1985-1994

Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios
Fischer Black
a world where everyone can hedge against nchanges in the value of real exchange rates (the relative values of domestic and foreign goods), and where no barriers limit international investment, there is a Universal constant that gives the optimal hedge ratio--the fraction of your foreign investments you should hedge. The formula for this optimal hedge ratio depends on just three inputs: The expected return on the world mar: ket portfolio. The volatility of the world market portfolio. AVerage exchange rate volatility. The formula in turn yields three rules: Hedge your foreign equities. Hedge equities equally for all countries. Don't hedge 100 per cent of your foreign equities. This formula applies to every investor who holds foreign securities. It applies equally to a U.S. investor holding Japanese assets, a Japanese investor holding British assets, and a British investor holding U.S. assets. That's why we call this method "universal hedging. ,' fication. Because it reduces risk for both sides, currency hedging provides a "free lunch."

Why Not Hedge All?

If investors in all countries can reduce risk through currency hedging, w h y shouldn't they hedge 100 per cent of their foreign investments? Why hedge less? The answer contains our most interesting finding. When they have different consumption baskets, investors in different countries can all add to their expected returns by taking some currency risk in their portfolios. To see how this can be, imagine an extremely simple case, where the exchange rate between two countries is now 1:1 but will change over the next year to either 2:1 or 1:2 with equal probability. Call the consumption goods in one country "apples" and those in the other "oranges." Imagine that the world market portfolio contains equal amounts of apples and oranges. To the apple consumer, holding oranges is risky. To the orange consumer, holding apples is risky. The apple consumer could choose to hold only apples, and thus bear no risk at all. Likewise, the orange cor~sumer could decide to hold only orangeS. But; surprisingly enough, each will gain in expected return by trading an apple and an orange. At year~end, an orange will be worth either two apples or 0.5 apples. Its expected value is 1.25 apples. Similarly, an apple will have an expected value of 1.25 oranges. So each consumer will gain from the swap. This isn't a mathematical trick. In fact, :it's sometimes called "Siegel's paradox. ''1 It's real, and it means that investors generally want to hedge less than 100 per cent of their foreign investments. To understand Siegel's paradox, consider historical exchange rate data for deutschemarks and U.S. dollars. Table 1 shows the quarterly percentage changes in the exchange rates and their averages. Note that, in each period and for the average, the gain for one currency exceeds the loss for the other currency.

WHY HEDGE AT ALL?

You may consider hedging a "zero-sum game." After all, if U.S. investors hedge their Japanese investments, and Japanese investors hedge their U.S. investments, then w h e n U.S. investors gain on their hedges, Japanese investors lose, and vice versa. But even though one side always wins and the other side always loses, hedging reduces risk for both sides. More often than not, w h e n performance is measured in local currency, U.S. investors gain on their hedging w h e n their portfolios do badly, and Japanese investors gain on their hedging when their portfolios do badly. The gains from hedging are similar to the gains from international diversi-

Reprinted from Financial Analysts Journal (July~August 1989):1622.

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Table 1. Siegel'sParadox
State-of-Quarter E x c h a n g e Rates Percentage C h a n g e s in Exchange Rates

mark Quarter 1Q84 2Q84 3Q84 4Q84 1Q85 2Q85 3Q85 4Q85 1Q86 2Q86 3Q86 4Q86 !Q87 2Q87 3Q87 4Q87 1Q88 2Q88 3Q88 4Q88 Average dollar 2.75 2.60 2.79 3.06 3.17 3.11 3.04 2.64 2.44 2.33 2.17 2.02 !.91 1.81 1.82 1.84 1.58 1.65 1.82 1.86

dollar mark .362 .384 .358 .326 .315 .321 .328 .377 .408 .427 .459 .494 .521 .549 .547 .541 .629 .603 .549 .537

mark dollar -5.58 7.18 9.64 3.66 -1.83 -2.25 -13.04 -7.59 -4.46 -6.80 -7.16 -5.19 -5.11 0.49 1.09 - 14.00 4.29 9.83 2.27 -4.88 - 1.97

dollar mark 5.90 -6.69 -8.79 -3.52 1.84 2.30 15.01 8.21 4.67 7.29 7.73 5.46 5.41 -0.49 -1.08 16.28 -4.12 -8.95 -2.22 5.12 2.47

Suppose, for example, that we know the return on a portfolio in one currency, and we know the change in the exchange rate between that currency and another currency. We can thus derive the portfolio return in the other currency. We can write down an equation relating expected returns and exchange rate volatilifies from the points of view of two investors in the two different currencies. Suppose that Investor A finds a high correlation between the returns on his stocks in another country and the corresponding exchange rate change. He will probably want to hedge in order to reduce his portfolio risk. But suppose Investor B in that other country would increase his own portfolio's risk by taking the other side of A's hedge. Investor A may be so anxious to hedge that he will be willing to pay B to take the other side. As a result, the exchange rate contract will be priced so that the hedge reduces A's expected return but increases g's. In equilibrium, both investors will hedge. Investor A will hedge to reduce risk, while Investor B will hedge to increase expected return. But they will hedge equally, in proportion to their stock holdings.

