Currency hedging: Perceptions and misperceptions

April 2003

Prof. Dr. Heinz Zimmermann

Universitt Basel - Wirtschaftswissenschaftliches Zentrum (WWZ)

Contents.
The free lunch (zero cost) currency hedging argument. Empirical papers on the return effects of currency hedging. The story about the Siegel paradox. Explaining the paradox: PPP deviations.

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The finance perspective on currency risk.

Theory of International Finance

Portfolio Theory:

Asset Pricing:

Equilibrium Hedging:

Currencies as separate
asset class

Impose conditions of
market clearing and equilibrium

Implications of market
equilibrium for individual portfolios

Portfolio efficiency and

diversification of currency risks

Determine market
price(s) of risk(s)

Equilibrium risk premia

and hedge ratios for every asset, including currencies

Individual hedging of
currency exposures

If currency risk is rewarded, full hedging cannot be optimal!

Heinz Zimmermann Source: Zimmermann and Mertens Seite 3

The academic discussion.

Models: Solnik (1974), Sercu (1980), Adler and Dumas (1983) Provocation: Prold and Schulman (1988) vs. Black (1989/90), The debate: Adler and Prasad (1990), Adler and Jorion (1992),

Solnik (1993a) Evidence: Dumas and Solnik (1995), De Santis and Grard (1997)

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The pricing of currency risk: Two counterpositions.

There are two fundamentally different positions: e.g. Perold/ Schulman (1988): Free lunch of currency hedging. Foreign exchange market as a zero sum game - gains and losses between party and counterparty compensate. So, the expected return on currencies is zero. Therefore, systematic currency hedging does not affect average returns. Full hedging is optimal.

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Cont.
The counterposition is as follows: e.g. Black (1989/90): there is a positive expected return on currencies for all currencies alltogether: the so-called Siegel paradox; Siegel (1972). So: there is no free lunch of currency hedging. Investors optimally hedge only part of their forex exposure. But: can a simple mathematical result imply real arbitrage opportunities? What are the implications for the definition of exchange risk?

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Implications from the Siegel paradox?

...or: the real meaning of forex risk.

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Exchange rate risk and expected returns

USD appreciates/ CHF depreciates

Exchange rate CHF/USD2.0 Exchange rate CHF/USD1.0

50%

USD depreciates/ CHF appreciates

Exchange rate CHF/USD0.5

50 %

Expected rate CHF/USD....1.25

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Exchange rate risk and expected returns

Exchange rate USD/CHF....0.5 Exchange rate USD/CHF....1.0 Exchange rate USD/CHF....2.0

50%

50 %

Expected rate USD/CHF....1.25

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Exchange rate risk and expected returns

Expected exchange rate return of the Swiss investor

25%

Expected exchange rate return of the US investor

25%

So, the foreign exchange risk implies a positive expected return for BOTH investors, the Swiss and the US. Is this an arbitrage opportunity?
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The mathematical point

Mathematically, the explanation of the puzzle is due to the following fact:

1 1 E > S E[S ]
This is known as Jensens inequality. However, this result does not help us explaining whether the puzzle creates an arbitrage opportunity.

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The economic relevance

Why is the question economically relevant at all? Is forex risk a zero sum game? The US and Swiss investor could pool their positions and share the gains from the positive expected return. If forex risk is rewarded with a positive risk premium for the US and the Swiss investor, then full currency hedging is not optimal for all investors irrespective of their home currency.

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Analyzing the puzzle with real goods

We assume that the Swiss investor has an income of 1000 CHF. There is only one good - call it wine. The price per bottle is 10 CHF. We assume that the US investor has an income of 1000 USD. Given the initial exchange rate of 1.00 the price per bottle is 10 USD. What is the quantity of wine which could be purchased by the two investors, initially and after the exchange rate change?

