To Hedge or Not to Hedge: Using a stress test to answer the question

Foreign-exchange rates can be very volatile. Investors looking to bet on markets outside their own base currency must decide whether to embrace or mitigate the additional risk. Depending on the correlations with other asset classes, FX-rate fluctuations can either amplify, dampen, or potentially even reverse local-market returns. Using FX forwards or options can eliminate part of the uncertainty, but they can also limit the potential upside from a foreign-currency appreciation as well as incur additional costs. In this paper, we propose a stress-testing framework that can help investors with the decision whether “to hedge or not to hedge”, given their assumptions on expected returns and cross-asset correlations.

Authors

Christoph Schon, CFA, CIPM

Senior Principal, Applied Research