Why UniversalHedging?
Why is the optimal hedge ratio identical for investors everywhere? The answer lies in how exchange rates reach equilibrium. Models of international equilibrium generally assume that the typical investor in any country consumes a single good or basket of goods. 2 The investor wants to maximize expected return and minimize risk, measuring expected return and risk in terms of his own consumption good. Given the risk-reducing and return-enhancing properties of international diversification, an investor will want to hold an internationally diversified portfoliO of equities. Given no barriers to international investment, every investor will hold a share of a fully diversified portfolio of world equities. And, in the absence of government participation, some investor must lend when another investor borrows, and some investor must go long a currency when another goes short. Whatever the given levels of market volatility, exchange rate volatilifies, correlations between exchange rates and correlations between exchange rates and stock, in equilibrium, prices will adjust until everyone is willing to hold all stocks and until someone is willing to take the other side of every exchange rate contract.

THE UNIVERSAL HEDGING FORMULA By extending the above analysis to investors in all possible pairs of countries, we find that the proportion that each investor wants to hedge depends on three averages: the average across countries of the expected excess return on the world market portfolio; the average across countries of the volatility of the world market portfolio; and the average across all pairs of countries of exchange rate volatility. These averages become inputs for the universal hedging formula: 3
~ m -- O'm2

'

/J'm -- ~O'e2

where tEJ, = the average across investors of the exm pected excess return (return above each investor's riskless rate) on the world market portfolio (which contains stocks from all major countries in proportion to each country's market value) o m ~- the average across investors of the volatility of the world market portfolio (where variances, rather than standard deviation, are averaged)

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o" = the a v e r a g e e x c h a n g e rate volatility (ave e r a g e d variances) across all pairs of countries N e i t h e r e x p e c t e d c h a n g e s in exchange rates n o r correlations b e t w e e n exchange rate c h a n g e s a n d stock returns or other exchange rate c h a n g e s affect optimal h e d g e ratios. In equilibrium, the expected c h a n g e s a n d the correlations cancel one another, so t h e y do n o t a p p e a r in the universal h e d g i n g formula. In the s a m e w a y , the Black-Scholes option formula includes neither the u n d e r l y i n g stock's expected r e t u r n n o r its beta. In equilibrium, they cancel o n e another. The Capital A s s e t Pricing M o d e l is similar. The optimal portfolio for a n y one investor could d e p e n d on the e x p e c t e d r e t u r n s a n d volatilities of all available assets. In equilibrium, h o w e v e r , the optimal portfolio for a n y investor is a mix of the m a r k e t portfolio w i t h b o r r o w i n g or lending. The expected returns a n d volatilities cancel one another (except for the m a r k e t as a whole), so they do not affect the i n v e s t o r ' s optimal holdings.

Inputs for the Formula

Historical data a n d j u d g m e n t are u s e d to create i n p u t s for the formula. Tables 2 t h r o u g h 8 give s o m e historical data that m a y be helpful. Table 2 lists w e i g h t s that can be applied to different countries in e s t i m a t i n g the three averages. Japan, the United States a n d the United K i n g d o m carry the m o s t weight. Tables 3 to 5 contain statistics for 1986-88 a n d Tables 6 to 8 contain statistics for 1981-85. These s u b p e r i o d s give an indication of h o w statistics change f r o m one s a m p l e period to another. W h e n a v e r a g i n g e x c h a n g e rate volatilities over pairs of countries, w e include the volatility of a c o u n t r y ' s exchange rate w i t h itself. T h o s e volatilities are always zero; t h e y r u n diagonally t h r o u g h Tables 3 a n d 6. This m e a n s that the a v e r a g e exchange rate volatilities s h o w n in Tables 5 a n d 8 are lower t h a n the a v e r a g e s of the positive n u m b e r s in Tables 3 a n d 6. The excess returns in Tables 4 a n d 7 are averages for the w o r l d m a r k e t r e t u r n in each c o u n t r y ' s currency, m i n u s that c o u n t r y ' s riskless interest rate. The a v e r a g e excess r e t u r n s differ