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Exchange rate risk: in real terms

USD appreciates/ CHF depreciates

Number of bottles: 500:10=50 Number of bottles: 1000:10=100

USD depreciates/ CHF appreciates

Number of bottles: 2000:10=200

Interpretation: If the exchange rate is 0.5 CHF/USD, the Swiss investor transforms his income of 1000 CHF to 2000 USD and purchases the wine at 10 USD per bottle, which gives 200 bottles.
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Exchange rate risk: in real terms

Number of bottles: 2000:10=200 Number of bottles: 1000:10=100 Number of bottles: 500:10=50

Interpretation: If the exchange rate is 0.5 USD/CHF, the US investors transforms his income of 1000 USD to 2000 CHF and purchases the wine at 10 CHF per bottle, which gives 200 bottles.
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The real effect to currency switching

Number of bottles: Swiss Number of bottles: US Number of bottles: Swiss Number of bottles: US Total: 100 100 200 Total:

USD appreciates/ CHF depreciates

50

200 250

Number of bottles: Swiss 200 Number of bottles: US Total: 50 250

USD depreciates/ CHF appreciates

Thus, by switching currencies, forex risk makes the society better off in terms of real income, in both exchange rate states. Surprising?
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The price of wine adjusts I

Exchange rate CHF/USD2.0 Wine price per bottle Exchange rate CHF/USD1.0 Wine price per bottle 10 CHF 10 USD Exchange rate CHF/USD0.5 Wine price per bottle: 10 CHF 20 USD
i.e. the wine prize remains constant in Switzerland, while it adjusts in the US - reciprocally to the exchange rate change.
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10 CHF 5 USD

Implications for the real income

USD appreciates/ CHF depreciates

Number of bottles: Number of bottles: 1000:10=100

500:5=100

Number of bottles: 1000:10=100

USD depreciates/ CHF appreciates With currency switch Without currency switch

Number of bottles: 2000:20=100 Number of bottles: 1000:10=100

Conclusion: Switching currencies does not affect real income, as measured by the number of bottles of wine.
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Implications for the real income

USD appreciates/ CHF depreciates

Number of bottles: 2000:10=200 Number of bottles: 1000:5=200 Number of bottles: 1000:10=100

With currency switch Without currency switch USD depreciates/ CHF appreciates

Number of bottles:

500:10=50

Number of bottles: 1000:20=50

Conclusion: Switching currencies does not affect the real income compared to the non-switching alternative.
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The real effect of currency switching

Number of bottles: Swiss Number of bottles: US Number of bottles: Swiss 100 Number of bottles: US Total: 100 200 Total:

USD appreciates/ CHF depreciates

100

200 300

Number of bottles: Swiss Number of bottles: US Total:

USD depreciates/ CHF appreciates

100 50

150

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... and the non-switching alternative

Number of bottles: Swiss Number of bottles: US Number of bottles: Swiss Number of bottles: US Total: 100 100 200 Total:

USD appreciates/ CHF depreciates

100

200 300

Number of bottles: Swiss Number of bottles: US Total:

USD depreciates/ CHF appreciates

100 50

150

The quantities of wine are identical in the switching and non-switching case. Thus, currency switching has no real effect under this scenario Heinz Zimmermann (adjusted wine price). Seite 21

Is the result suprising?

Summing up: Forex risk and that switching currencies only increases global real income (the Siegel paradox) if relative good prices remain constant. If relative prices adjust in exactly the same way as the exchange rate, then the effect disappears. Is this surprising? No, because the Purchasing Power Parity (or in the case of one single good, the law of one price) would hold in this case.

See next page

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The exchange rate in terms of the price of wine

Exchange rate CHF/USD2.0 Wine price per bottle Exchange rate CHF/USD1.0 Wine price per bottle 10 CHF 10 USD Exchange rate CHF/USD0.5 Wine price per bottle:

2.0

10 CHF 5 USD

1.0

0.5

10 CHF 20 USD

i.e. the wine prize remains constant in Switzerland, while it adjusts in the US - reciprocally to the exchange rate change.
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Implications of the previous analysis...

