Bridge over ocean
1 July 1992 Financial Analysts Journal Volume 48, Issue 4

Is Complete Hedging Optimal for International Bond Portfolios?

  1. Victor S. Filatov
  2. Peter Rappoport

International investments offer diversification benefits for investors, but they also expose portfolios to highly volatile currency movements. Some have argued that hedging currency exposure completely offers investors a free-lunch lower risk with no sacrifice of expected return. Complete hedging did turn out to be a sound strategic position for U.S. dollar based investors in the 1980s.

Over the 1980s, however, non U.S. investors could have lowered their international portfolios' risks by taking on some currency exposure. For these investors, the benefits of diversification across currencies more than offset the cost of the currencies volatilities. Evidently the free-lunch argument misses something and investors should be concerned that the missing link might change across countries or over time.

The conditions under which currency hedging does or does not contribute to diversification turn on the correlations between asset and currency returns standard parameters in optimal portfolio selection. Investors need to take care in estimating these parameters given their importance to the hedging decision. On the other hand investors need have no strong views about or special expertise in forecasting exchange rate movements in order to avail themselves of the diversification benefits of currency exposure.

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