Table 2. Capitalizations and Capitalization Weights

Domestic Companies Listed on the Major Stock Exchange as of December 31, 1987" Capitalization (U.S. $ billions) Japan United States United Kingdom Canada Germany France Australia Switzerland Italy Netherlands Sweden Hong Kong Belgium Denmark Singapore New Zealand Norway Austria Total
TM

Companies in the FT-Actuaries World Indices" as of December 31, 1987-t Capitalization (U.S. $ billions) 2100 1800 560 110 160 100 64 58 85 66 17 38 29 11 6.2 7.4 2.2 3.9 5300 Weight (%) 41 34 11 2.1 3.1 2.0 1.2 1.1 1.6 1.3 0.32 0.72 0.56 0.20 0.12 0.14, 0.042 0.074 100

Weight (%) 40 31 10 3.2 3.2 2.3 2.0 1.9 1.8 1.3 1.0 0.79 0.61 0.30 0.26 0.23 0.17 0.12 100

2700 2100 680 220 220 160 140 130 120 87 70 54 42 20 18 16 12 7.9 6800

* From "Activities and Statistics: 1987 Report" by Federation Internationale des Bourses de Valeurs (page 16). t The FT-Actuaries World Indices are jointly compiled by The Financial Times Limited, Goldman, Sachs & Co., and County NatWest/Wood Mackenzie in conjunction with the Institute of Actuaries and the Faculty of Actuaries. This table excludes Finland, Ireland, Malaysia, Mexico, South Africa and Spain.

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Table 3. Exchange Rate Volatilities, 1986-1988
Japan U . S . U . K . Can- GerAus- SwitzerNether- Swe- Hong Bel- Den- Singa- New Zea- Nor- Ausada m a n y France tralia land Italy lands den Kong gium mark pore land way tria

Japan United States United Kingdom Canada Germany France Australia Switzerland Italy Netherlands Sweden Hong Kong Belgium Denmark Singapore New Zealand Norway Austria

0 11 9 12 7 7 14 7 8 7 7 11 9 8 10 17 9 8

11 0 10 5 11 11 11 12 10 11 8 4 11 11 6 15 10 11

9 11 0 11 8 8 14 9 8 8 7 11 9 8 10 16 9 9

12 5 11 0 12 11 12 13 11 11 9 6 12 11 8 15 10 12

7 11 8 12 0 2 14 4 3 2 5 11 6 4 10 17 7 5

7 11 8 11 3 0 14 5 3 3 5 11 6 4 10 17 7 5

14 11 14 12 15 14 0 15 14 14 12 11 14 14 12 14 13 15

7 12 9 13 4 5 15 0 5 5 7 12 8 6 11 18 9 7

8 10 8 11 3 3 14 5 0 3 5 10 6 4 10 17 7 5

7 11 8 11 2 3 14 5 3 0 5 11 6 4 10 17 7 5

7 8 7 9 5 5 12 7 5 5 0 8 6 4 8 15 5 5

11 4 11 6 11 11 11 12 11 11 8 0 11 11 5 14 10 11

9 11 9 12 6 6 14 8 6 6 6 11 0 6 10 17 8 6

8 11 8 11 4 4 14 6 4 4 4 11 6 0 10 17 7 5

10 6 10 8 10 10 12 11 10 10 8 5 10 10 0 15 10 10

17 15 16 15 17 17 14 18 17 17 16 14 17 17 15 0 16 17

9 10 9 10 8 7 14 9 7 7 6 10 8 7 10 16 0 8

8 11 9 12 5 5 14 7 5 5 5 11 6 5 10 17 7 0

Source: FT-Actuaries World Indices" data base. between countries because of differences in exchange rate movements. T h e e x c e s s r e t u r n s a r e not n a t i o n a l m a r k e t returns. For example, the Japanese market did b e t t e r t h a n t h e U . S . m a r k e t i n 1987, b u t t h e w o r l d market portfolio did better relative to interest rates in the United States than in Japan. Because exchange rate volatility contributes to a v e r a g e s t o c k m a r k e t v o l a t i l i t y , O'm2 s h o u l d b e g r e a t e r t h a n o-e E x c h a n g e r a t e v o l a t i l i t y a l s o 2. contributes to the average return on the world m a r k e t , s o ~ m s h o u l d b e g r e a t e r t h a n ~cre2, t o o .

