Investment policy implications of currency hedging

The issue of whether to hedge the currency exposure of U.S. pension funds' allocations to international stocks has aroused considerable controversy. For funds that choose to hedge, the authors discuss an alternative approach that avoids the financial and administrative expenses of directly implementing a currency hedging program. Specifically, they use the Sharpe effective asset mix methodology to examine the U.S. capital markets ''components'' of hedged international stock returns. They conclude that the risk-modifying effects of hedging could be accomplished by simply increasing the allocation to domestic assets, while reducing the allocation to unhedged international stocks. The authors' investigation confirms that such a domestic-for-international swap leads to total portfolio risk that is usually lower than (and at worst insignificantly greater than) total portfolio risk using currency hedging.