Research area: meso, quantitative finance
Department: ORTEC Centre for Financial Research (OCFR)
Supervisor: dr. Henk Hoek and drs. Loranne van Lieshout
Description: Long term investors, like pension funds, typically not only invest in domestic assets but also in foreign assets, and therefore face currency risk. Conventional wisdom claims that investors should fully hedge their currency risk exposure, as not hedging results in higher volatility but not in higher expected returns. Froot (1993) however argued that currency hedging only lowers short-term volatility but actually increases long term volatility. Also, as discussed in Campbell et. al. (2007) due to correlations between currency returns and asset returns, the optimal hedge ratio for foreign bonds and foreign equity portfolios should be different. The objective of this project is to analyze the optimal strategic currency hedge for a pension fund. Although a pension fund is a long term investor and is confronted with long term volatility, it can also not ignore short term volatility. High short term volatility might result in more volatile contributions and indexations and is therefore undesirable from the perspective of the stakeholders of the pension fund.
Background information:
Campbell, J.Y., K. Serfaty-de Medeiros and L.M.Viceira (2007), “Global Currency Hedging”, Working Paper. (www.hbs.edu/research/pdf/07-084.pdf).
Campbell, J.Y., L.M. Viceira and J.S. White (2002), “Foreign Currency for Long-Term investors”, NBER Working Paper No. 9075.
Froot, K.A. (1993), “Currency Hedging Over Long Horizons”, NBER Working Paper No. 4355.