Financial analyst

TO HEDGE OR NOT TO HEDGE — THAT IS THE QUESTION!

Central to the idea of managing currency risk separately and independently from the risk represented by the underlying asset is the issue of whether or not to hedge that currency risk. Just as the idea of separating currency risk continues to attract much debate, so the more specific issue of hedging out that currency risk remains a topic of much controversy and discussion, both within the academic world and within the financial markets themselves. Indeed, while there may be some who take a pragmatic view of compromise, approaching this from the perspective of a case-by-case basis, the majority seem polarized between two opposite and opposing camps. Within the academic world, this is expressed at opposite ends of the spectrum by Perold and Schulman (1988) and by Froot and Thaler (1990, 1993), who advocated on the one hand full hedging of currency risk and on the other leaving currency risk unhedged.
There is a clear division of opinion within the financial markets as well, if perhaps marginally less pronounced and polarized. Within the institutional investor community, international equity funds are generally known for taking a view of either not hedging currency risk or adopting an unhedged currency benchmark. Fixed income funds are clearly more tolerant of the idea of hedging currency risk, frequently adopting a currency hedging benchmark that reflects such a view. We will go through the range of possible currency hedging benchmarks shortly, but for now suffice to say that they vary at the most basic level, being hedged (partially or fully) and unhedged. The “sell side”, which is used to selling foreign exchange-type products, is well versed in the need for hedging availability. Conversely, the fixed income sell side within the financial industry in general appears to focus more on selling the core product rather than on its denomination, or the potential need to separate and hedge out that corresponding currency risk. In response, the majority of rigorous studies have distilled this debate down to an elegant compromise between risk and reward, focusing less on an absolute answer to the question than the need to account for the individual investor’s requirements and the portfolio variance across the spectrum of hedging strategies. The debate between hedging or not hedging thus remains unresolved, and there appears little prospect on the horizon of that changing. There is no one answer to the question of whether or not to hedge currency risk, nor perhaps should there be. Any such answer depends crucially on the specifics of the investor’s portfolio aims and constraints. The assumption might on the face of it be that one’s approach to managing currency risk can be broken down simply into active or passive — or alternatively not to manage currency risk! At a slightly more sophisticated level however, the focus should be on the type of returns targeted; that is absolute vs. relative returns.