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Applying Regret Theory to Investment Choices: Currency Hedging Decisions Sébastien Michenaud & Bruno Solnik Edinburgh, March 2009 We thank Inquire Europe VERY MUCH for their financial support Currency Risks Currency Risks can be significant in the short run
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We thank Inquire Europe VERY MUCH for their financial support
- Universal hedging
What is the typical currency hedging benchmark of institutional investors?
- Very diverse!
As quoted in Jason Zweig, "How the Big Brains Invest at TIAA-CREF", Money, 27(1), p114, January 1998.
We look at the performance of peers (competitors). It is more than looking at passive benchmarks.
The euro was introduced in 1999 at 130 yen, two years later it was down to 90 yen, went to 167 in July 2007, and 120 in Jan 2009.
Solnik and Michenaud, “Applying regret theory to investment choices: Currency hedging decisions’, Journal of International Money and Finance, Sept 2008.
Currency hedging decisions are simple enough to model in the framework of RT. The ex-post optimal currency hedging choice is only one of two decisions.
- Simple case
- There exists a correlation between R and s
- There is some expected movement in s.
"A partial hedging policy – such as 50/50 or 70/30 – means the investor won’t ever experience the major highs of an unhedged portfolio, but won’t be subject to the lowest returns either."
To Hedge or not to hedge, Simon Segal, SuperReview.com.au, 21 march 2003
"The 50% hedge benchmark is gaining in popularity around the world as it offers specific benefits. It avoids the potential for large underperformance that is associated with "polar" benchmark, i.e. being fully unhedged when the Canadian dollar is strong or being fully hedged when it is weak. This minimizes the "regret" that comes with holding the wrong benchmark in the wrong conditions."
" Managing Currency Risk: A Canadian Perspective", Gregory Chrispin, State Street Global Advisor, Essays and Presentations, March 23, 2004.
Hedge ratio = 50% if regret aversion dominates risk aversion.