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I am building a global tactical equity allocation model. The model will help determine an optimal allocation amongst a number of major developed and emerging stock markets (represented for my purposes by the MSCI country indices). The model will use inputs such as macroeconomic indicators, local currency yield curves and differentials, valuation (e.g. P/E), momentum, etc.

Question:

Should the returns series input into the model be currency hedged or unhedged? In practice, we will have the option of making separate currency bets. Is the fundamental series which should be compared across countries the hedged or unhedged series? To clarify, the goal in making this decision is to maximize our predictive power.

For example, if I were building an options relative value model, I would certainly compare only delta-hedged returns, even though my actual hedging may differ I practice. in this case, however, adding currency hedging may actually be adding noise rather than reducing it.

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2 Answers 2

up vote 3 down vote accepted

Check out:

"Universal hedging: Optimizing currency risk and reward in international equity portfolios," Fischer Black - Financial Analysts Journal, 1989.

as well as many of the subsequent research that references this article (via Google Scholar, for instance). Good luck.

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Very interesting paper (full version found here). I think Black's paper answers the essence of the question quite well. For future reference, the subsequent research is summarized well by this SSgA Essay. Bottom line: about 50% currency hedged should be somewhere close to the global optimum for the typical investor. –  Tal Fishman Aug 16 '11 at 15:20

Since currencies are explicitly part of your asset set, it does not matter in principle which choice you make (currency hedged or unhedged) for the other securities.

In order for you model weights to have the most intuitive meaning, you should choose unhedged if you think you will generally be neglecting to hedge the risk, and hedged otherwise.

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At this point, I have a choice as to whether to hedge or not as part of the strategy itself. The question is about which choice I should make. It definitely does matter in principle which choice I make, since this choice will feed through to all subsequent modeling. –  Tal Fishman Aug 15 '11 at 19:11

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