INSIGHT 1 Siegels paradox of positive-expectedreturns-on-currencies is a purely nominal puzzle. Irrelevant for investors concerned about real returns, i.e. measured in foreign consumption units IMPLICATIONS

There are no
implications from Siegels paradox for currency hedging

It is the real
INSIGHT 2 Under PPP, there are no real wealth effects from exchange rate changes. They can only be accomplished by deviations from PPP exchange rate risk i.e. inflation risk not reflected by currency rates which affects currency hedging Siegels Paradox comes from a misleading change of numeraire!
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... and summary.

PPP ...
holds holds not

No real exchange
rate risks, no premia

Real exchange rate risks exist, risk

premia can be earned

No need for hedging, PPP

provides the hedge!

Full hedging foregoes rewards for

bearing currency risk, not optimal

In real terms, the exchange rate

is not stochastic, hence no inequality, no paradox (E(r)=1/E(r)=1)

Investors with different objective

functions gain from trading with each other

Source: Zimmermann and Mertens, Obstfeld and Rogoff (1996, p. 586ff), Kritzman (2000) Heinz Zimmermann Seite 25

Currency risk hedging for risky assets: empirical.

How is the ex-post performance of portfolio returns affected if the position is fully hedged against exchange rates? What does fully hedged mean? What is the appropriate performance measure?

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Empirical evidence on currency hedging.

The Hfliger/ Wlchli/ Wydler study addresses the following strategies:
1. Domestic Investments: investments in domestic government bonds or domestic equities. 2. Single Foreign Currency Investments: investments in bonds or equities denominated in a single foreign currency or from a single country. 3. Multi Foreign Currency Investments: investment in a global portfolio of foreign currency bonds or equities. The starting point is an original equal weighting of the four foreign markets as of December 1984, but without any rebalancing (i.e. a buyand-hold strategy) 4. Hedged Single Foreign Currency Investments: Same as strategy 2, but with currency hedging with respect to the respective reference currency. 5. Hedged Multi Foreign Currency Investments: Same as strategy 3, but with currency hedging with respect to the respective reference currency.
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Bonds.

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Hfliger/ Wlchli/ Wydler (2000)

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Stocks.

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Hfliger/ Wlchli/ Wydler (2000)

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Summary.

Hfliger/ Wlchli/ Wydler (2000)

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Summary.

Hfliger/ Wlchli/ Wydler (2000)

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References.
Black, Fischer. 1989. Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios.. Financial Analysts Journal, vol. 45, no. 4 (July/August), 16-22. Black, Fischer. 1990. Equilibrium Exchange Rate Hedging Journal of Finance vol. 45, no. 3, 899-907. Gastineau, Gary L. 1995. The Currency Hedging Decision: A Search for Synthesis in Asset Allocation.. Financial Analysts Journal, vol. 51, no. 3 (May/June), 8-17. Glen, Jack, and Philippe Jorion. 1993. Currency Hedging for International Portfolios.. Journal of Finance, vol 48, no. 5, 1865-1886. Hfliger, Thomas, Urs Wlchli and Daniel Wydler. 2002. Hedging Currency Risk: Does It Have to Be So Complicated? Working Paper. Jorion, Philippe. 1989. Asset allocation with hedged and unhedged foreign stocks and bonds.. Journal of Portfolio Management, vol. 15, no. 4, 49-54.
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Heinz Zimmermann

Cont.
Solnik, B., 1998. Global Asset Management: To hedge or not to hedge a question that cannot be ignored, Journal of Portfolio Management 25, 43-51 Perold, Andre F., and Evan C. Schulman. 1988. The Free Lunch in Currency Hedging, Implications for Investment Policy and Performance Standards.. Financial Analysts Journal, vol. 44, no. 3 (May/June), 45-50. Solnik, B., 1993. Currency Hedging and Siegels Paradox: On Blacks Universal Hedging Rule, Review of International Economics, 180-187

Other references see the presentation of International Asset Pricing.

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