When the investor adds foreign assets to his portfolio, he also adds exposure to exchange rate fluctuations. A positive asset return can therefore be canceled out by a negative exchange rate move. Removing the currency risk is trivial using forwards or futures, and there might be an advantage from hedging the currency risk in a stock portfolio. The academic literature does not provide a clear-cut answer to whether the investor should hedge the currency risk or not. One position is that hedging is a free lunch because it lowers volatility without changing the expected return while another position is that since currencies are a zero sum game, and exchange rates tend to be mean-reverting over time, hedging should add volatility. Hedging the listing currency of a stock is not the same as removing the influence from exchange rate changes on the value of the company since most companies face international competition and have cash flows in more currencies than one. I find support for the argument that currency hedging is a free lunch for the Danish investor. Over the period of 1976-2009, adding a passive currency overlay to an internationally diversified stock portfolio would have lowered volatility of the return in Danish kroner. Risk-adjusted returns are accordingly higher, and adding a passive overlay should still be preferred even when adjusting for costs comparable to those seen in big mutual funds. The results hold both through the 1980s, the 1990s and the 2000s, as well as through both economic expansions and contractions. Hedging currencies is essentially a shift in focus from the spot rate movements to the difference between the forward rate and the realized spot rate at delivery. I show that a carry trade overlay, which actively takes advantage of patterns in the difference between the forward rate and the realized spot rate at delivery, increases both risk and average return, and has higher risk-adjusted returns than the passive full hedge.
|Educations||MSc in Finance and Strategic Management, (Graduate Programme) Final Thesis|
|Number of pages||87|