What is the appropriate currency hedge ratio?

In a globally invested portfolio, currency hedging can help an investor mitigate foreign currency risk. We look at how to find the optimal strategic currency hedge ratio for a portfolio, depending on the base currency. The currency hedge ratio is the proportion of currency exposure that is hedged back to the base currency such that volatility is minimised.

Currencies with similar characteristics share similar optimal ratios

We compared the 100% currency hedged and unhedged (i.e. 0% currency hedged) volatility of global equity portfolios denominated in various major base currencies over different time periods. We organised the base currencies into five groups based on what we believe to be the dominant common drivers of volatility.

  • Group 1 (e.g. USD, JPY)[1]: ‘risk-off’ currencies
  • Group 2 (e.g. GBP, EUR): variable risk characteristics (oscillate between risk-on and risk-off)
  • Group 3 (e.g. CAD, AUD): currencies with a significant exposure to commodities
  • Group 4 (e.g. SGD): liquid/readily tradeable emerging market proxy currencies
  • Group 5 (e.g. BRL, MXN): emerging market currencies (not discussed in this paper)

We find that the results differ significantly across base currencies and when evaluated over different time periods. As a result, the optimal strategic currency hedge ratio ranges between 0-100%, with results for different currencies clustering in groups with similar characteristics.

For example, for Group 1 countries, currency hedging tends to decrease equity volatility over 10-year rolling periods given a negative currency-equity correlation. For this reason, the optimal hedge ratio for Group 1 investors is 100%. However, currency hedging increases equity volatility over 10-year rolling periods for Group 2, 3 and 4 countries because of a positive currency-equity correlation. The optimal hedge ratios for Group 2 currencies are 62% for GBP-based investors and 55% for EUR-based investors, 0% for CAD-based and 23% for AUD-based investors (Group 3 countries) and 0% for SGD-based investors (Group 4 countries).

We also find that the optimal hedge ratios increase as bond weight increases in a multi-asset portfolio and as currency ‘riskiness’ decreases.

Currency hedge ratios for balanced portfolios, grouped by type

equity/bond allocation matrix

Source: Schroders, Datastream. Optimal hedge ratio is defined as the hedge ratio that minimises portfolio volatility. Calculated over a 20-year period ending 30 November 2018. Bonds are assumed to be 100% hedged.

Taking the cost of hedging into account

In reality, it is unlikely that investors will always be positioned at the optimal hedge ratio; some pragmatism will be required in order to determine whether or not the marginal risk reduction benefits are worth the marginal cost. This is particularly the case when hedging emerging market currencies; it is generally accepted that the cost and difficulty of hedging these generally small individual emerging currency exposures is prohibitive. For major developed market currencies, the explicit hedging costs (i.e. transaction costs) are minimal.

Because the optimal strategic currency hedge ratio differs significantly for different base currencies and when evaluated over different time periods, we believe that managers should be given sufficient leeway to manage currency exposure away from the strategic benchmark, just as they are permitted to do with other asset classes.

[1] USD is US dollars, JPY is Japanese yen, GBP is pound sterling, EUR is euro, CAD is Canadian dollars, AUD is Australian dollars, SGD is Singapore dollars, BRL is Brazilian real, MXN is Mexican peso