How Do Global Portfolio Investors Hedge Currency Risk?

We use monthly portfolio data from one of the world’s largest custodian banks, with over $40 trillion assets under custody, to study how global portfolio investors hedge foreign exchange risk in their equity and fixed income portfolios over the past 25 years. The data allow us to match asset positions with their corresponding foreign exchange forward positions. We present five findings: 1) We confirm the oft-conjectured hypothesis that fixed income investors hedge more than equity investors; Fixed income managers are more likely to hedge at all, and when they do hedge, their hedge ratios are more likely to be approximately one; 2) Across fixed income and equity managers, non-US dollar domiciled investors hedge more than US-domiciled investors, but the difference is shrinking over time 3) Hedging activity has increased steadily especially after 2008, both for USD-domiciled and non-USD-domiciled investors; 4) A significant fraction of currency hedgers manage towards a target hedge ratio and rebalance their currency positions accordingly. 5) We investigate the determinants of USD and EUR domiciled investors’ hedge ratios across currencies and over time, including carry, volatility, and FX momentum. For equity investors, we find higher carry and lower volatility are associated with stronger hedging. USD equity investors hedge low momentum currencies more strongly, EUR equity investors less strongly. For fixed income investors, we find higher carry, lower currency momentum, lower FX volatility, higher bond volatility, and, for USD investors, higher FX-FI correlations are associated with stronger hedging. Even after controlling for these correlations, we observe an increase in hedging after the 2008 global financial crisis across domiciles and asset classes.