Global Currency Hedging

Over the period 1975 to 2005, the US dollar (particularly in relation to the Cana-dian dollar) and the euro and Swiss franc (particularly in the second half of the period) have moved against world equity markets. Thus these currencies should be attractive to risk-minimizing global equity investors despite their low average returns. The risk-minimizing currency strategy for a global bond investor is close to a full cur-rency hedge, with a modest long position in the US dollar. There is little evidence that risk-minimizing investors should adjust their currency positions in response to movements in interest differentials. What role should foreign currency play in a diversi\u85ed investment portfolio? In practice, many investors appear reluctant to hold foreign currency directly, perhaps because they see currency as an investment with high volatility and low average re-turn. At the same time, many investors hold indirect positions in foreign currency when they buy foreign equities or bonds without hedging the currency exposure im-plied by the foreign asset holding. Such investors receive the foreign-currency excess return on their foreign assets, plus the return on foreign currency. In this paper we consider an investor with an exogenous portfolio of equities or bonds and ask how the investor can use foreign currency to manage the risk of the portfolio. We assume that the investors domestic money market is riskless in real terms, and use mean-variance analysis to \u85nd the foreign currency positions that minimize the risk of the total portfolio. We consider seven major developed-marke