Investors can increase their returns by holding foreign stocks in addition to domestic ones. They can also gain by taking the appropriate amount of exchange risk. But what amount is appropriate?
Assume that investors see the world in light of their own consumption goods and count both risk and expected return when figuring their optimum hedges. Assume that they share common views on stocks and currencies, and that markets are liquid and there are no barriers to international investing. In this perfect world, it is possible to derive a formula for the optimal hedge ratio.
This formula requires three basic inputs—the average across countries of the expected returns on the world market portfolio; the average across countries of the volatility of the world market portfolio; and the average across all pairs of countries of exchange rate volatility. These values can be estimated from historical data.
The formula in turn gives three rules. (1) Hedge foreign equity. (2) Hedge less than 100 per cent of foreign equity. (3) Hedge equities equally for all countries. The formula’s solution applies no matter where an investor lives or what investments he holds. That’s why it’s called “the universal hedging formula.”