An Example
Tables 5 and 8 suggest one way to create inputs for the formula. The average excess return on the world market was 3 per cent in the earlier p e r i o d a n d 11 p e r c e n t i n t h e l a t e r p e r i o d . W e m a y thus estimate a future excess return of 8 per cent. The volatility of the world market was higher in the later period, but that included the crash, so w e m a y w a n t t o u s e t h e 15 p e r c e n t v o l a t i l i t y f r o m the earlier period. The average exchange rate vola t i l i t y o f 10 p e r c e n t i n t h e e a r l i e r p e r i o d m a y a l s o be a better estimate of the future than the more recent 8 per cent. This reasoning leads to the following possible values for the inputs: ~m = 8%,

Table 4. World Madmt Excess Returns and Retum Volalfiities in Different Currencies, 19861988
Excess Return Currency Japan United States United Kingdom Canada Germany France Australia Switzerland Italy Netherlands Sweden Hong Kong Belgium Denmark Singapore New Zealand Norway Austria 1986 1987 1988 21 14 16 5 30 27 -6 36 23 30 19 17 28 26 16 13 15 30 Return Volatility 1986 14 13 14 14 15 14 19 15 15 15 13 13 15 15 12 20 14 15 1987 26 25 26 24 27 26 25 27 27 27 25 25 27 27 25 29 26 27 1988 15 11 15 11 14 14 14 15 14 14 13 11 14 14 12 14 12 14

orm = 1 5 % ,

cre = 10%. Given these inputs, the formula tells us that 77 per cent of holdings should be hedged: 0.08 - 0.152 -0.77.

8
29 23 26 8 11 23 8 2 8 16 30 7 8 36 15 19 7

- 12
12 - 14 4 -5 -7 -2 -8 -6 - 7 -6 13 -8 - 10 6 -22 -11 -6

0.08 - ~(0.10) 2

Table 5.

World Average Values, 1986-1988

Excess Return Return Volatility 14 26 13 18 Exchange Rate Volatility 9 8 8 8

1986 1987 1988 1986-88

17 -3 18 11

Source: FT-Actuaries World Indices TM data base.

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Table 6. Exchange Rate VolaBities, 1981-1985
Japan Japan United States United Kingdom Canada Germany France Australia Switzerland Italy Netherlands 0 11 12 11 10 10 12 11 9 10 United United States Kingdom Canada 12 0 13 4 12 13 10 14 10 12 13 12 0 11 10 11 13 12 11 10 11 4 12 0 12 12 10 13 10 11 Germany 10 12 10 11 0 4 12 7 5 2 France Australia Switzerland Italy 10 13 11 12 5 0 12 8 5 5 12 11 14 10 13 12 0 14 12 12 11 13 12 12 7 8 13 0 8 7 9 10 11 10 5 5 11 8 0 5 Netherlands 10 12 10 11 2 5 12 7 5 0

Source: FT-Actuaries World Indices" data base. To c o m p a r e the results of using different inputs, we can use the historical averages from both the earlier a n d later periods: /-~m = 3% or 11%, O" m 15% or 18%, ~e = 10% or 8%.
=

Optimization
The universal h e d g i n g formula a s s u m e s that y o u p u t into the formula y o u r opinions about w h a t investors a r o u n d the w o r l d expect for the future. If y o u r o w n views o n stock markets a n d on exchange rates are the same as those y o u attribute to investors generally, then y o u can use the formula as it is. If y o u r views differ from those of the consensus, y o u m a y w a n t to incorporate t h e m using optimization m e t h o d s . Starting with expected returns a n d covariances for the stock markets a n d exchange rates, y o u w o u l d find the mix that maximizes the expected portfolio return for a given level of volatility. The optimization a p p r o a c h is fully consistent with the universal h e d g i n g approach. W h e n y o u p u t the expectations of investors a r o u n d the world into the optimization approach, y o u will find that the optimal currency h e d g e for a n y foreign inw~stm e n t will be given b y the universal h e d g i n g formula.

With the historical averages from the earlier period as inputs, the fraction h e d g e d comes to 30 per cent: 0.03 - 0.152 0.03 - ~(0.1012 Using averages from the later period gives a fraction h e d g e d of 73 per cent: 0.11
-

0.30.

0.18 2

-0.73. 0.11 - 1~(0.08)2 Generally, straight historical averages vary too m u c h to serve as useful inputs for the formula. Estimates of l o n g - r u n average values are better.

