medeiros and Luis M. Viceira

This article is forthcoming in the Journal of Finance. How much should investors hedge the currency exposure implicit in their international portfolios? Using a long sample of foreign exchange rates, stock returns, and bond returns that spans the period between 1975 and 2005, this paper studies the correlation of currency excess returns with stock returns and bond returns. These correlations suggest the existence of a typology of currencies. First, the euro, the Swiss franc, and a portfolio simultaneously long U.S. dollars and short Canadian dollars are negatively correlated with world equity markets and in this sense are "safe" or "reserve" currencies. Second, the Japanese yen and the British pound appear to be only mildly correlated with global equity markets. Third, the currencies of commodity producing countries such as Australia and Canada are positively correlated with world equity markets. These results suggest that investors can minimize their equity risk by not hedging their exposure to reserve currencies, and by hedging or overhedging their exposure to all other currencies. The paper shows that such a currency hedging policy dominates other popular hedging policies such as no hedging, full hedging, or partial, uniform hedging across all currencies. All currencies are uncorrelated or only mildly correlated with bonds, suggesting that international bond investors should fully hedge their currency exposures. Key concepts include:

It is striking that the U.S. dollar, Swiss franc, and euro are widely used as reserve currencies by central banks, and more generally as stores of value by corporations and individuals around the world.
Interestingly, the euro, the Swiss franc, and a long-short position in the U.S. dollar and the Canadian dollar are negatively correlated with world equity markets. By contrast, other currencies such as the Australian dollar, the Canadian dollar, the Japanese yen, and the British pound are either uncorrelated or positively correlated with world stock markets.
These patterns imply that international equity investors can minimize their equity risk by taking short positions in the Australian and Canadian dollars, Japanese yen, and British pound, and long positions in the U.S. dollar, euro, and Swiss franc.
For U.S. investors, currency exposures of international equity portfolios should be at least fully hedged, and probably overhedged. Exceptions are the euro and Swiss franc, which should be at most partially hedged.
Risk management demands for currencies by bond investors are small or zero, regardless of the home country of these investors, and regardless of whether these investors hold only domestic bonds or an international bond portfolio.

Author Abstract

Over the period 1975 to 2005, the US dollar (particularly in relation to the Canadian dollar) and the euro and Swiss franc (particularly in the second half of the period) have moved against world equity markets. Thus these currencies should be attractive to risk-minimizing global equity investors despite their low average returns. The risk-minimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the US dollar. There is little evidence that risk-minimizing investors should adjust their currency positions in response to movements in interest differentials.