One issue that has elicited different responses is the role of currency risk in overall risk and return. Currency risk has been accounted for in all of the evidence presented. So the existence of currency risk will not reduce the benefits of investing in foreign markets. Rather, the question is whether managing currency risk will improve the gains from international investing.

While the reduction of any kind of risk is good, there are two issues that must be considered with regard to currency risk. First, the correlation between currency risk and stock market risk is close to zero. That means that currency changes and stock returns are independent of one another. Though both currency risk and stock market risk contribute to the total risk of a portfolio of foreign stocks, the contribution of currency risk to the total risk is not very large because of the zero correlation. On average, currency risk contributes less than 20 percent of the total risk.

FundsThe second issue is the cost of hedging currency risk. To completely eliminate currency risk, a dynamic hedging strategy is required, which can be very expensive. Even incomplete hedging can be costly due to the time required and the expense of putting the hedge in place. Consider an investment in the EAFE index. For a given level of risk, the hedged portfolio has a return that is at most 0.5 percent higher than an unhedged portfolio. If the cost of hedging is less than that, hedging is worthwhile; otherwise it is not.

The case for hedging an investment in emerging markets is even weaker because the correlation between currency risk and stock market risk is very often negative. In such cases, hedging currency risk will increase the total risk instead of reducing total risk.

The performance of foreign portfolios including international mutual funds can depend a great deal on whether the funds hedge against currency risk or not. A comparison of the MSCI EAFE hedged and unhedged indexes is telling. The hedged MSCI EAFE index lost only 4.4 percent in 2000 compared with the unhedged index that lost 14.2 percent in the same period. On the other hand, the hedged index gained 11.0 percent in 1998 compared with 20.0 percent for an unhedged index. Note, however, that the hedged index does not include the cost of hedging.

Since it is difficult to predict which way the currency is going, is it worthwhile spending money on currency hedging? There isn’t a good answer. But as an investor, you should be aware of whether or not the mutual fund you hold hedges currency risk.

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Currency Hedging