Economics Update (October-December 1997)

Currency Derivatives in Internationally
Diversified Investment Portfolios

I nvestors seeking to reduce risk in their investment portfolios often engage in international diversification. In recent years, this practice has grown as investors search for alternatives to help them obtain greater scope for diversification than domestic markets can offer. While international diversification helps to reduce the impact of certain systemic risks associated with investments in one country, the internationalization of security portfolios can create additional risks — foreign exchange risks.

Many investors have turned to currency derivatives to help diversify among currencies and reduce foreign exchange risks. In the Atlanta Fed's Third Quarter 1997 Economic Review, Fed economist Peter Abken and visiting scholar Milind Shrikhande examine the impact of currency hedging of investment portfolios — specifically, index portfolios of stocks and bonds from markets in seven industrialized nations: Canada, France, Germany, Japan, Switzerland, the United Kingdom and the United States.

The authors examined data for international equity and bond returns and foreign exchange rates for sample periods between 1980 and 1996 for equities and 1986 and 1996 for bonds. They found 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. This finding agrees with earlier studies of currency hedging based on earlier sample periods.

The authors find that the case for, or against, currency hedging is not decisive because the lower variability of hedged returns historically is associated with lower returns. To a large extent, the decision to hedge depends on the investor's preference for risk and return.

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