The literature on currency hedging of an international portfolio has not reached a final verdict. However, when global markets fall, developing market currencies tend to depreciate, mitigating part of the negative global returns in a portfolio that is not fully hedged. The findings come from a new study authored by Dr. Eduardo Walker to be published in the June issue of the Journal of Business Research.

“Hard currencies act as natural hedges against global and local portfolio losses since they tend to appreciate with respect to emerging market currencies when the world portfolio return is negative,” writes Walker. “This result is likely to hold generally for relatively open economies with flexible exchange rate regimes.”

There is a wide spectrum of research on whether to hedge or not hedge a portfolio with foreign currency exposure. Dr. Bruno Solnik addressed the issue as early as 1974. Solnik concluded that the optimal hedge ratio lies between 50% (where regret aversion dominates risk aversion) and 100% (where investors will have no regret aversion). Differences in the level of regret aversion among investors may explain why there is such a wide diversity of currency hedging policies among institutional investors.

Fisher Black (1990) also shows that investors should never fully hedge their currency exposure. He favoured a universal hedge ratio that should be the same for all investors, regardless of nationality.

Global portfolio

The issue of currency hedging continues to grow for emerging-market based investors who invest globally. This is a perspective that Walker examines in his study. His findings that a number of Latin American countries have higher currency betas than in the past have provided some of the rationale for Chile to consider removing the minimum hedge ratio used in its five pension funds. A higher beta reduces the risk of international investments for emerging-market based investors who are not hedged.

“Latin American currency betas with respect to global equity have tripled on average when comparing the five years until 2005 with the previous five,” concludes the study. “Intuitively, this means that more strongly than before emerging market currencies tend to depreciate when global equity returns are negative and vice versa. This condition could be due to a flight to quality phenomenon when global stock markets tend to fall at the same time that capital flights from emerging markets depreciate local currencies.”

Another explanation for positive currency betas is linked to emerging market export prices. Open economies that significantly rely on exports benefit from competitively priced currencies. The study covers seven Latin American countries that allocate part of their portfolio to global equities. Returns were measured using the MSCI World Free Index and translated into the currency of the country of origin.

VB