Should You Hedge Foreign Exchange Risk?
Since foreign exchange risk does add to the dollar risk of holding foreign
securities, it could be desirable for an investor in foreign markets to
hedge against currency movements. Currency hedgingmeans entering
into a currency contract that offsets unexpected changes in the price of
foreign currency relative to the dollar.
Although currency hedging seems like an attractive way to offset
exchange risk, in the long run it is often unnecessary and could be detri-
mental. This is because the cost of hedging depends on the difference be-
tween the interest rate in the foreign country and the domestic country,
and that could be high.
For example, the British pound depreciated from $4.80 to about
$2.00 over the past century. But since British interest rates were, on aver-
age, substantially higher than interest rates in the United States, the cost
of hedging exceeded the depreciation in the pound. Thus investors’ dol-
lar returns were higher if they owned British stocks without hedging
them than their dollar returns if they owned British stocks and paid to
hedge them.
Furthermore, for investors with long-term horizons, hedging cur-
rency risk in foreign stock markets is not important. In fact, there is some
evidence that in the long run, currency hedges might actually increase
the volatility of dollar returns.^9 In the long run, exchange-rate move-
ments are determined primarily by differences in inflation between
countries, a phenomenon called purchasing power parity. Since equities
are claims on real assets, their long-term returns have compensated in-
vestors for changes in inflation and thus protected investors from ex-
change-rate risk. Therefore, it is not worth the cost for long-term stock
investors to hedge their currency risk.Sector Diversification
Although the returns between foreign and U.S. stocks might be increas-
ingly correlated, the returns between international industrial sectors are
not becoming more correlated. The trends in correlations between the
major world industry sectors as classified by the Morgan Stanley Capi-
tal Market Indexes are shown in Figure 10-4.
Sector correlation sunk rapidly in the late 1990s and reached a low
point in 2000 when the technology stocks soared while other sectors fellCHAPTER 10 Global Investing and the Rise of China, India, and the Emerging Markets 173
(^9) See Kenneth A. Froot, “Currency Hedging over Long Horizons,” National Bureau of Economic Re-
search (NBER) Working Paper No. 4355, Cambridge, Mass.: NBER, May 1993.