Global Asset Allocation and Optimal US Dollar Hedging

Daniel Brehon and Arup Pal

In this chapter, we will offer a theoretical quantitative framework for US dollar hedging. In short, benchmarked pension funds that target information ratios should hedge excess dollar exposure when overweight global assets relative to the benchmark asset allocation, including global private equity assets. Pension funds should also US dollar hedge when they hold a strong dollar view.

Investors take up undesired currency exposures when they choose to invest in foreign assets. We use the word “undesired” because FX is not perceived as an asset class and seldom features as a stand-alone investment. In the absence of a mandate for a short dollar position, US international investors traditionally view the hedging decision in binary terms: fully hedge the dollar position or do not hedge at all. Investors sometimes justify their decision not to hedge using the uncovered interest parity (UIP) theory that argues for a long-run zero expected (total) return from currency exposure. Full hedgers choose to remove all uncertainty that seeps into the portfolio returns from the volatility in foreign currencies over the medium term. Sometimes, a third option is floated to hedge 50% of the currency