The Takeaway
This research aims to explain the phenomenon wherein we observed a hedged-currency portfolio exhibiting higher volatility than an unhedged-currency portfolio.
Currency hedging should not be viewed as a direct mechanism to reduce the total portfolio risk. The purpose of hedging currency risk should be thought of as a process to ensure that the risk of the home-currency portfolio closely mimics the foreign-currency portfolio, by eliminating the impact on risk contributed by currency translations.
The unhedged home-currency portfolio experiences risk from three main sources: the inherent risk of the foreign-currency portfolio, the risk associated with forex-rate movements, and the risk resulting from the interaction between foreign-currency portfolio returns and forex-rate movements.
Currency hedging should not be viewed as a direct mechanism to reduce the total portfolio risk. While hedging foreign exchange (forex) risk aligns the risk profile of international investments with that of domestic portfolios, it does not always lower overall portfolio volatility. In some cases, hedging can inadvertently increase total portfolio risk. This occurs when a negative correlation exists between foreign asset returns and currency movements, as unhedged exposure can provide natural diversification benefits. However, this effect is not universal across all negatively correlated assets. This research establishes the mathematical conditions under which hedging forex risk may lead to higher total portfolio volatility, offering valuable insights for investors.
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