A Valuation Approach to Currency Hedging

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.