The Currency Hedging Decision: A Search for Synthesis in Asset Allocation

Abstract

Many asset allocation and liability management decisions are controversial, but the decision that frequently generates the most debate is the currency hedging decision. Strong feelings on currency exposure policy are usually based on the conviction that currency exposures should be determined by a simple mechanical process, but not everyone advocates the same process. A survey of the leading proposals to simplify the currency-management process suggests that a baseline currency policy may lend itself to some mechanical rules, but the rules are more complex than any of the widely advocated currency-hedging policies suggest. Equity and fixed-income managers, as well as asset allocators, will find currency issues easier to understand if they view currencies as they would view any other financial instrument. The importance of currency management is clearer if a manager and client start from a 50/50 hedged/ unhedged currency benchmark and if currency and money market returns are combined. The combination of currency and money market returns strips primary currency movements from stock and bond returns, clarifying intermarket correlations and creating synthetic stock and bond futures portfolios. No one can harbor illusions that this study-or any similar effort-can completely eliminate currency-hedging controversies. The argument has gone on too long, and too many positions are ossified. Nonetheless, most practitioners can understand the strengths and weaknesses of the various currency-hedging viewpoints, and the assumptions behind them can be evaluated dispassionately. This dispassionate evaluation leads to a baseline currency policy but not to a rigid prescription for currency hedging designed to satisfy the demand for a simple rule. The policy suggests an approach that can help a manager measure the cost or risk of a specific currency com

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