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The role of currency derivatives in internationally diversified portfolios

  • Peter A. Abken
  • Milind M. Shirkhande
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    Diversification is widely practiced by investors seeking to reduce risk. In recent years investors have been turning to foreign markets to obtain even greater scope for diversification than domestic markets offer. With the internationalization of security portfolios, however, also comes an additional risk-foreign exchange risk. ; The use of currency derivatives in internationally diversified portfolios can help mitigate foreign exchange risk. This article investigates the impact of currency hedging on these portfolios, in particular index portfolios of stocks and bonds from markets in seven industrialized countries. The author finds that the apparent risk-reducing benefits of currency hedging of equity portfolios in the early 1980s did not continue into subsequent periods. In contrast, foreign long-term bond portfolios consistently exhibited dramatically lower variability of hedged returns compared with unhedged returns. The case for (or against) currency hedging is not decisive, though, because the lower variability of hedged returns historically is associated with lower returns. The decision to hedge depends on the investor's preference for risk and return.

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    Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

    Volume (Year): (1997)
    Issue (Month): Q 3 ()
    Pages: 34-59

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    Handle: RePEc:fip:fedaer:y:1997:i:q3:p:34-59:n:v.82no.3
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    1. Kaplanis, Evi & Schaefer, Stephen M., 1991. "Exchange risk and international diversification in bond and equity portfolios," Journal of Economics and Business, Elsevier, vol. 43(4), pages 287-307, November.
    2. King, Mervyn & Sentana, Enrique & Wadhwani, Sushil, 1994. "Volatility and Links between National Stock Markets," Econometrica, Econometric Society, vol. 62(4), pages 901-33, July.
    3. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
    4. Chow, Edward H & Lee, Wayne Y & Solt, Michael E, 1997. "The Exchange-Rate Risk Exposure of Asset Returns," The Journal of Business, University of Chicago Press, vol. 70(1), pages 105-23, January.
    5. Eun, Cheol S & Resnick, Bruce G, 1988. " Exchange Rate Uncertainty, Forward Contracts, and International Portfolio Selection," Journal of Finance, American Finance Association, vol. 43(1), pages 197-215, March.
    6. Christopher L. Culp & Merton H. Miller, 1995. "Metallgesellschaft And The Economics Of Synthetic Storage," Journal of Applied Corporate Finance, Morgan Stanley, vol. 7(4), pages 62-76.
    7. Richard M. Levich & Lee R. Thomas, 1993. "Internationally Diversified Bond Portfolios: The Merits of Active Currency Risk Management," NBER Working Papers 4340, National Bureau of Economic Research, Inc.
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