Optimal Currency Hedging: Horizon Matters

Investors have long debated what fraction of their portfolios' currency exposure they should hedge, if any. The answers cover a broad range, often with dubious rationale. Yet most informed investors agree that the solution should use mean-variance optimization to maximize expected utility or, when the return means are assumed to equal zero, minimize risk. However, this approach presents a serious challenge because it depends on how currencies covary with each other and with the underlying portfolio, and these covariances, themselves, vary significantly with the return interval used to estimate them. The authors show that monthly covariances produce unreliable results for horizons that are longer than one month.