An Optimal Hedge Ratio Discussion - One Size Does Not Fit All

Abstract

As institutional investors increase their allocations to non-domestic securities, the associated currency risk becomes an increasingly pertinent subject in need of addressing. Our advisory position on currency hedging is that for most clients, the drawbacks can be significant and the benefits over the long-term may be small and are not guaranteed. There are no easy answers in regards to currency management. In this paper we provide background on the currency market, develop a decision making framework as it pertains to whether or not to hedge currency, and share our thoughts and experience in regards to implementation should clients determine hedging currency is appropriate given their specific circumstances. Contained within Appendix I is a currency hedging decision matrix which summarizes relevant issues for consideration as it pertains to hedging currency. In addition, we’ve developed an Excel-based tool which encompasses the points outlined in the currency hedging decision matrix. This tool allows the user to weight the importance of each factor resulting in a “suggested” hedge ratio. As with any tool such as this, it should be used as guidance in developing an appropriate hedge ratio. Contained within Appendix II are two case studies, detailing institutional investors with unique circumstances, which helps to illustrate the functionality and usefulness of this Excel-based tool.