Dramatic movements in the equity and bond markets have largely overshadowed those in the currency markets during the past few months. But currency markets have also moved substantially. In fact, currency losses have sometimes outstripped equity market declines. For example, a USD investor during the last six months experienced losses of 26% in the Australian equity market, and 22% in the UK market; however, the same investor experienced currency declines of 30% and 26% respectively. Thus, currency movements more than doubled the equity market losses for the USD-based investor in the Australian and UK markets. Big movements like these highlight the potential importance of currency hedging for investors with foreign assets.

But does currency hedging pay off in the long run? We investigate this question using data from the hedged and unhedged versions of the MSCI Global Investable Market Indices, which allow us to perform comparisons of unusually large breadth (four base currencies and 40 markets) and history (1987 to 2008).

Our research indicates that the answer depends not only on the base currency, market, and hedging horizon, but also on the investor’s goals, e.g. risk reduction, risk return/maximisation.

Our research determined that if the goal was risk reduction, JPY based investors would have benefited from hedging during the period observed, but for investors in other base currencies, the results varied depending on the market and/or hedging horizon. Our research also concluded that if the goal was return/risk maximisation, EUR and AUD based investors would have benefited for the most part, while USD and JPY investors would have largely fared better during the period we observed from not hedging their currency exposure.

Reducing currency risk
In the decision to hedge portfolio currency exposures, some investors care only about reducing currency risk rather than about the potential return opportunities. For an analysis from this perspective, we examined one measure of currency contribution: the percent increase or decrease in total risk from hedging (“Percent of Total Risk”).

We started with monthly hedged and unhedged MSCI index data from 1987 to 2008 for 40 indices and four base currencies – USD, EUR, JPY and AUD. We then calculated annualised returns and the standard deviation of those returns for hedging horizons of 1, 3, 6, and 12 months. For each index we then calculated the Percent of Total Risk, defined as the difference between the standard deviation of the hedged index and the standard deviation of the unhedged index. The Percent Total Risk measures the incremental increase or decrease in total risk from currency hedging and uses the unhedged portfolio as the benchmark for the hedged portfolio.

Table 1 provides the mean Percent of Total Risk from 1987 to 2008 for selected indices: MSCI USA, MSCI Germany, MSCI UK, MSCI Japan, and MSCI World Indices. We chose these indices to provide a diverse view of the developed markets. The highlighted, negative values mean currency hedging decreased risk, and thus, from the perspective of reducing risk, hedging made sense. The results show a somewhat mixed picture of whether hedging was beneficial from a risk reduction perspective. JPY based investors across markets and horizons benefited from hedging since it reduced risk. Investors in the MSCI USA Index also benefited from hedging regardless of their base currency. No other clear picture emerges; everything else depends on the market and/or the hedging horizon.

For example, from the perspective of the USD based investor in the MSCI World Index, hedging was beneficial for the one and three month horizons, but not for the six and 12 month horizon. For investors in Japan, hedging on the one month horizon was beneficial for all base currencies, while hedging on the six and 12 month horizons was not beneficial; for the three month horizon, USD and EUR based investors benefited from hedging but AUD based investors did not. Also note that the range is large, with a decrease of risk by 32% for the JPY investor in the MSCI USA Index and an increase of risk by 15% for the AUD investor in the MSCI Japan Index.

These results indicate that for the investor interested in reducing risk through currency hedging, the investor needs to pay close attention to all three variables – base currency, hedging horizon, and markets – before making a decision regarding whether to hedge.

Return and risk
While some investors are only interested in reducing risk by hedging their currency exposures, others are also interested in the potential return opportunities. In this section, we look at the currency hedging decision from the return and risk perspective. Our measure for analysing return and risk is the information ratio. For the same dataset described above, we first calculate the annualised excess returns of the hedged over the unhedged indices for the 1, 3, 6 and 12 month hedging horizons, as well as means and standard deviations of the excess returns. From these values, we calculated the information ratio, which is defined as the mean excess return divided by the standard deviation of the excess returns.

Table 2 provides the values of the mean information ratios from 1987 to 2008. As in Table 1, we present results for the MSCI USA, MSCI Germany, MSCI UK, MSCI Japan, and MSCI World Indices, and negative values are highlighted. However, in Table 2 negative values are negative information ratios and mean no hedging benefit resulted from a return and risk perspective. Positive values mean hedging was beneficial.

The results from a return and risk perspective are clearer relative to those from a risk reduction perspective. The results group around base currencies. For JPY investors, hedging was not beneficial since information ratios were negative across all markets and hedging horizons. For the EUR and AUD based investors, information ratios were negative across all hedging horizons and almost all markets, with the exception of the MSCI UK Index, indicating the benefits of hedging for investors in these base currencies. As for USD based investors, hedging was not beneficial except for those investors in the MSCI Japan Index. As recent events have shown, the JPY can be one of the only currencies that appreciate respective to the USD when the USD itself appreciates against most other currencies. The JPY appreciated 22% versus the USD during the past six months.

Note that the values of the information ratios can be relatively high. For the positive information ratios, the highest value is 2.68 with 33% of the positive values at 0.5 and above. According to Richard Grinold and Ronald Kahn, the values 0.5 and greater are in the 75th percentile and above for all fund managers before fees. The results are particularly interesting given that they relate to return and risk considerations from passive hedging rather than from actively seeking alpha from a currency overlay.

Conclusions
The magnitude and volatility of currency movements during the past months underscore the importance of the currency hedging decision for investors.

Using MSCI index data, we have highlighted some of the relevant factors for the hedging decision, including: (1) goals: e.g. risk reduction or return/risk maximisation; (2) base currency; (3) hedging horizon; and (4) market or portfolio. Based on the goal of risk reduction, JPY investors benefited from hedging from 1987 to 2008.

From the perspective of return and risk, EUR and AUD investors benefited from hedging, while JPY and USD investors did not. However, the results were less clear cut for risk reduction than for return and risk.

Dr Kelly Chang was an Assistant Professor at the University of Wisconson-Madison and a Robert Wood Johnson Scholar in Health Policy at the University of Michigan, Ann Arbor. Prior to joining MSCI Barra in August 2008, she was a Senior Economist at Greylock McKinnon Associates, an economics consulting firm based in Cambridge, MA. She has also worked for UBS Wealth Management and Business Banking as Chief Currency Strategist and Senior Economist in Switzerland.

BIBLIOGRAPHY

Richard C. Grinfold and Ronald N. Kahn, ‘Active Portfolio Management: A Quantitative Approach For Providing Superior Returns and Controlling Risk’, Second Edition, McGraw Hill, San Francisco, 2000.