The management of the currency risks inherent in a portfolio of international assets can be separated from the management of the assets themselves. Hedging the portfolio’s full exposure to currency risks lowers volatility without lowering the portfolio’s expected return. But more complex hedging strategies offer better solutions for specific investors. Less than full hedging, for example, can be designed to take into account the investor’s future consumption of foreign goods. And investors who believe they can forecast long-term cyclical movements in currency values will want to be more or less hedged according to their forecasts.
Once an investor determines the proportion of currency exposure to hedge, she can choose between several currency risk management techniques. Full hedging is the most straight-forward; it eliminates exposure to both upside and downside moves in foreign currencies. Minimum-variance hedging is similar to full hedging but takes into account the correlations between currency movements and asset values. Downside, or option-based, hedging protects a portfolio from downside moves due to currency changes while retaining the portfolio’s exposure to upside moves.
A hedge of the total portfolio is generally less costly than a hedge constructed of options on the individual currencies, but it is dependent on accurate forecasts of currency correlations. Portfolio hedging involves the creation of a synthetic put (usually via the sale of forward and futures contracts). A put constructed by determining the relative importance of each currency to the aggregate currency value of the portfolio is generally the most cost-efficient approach; it also provides insights into the marginal sensitivity of the internationally diversified portfolio to changes in specific currencies.