Currency Hedging Strategy: An Empirical Study of Emerging Markets

Abstract

Large Canadian pension funds have doubled their investment in emerging markets over the last decade. The foreign exchange risk exposure arising from emerging market investments can substantially affect the underlying assets’ overall risk-return profile once redenominated in the investors’ home currency. Yet there is a lack of financial literature on currency hedging strategies for emerging markets. This paper studies the correlations of foreign exchange rates with stock and bond returns in both developed and emerging markets over the period 1975 to 2021, from a Canadian investor’s perspective. The emerging markets in our analysis include Brazil, China, and India, while selected developed markets are the USA, Germany, the UK, Japan, and Australia. We use mean- variance analysis to find the foreign currency positions that minimize the risk of the total portfolio. Within the period we studied, we find that Canadian equity investors should maintain close to an unhedged position in US Dollars, hold a net long position in Chinese Yuan while holding a net short position in Brazilian real. For Canadian fixed income investors, the FX exposures of international bond portfolios should be at least fully hedged, if not overhedged, except for the Australian Dollar which should be partially hedged.