Bridge over ocean
1 July 2002 Financial Analysts Journal Volume 58, Issue 4

Conditional Hedging and Portfolio Performance

  1. David VanderLinden
  2. Christine X. Jiang
  3. Michael Y. Hu

Simple conditional currency-hedging rules often increase risk-adjusted portfolio returns and are thus of interest to investors. Several researchers have reported successful application of a “forward hedge rule” (FHR) in which one hedges whenever the foreign currency trades at a forward premium. An alternative strategy, a “real-interest-rate hedge rule” (RIR), is based on hedging when the domestic real interest rate exceeds the foreign rate. As an extension, we propose a combination of these rules—a “real forward hedge rule” (RFHR). We evaluate the performance of the rules for various currency, stock, and bond portfolios from the developed countries. In tests of risk-adjusted returns for 1976–1997, the RFHR significantly outperformed standard benchmarks and often beat the FHR and the RIR. Moreover, results of a simple dominance test for rolling 5- and 10-year periods suggest that the RFHR consistently improves portfolio performance for a U.S. investor.

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