14 August 2014

New working paper on efficient hedging of currency risks

Working paper no. 65, “Should Icelandic pension funds hedge currency risk in their foreign investments?”, by Ásgeir Daníelsson has now been published. The paper discusses arguments for and against purchases of short term forward currency contracts by long term investors and derives efficient hedging assuming different circumstances.

This paper discusses efficient hedging of currency risk in foreign investments through short term forward contracts. It is shown that for long term investors the efficient level of currency hedging depends on the behaviour of the exchange rate. If the exchange rate follows random walk the efficient hedging of the currency risk may be as large as it is for the short term investor, or possibly larger, but if the exchange rate follows a stationary stochastic process efficient hedging of the long term currency risk through short term forward contracts is zero in most cases. It is also shown that pass through of changes in the exchange rate into inflation forms a partial hedge for an investor that considers the real return and its volatility rather than the nominal return, diminishing the efficient level of forward currency contracts. It is shown that it is possible to use forward currency contracts for speculative investments. These contracts are profitable investment opportunities if the interest rate differential exceeds the expected change in the exchange rate. This same condition motivated the carry trade.

The paper is accessible at the bank‘s website: Working papers