Should I fully hedge foreign currency exposure in an international equity portfolio?

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AcadiFi · Accepted Answer

Currency hedging decision depends on: (1) investor domicile and liabilities, (2) correlation between currency and underlying asset, (3) hedging cost (forward points), (4) investor time horizon.

Framework (Froot, Perold):
- If currency is uncorrelated with assets: partial hedging reduces volatility without return impact — hedge moderately (30-50%).
- If currency is negatively correlated: unhedged positions act as natural hedge — stay unhedged.
- If positively correlated: hedge more aggressively.

Correlations empirically:
- JPY with Japanese equities: slightly negative (-0.15) — some natural hedge
- EUR with European equities: near zero
- Emerging FX with EM equities: strongly positive (+0.30 to +0.50) — currency adds to drawdowns

Example: Threadington Pension (USD-based) holds $250M international equity (Japan $80M, Europe $100M, EM $70M). Full portfolio vol 14%; unhedged international contribution 4.8%.

Hedging analysis:
- Japan: hedge 0% (natural negative correlation). Keeps natural diversifier.
- Europe: hedge 50% (low correlation, cost 70bp). Reduces euro volatility drag.
- EM: hedge 0% can't easily hedge many EM currencies; use partial proxy hedge via MXN/ZAR basket at 30%. Cost 180bp.

Post-hedge portfolio vol drops to 13.4%, return drag -0.6% from hedging costs. Sharpe ratio roughly unchanged but drawdown profile improved.

Liability matching: Threadington pays USD benefits, so FX volatility is pure risk. Defensive mandates fully hedge developed currencies. Growth mandates with long horizons often leave FX unhedged since long-run FX reverts near purchasing power parity. Policy statement should pre-commit to static hedge ratios to avoid timing traps.

Should I fully hedge foreign currency exposure in an international equity portfolio?

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