Universal hedging: Optimizing currency risk and reward in in

• Published in: Financial analysts journal 1995-01, Vol.51 (1), p.161
• Main Author: Black, Fischer
• Format: Article
• Language: English
• Subjects: Apples; Capital assets; Consumption; Currency; Economic models; Equilibrium; Expected values; Foreign exchange rate risk; Foreign exchange rates; Foreign investment; Hedging; International finance; Portfolio management; Statistical analysis; Stock exchanges; Stocks; Volatility
• ISSN: 0015-198X; 1938-3312

In a world where everyone can hedge against changes in the value of real exchange rates, and where no barriers limit international investment, there is a universal constant that gives the optimal hedge ratio - the fraction of the foreign investments an investor should hedge. The formula for this optimal hedge ratio depends on just 3 inputs: 1. the expected return on the world market portfolio, 2. the volatility of the world market portfolio, and 3. average exchange rate volatility. The formula in turn yields 3 rules: 1. Hedge foreign equities. 2. Hedge equities equally for all countries. 3. Do not hedge 100% of the foreign equities. The universal hedging formula assumes that investors hedge real (inflation-adjusted) exchange rate changes, not changes due to inflation differentials between countries. The formula's results may be thought of as a base case. When an investor deviates from the formula because she thinks a particular currency is overpriced or underpriced, she can plan to bring her position back to normal as the currency returns to normal.