A Note on the Currency Hedge

The formula a s s u m e s that investors h e d g e real (inflation-adjusted) exchange rate changes, not changes due to inflation differentials b e t w e e n countries. To the extent that currency changes are the result of changes in inflation, the formula is only an approximation. In other words, currency h e d g i n g only approximates real exchange rate hedging. But most

Table 7. World Manet Excess Returns and Retum Volatilities in Different Currencies, 19811985
Currency Japan United States United Kingdom Canada Germany France Australia Switzerland Italy Netherlands Excess Return 3 -1 10 2 8 7 7 9 4 8 Return Volatility 17 13 16 13 15 16 18 16 15 15

Table 8. World Average Values, 1981-1985

Excess Return 3 Return Volatility 15 Exchange Rate Volatfli.W 10

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changes in currency values, at least in countries with moderate inflation rates, are due to changes in real exchange rates. Thus currency hedging will normally be a good approximation to real exchange rate hedging. In constructing a hedging basket, it may be desirable to substitute highly liquid currencies for less liquid ones. This can best be done by building a currency hedge basket that closely tracks the basket based on the universal hedging formula. When there is tracking error, the fraction hedged should be reduced. In practice, then, hedging may be done using a basket of a few of the most liquid currencies and using a fraction somewhat smaller than the one the formula suggests. The formula also assumes that the real exchange rate between two countries is defined as the relative value of domestic and foreign goods. Domestic goods are those consumed at home, not those produced at home. Imports thus count as domestic goods. Foreign goods are those goods consumed abroad, not those produced abroad. Currency changes should be examined to see if they track real exchange rate changes so defined. When the currency rate changes between two countries differ from real exchange rate changes, the hedging done in that currency can be modified or omitted. If everyone in the world eventually consumes the same mix of goods and services, and prices of goods and services are the same everywhere, hedging will no longer help. In case (a), you should hedge more than the formula suggests. In case (b), you should hedge less than the formula suggests. In case (c), it probably makes sense to apply the formula as given to the foreign equities you hold. If the barriers to foreign investment are small, you should gain by investing more abroad and by continuing to hedge the optimal fraction of your foreign equities.

Foreign Bonds
What if your portfolio contains foreign bonds as well as foreign stocks? The approach that led to the universal hedging formula for stocks suggests 100 per cent hedging for foreign bonds. A portfolio of foreign bonds that is hedged with short-term forward contracts still has foreign interest rate risk, as well as the expected return that goes with that risk. Any foreign bonds you hold unhedged can be counted as part of your total exposure to foreign currency risk. The less you hedge your foreign bonds, the more you will want to hedge your foreign stocks. At times, you may want to hold unhedged foreign bonds because you believe that the exchange rate will move in your favor in the near future. In the long run, though, you will want to hedge your foreign bonds even more than your foreign equities.

CONCLUSION APPLYING THE FORMULA TO OTHER TYPES OF PORTFOUOS

H o w can you use the formula if you don't have a fully diversified international portfolio, or if foreign equities are only a small part of your portfolio? The answer depends on w h y you have a small amount in foreign equities. You may be (a) wary of foreign exchange risk; (b) wary of foreign equity risk, even if it is optimally hedged; or (c) wary of foreign exchange risk and foreign equity risk, in equal measure. The formula's results may be thought of as a base case. When you have special views on the prospects for a certain currency, or w h e n a currency's forward market is illiquid, you can adjust the hedging positions that the formula suggests. When you deviate from the formula because you think a particular currency is overpriced or underpriced, you can plan to bring your position back to normal as the currency returns to normal. You may even want to use options, so that your effective hedge changes automatically as the currency price changes.

Foo'rNOTES
1. J.J. Siegel, "Risk, Interest Rates, and the Forward Exchange," Quarterly Journal of Economics (May 1972). 2. See, for example, B.H. Solnik, "An EquilibriumModel ofthe International Capital Market," Journal of Economic Theory

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(August 1974); F.L.A. Grauer, R.H. Litzenberger, and R.E. Stehle, "Sharing Rule=~and Equilibrium in an International Capital Market Under Uncertainty,'"Journal of Financial Economics (June 1976); P. Sercu, "A Generalization of the International Asset Pricing Model," Revue de l'Association Francaise de Finance, (June 1980); and R. Stulz, "A Model of International Asset Pricing," Journal of Financial Economics (December 1981). 3. Thederivation of the formula is desqribed in detail in F. Black, "Equilibrium Exchange Rate Hedging," National Bureau of Economic Research Working Paper No. 2947 (April 1989).

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