Bridge over ocean
1 March 1994 Financial Analysts Journal Volume 50, Issue 2

A Valuation Approach to Currency Hedging

  1. Thomas B. Hazuka
  2. Lex C. Huberts
Because Central Banks manipulate their countries' short interest rates in attempting to control inflation, exchange rates and business-cycle expansions and contractions, real interest rates tend to differ across borders, at least in the short term. A strategy that captures these differences can yield positive returns from opportunistic manipulation of international portfolios' currency exposures. A model that incorporates spot exchange rates, forward exchange rates and estimates of expected inflation is used to forecast the opportunity cost of hedging--the spot rate an internationally diversified portfolio could capture by remaining unhedged versus the forward rate it locks in by being fully hedged. Over a 228-month period, a simulation strategy based on this model outperformed a fully hedged benchmark, an unhedged benchmark and a "naive" strategy based on nominal interest rates.
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