U.S. plan sponsors seeking to diversify internationally may encounter losses from currency translation. These can add significantly to international portfolio volatility. Solutions for managing this risk have thus far ranged from doing nothing to hedging all currency exposure.
A systematic method for identifying the optimal degree of currency exposure depends on three critical factors—(1) hedging costs, (2) the size and composition of the international allocation and (3) sponsor risk-aversion. This method produces a “normal” currency exposure unique to each plan sponsor’s circumstances.
At likely hedging costs, the average sponsor will not find currency hedging beneficial at international allocations below 5 per cent of total assets. At 10 per cent of assets, currency hedging is attractive only at lower cost estimates. Sponsors with international allocations above 15 per cent should strongly consider hedging, but not for 100 per cent of their currency exposure.