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Currency Hedging and the Risk Premium in Global Portfolios

Article Quant Q&A · Author: dm63
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Summary

The document addresses whether currency exposure in international portfolios earns compensation for its risk. Its answer characterizes foreign exchange returns as having approximately zero expected return while retaining volatility, suggesting that currency risk may add fluctuations without a corresponding premium.

It further states that hedging currency exposure can improve the Sharpe ratio of global equity and bond portfolios, and points to research on strategic foreign exchange hedging as support. The note gives no portfolio data, hedging design, or quantitative comparison, so it does not establish that hedging improves every portfolio or over every period. The claim is a broad portfolio-level perspective, and results can depend on the assets, currencies, hedge costs, and evaluation horizon.

Key ideas

  • Currency exposure can contribute volatility without a positive expected return, according to the answer.
  • Hedging foreign exchange risk may improve the Sharpe ratio of global equity and bond portfolios.
  • The document cites strategic currency hedging research but provides no underlying data or implementation details.
  • The stated conclusion should not be assumed to apply identically across portfolios or time periods.

Tags

ForexMulti-assetRisk managementPortfolio construction
Full text
# Portfolio Theory: Currency Risk


# Portfolio Theory: Currency Risk












It seems to me that Currency Risk can be diversified away and hence one should not get paid for taking it. Do you agree?

## Answer by Helin (score 3, accepted)

https://quant.stackexchange.com/a/31690

Yes, FX generally does not command a risk premium (expected return = 0, but volatility is not 0), and you can improve the Sharpe ratios of global equity/bond portfolios just by hedging away FX risk. See this excellent AQR paper: Risk Without Reward: The Case for Strategic FX Hedging.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.