Aurora Borealis
1 January 1995 Financial Analysts Journal Volume 51, Issue 1

Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios

  1. Fischer Black

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 the circumstances for three rules. (1) Hedge foreign equity. (2) Hedge less than 100 percent of foreign equity. (3) Hedge equities equally for all countries. The formula's solution applies no matter where an investor lives or what investments are held—which is why it is called "the universal hedging formula."

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