Bridge over ocean
1 May 1988 Financial Analysts Journal Volume 44, Issue 3

The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards

  1. André F. Perold
  2. Evan Schulman

At recent levels of exchange rate volatility, hedging currency exposure greatly enhances the diversification potential of foreign investments. By following a hedged policy, U.S. investors gain as much in risk reduction as they do by investing abroad, unhedged, in the first place. Outside of transaction costs, it is hard to make the case that currency hedging reduces long-run expected returns, and the transaction costs associated with hedging appear minimal.

Under the circumstances, managers should be measured against a hedged benchmark. The standard that is easiest to apply consists of the foreign market return in local currency, adjusted for both the ex post covariance between this return and the exchange rate and the forward premium/discount.

Exposure to currency risk should be viewed as an active decision.

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