Currency Risk Hedging in Times of Crisis: An Analysis of European Portfolios

Our paper investigates the changing diversification potential of European emerging capital markets for portfolios of developed European capital markets in times of crisis compared to normal times, taking into account the experience of the recent financial turmoil. We examine the impact of currency risk on investments made by a Euro based investor in European countries, in a static and dynamic framework by considering its evolution in normal versus turbulent times. We find that the contribution of currency risk to an investment made by a euro-based investor in other European countries was positive indicating that currency risk adds to the local market risk, with a higher contribution of currency risk to the overall investment volatility in the case of emerging markets. A definite conclusion in terms of whether hedging provides investors with better diversification opportunities cannot be reached, not even in crisis times. Clearly, when only emerging markets are added to EMU, hedging currency risk is a better option compared to keeping investments unhedged.