Should I hedge currency exposure on international equity investments?

Question

AcadiFi · Accepted Answer

Currency hedging of international equity is a tradeoff between reducing volatility and bearing hedging costs. The optimal approach depends on investor horizon, home currency stability, and correlation structure.

Academic findings:

1. CURRENCY HAS NEGLIGIBLE LONG-RUN EXPECTED RETURN: Over 20+ years, developed-market FX returns average near zero (ignoring carry). So hedging doesn't sacrifice expected return much.

2. FX REDUCES SHORT-TERM VOLATILITY WHEN HEDGED: Unhedged international equity from a USD investor has σ ≈ 17-19%, hedged ≈ 14-16%.

3. HEDGING COST ≈ INTEREST RATE DIFFERENTIAL: Hedging EUR back to USD when US rates are higher earns a positive carry. Hedging AUD when Australian rates are higher costs money.

When to hedge:

1. SHORT HORIZON (< 3 years): Hedge. FX volatility swamps equity signal.
2. LONG HORIZON (> 10 years): Don't bother or hedge partially. FX mean-reverts.
3. EMERGING MARKETS: Hedging costs are prohibitive (5-15% per year for currencies like TRY, ARS, ZAR) and hedges may not be available. Don't hedge; reduce position size instead.
4. DEVELOPED MARKETS: Hedging is cheap; 50% hedge is a common 'minimum regret' choice.

```mermaid
flowchart LR
  A[Int'l Equity] --> B{Horizon}
  B -->|Short| C[Hedge]
  B -->|Long| D[Partial/none]
  A --> E{Market}
  E -->|DM| F[Hedge cheap]
  E -->|EM| G[Don't hedge]
```

Case: Silvercliff Pension (USD investor, 15-year horizon) holds 35% international equity. It hedges 50% of developed-ex-US exposure (capture some currency diversification) and 0% of emerging markets. Expected volatility reduction: 80 bps with expected return cost of 10-20 bps. Net Sharpe improvement.

Another angle: currency can hedge domestic tail risk. USD tends to strengthen in global risk-off — so unhedged foreign equity takes a bigger hit in crises. This argues for hedging from risk-off currencies and unhedging from safe-haven currencies.

Should I hedge currency exposure on international equity investments?

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