Dynamic Exchange Rate Hedging for Cross-currency Equity Holdings

How can cross-currency equity investors best approach hedging the associated currency exchange risk? In their December 2024 paper entitled “The Best Strategies for FX Hedging”, Pedro Castro, Carl Hamill, John Harber, Campbell Harvey and Otto Van Hemert analyze pair-wise dynamic currency exchange risk hedging strategies for global equity markets based on three widely accepted exchange rate strategies, as follows:

1. Carry – if the difference in interest rates for the equity market currency minus home currency is negative, do not hedge currency exchange risk. If positive, then hedge.
2. Value – if the equity market currency is undervalued according to Purchasing Power Parity, do not hedge currency exchange risk. If the equity market currency is overvalued, then hedge.
3. Momentum – if the equity market currency outperforms the home currency over the last 12 months, do not hedge the currency exchange risk next month. If the opposite, then hedge.

Comparisons of different hedging strategies consider both individual equity markets and a portfolio of capitalization-weighted world equities. Using data for developed market currencies and stock indexes starting April 1973 and for emerging market currencies starting November 1997-August 2000, all through June 2024, they find that:

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