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"A second option is to cross hedge. In one common form of cross hedging, you would sell short a different currency, effectively but imperfectly shifting your currency risk. In our example, when you buy your South Korean bond and the won with which you pay for the transaction, you decide to sell short Japanese yen as a cross hedge.But the question is: Does this second type of hedge actually reduce risk, which is your objective?As shown in the Display below, although returns were indeed higher for cross hedging over the past 10 years, the volatility profile of the two strategies was hugely different. In terms of returns, the direct hedge performed similarly to the local Korean bond market. However, the cross hedge didn’t function like a hedge at all, behaving instead in an even more volatile fashion than the security that was not hedged in any way.
The risk-adjusted return, or Sharpe ratio, tells the whole story: a US dollar–hedged investor in the above scenario had a Sharpe ratio of 1.0, while the cross-hedged investor had a Sharpe ratio of just 0.4.That kind of volatility runs counter to your objective of reducing currency risk.We think that if an investor is looking to manage volatility—and especially if an investor thinks of their bond portfolio as a source of stability—direct hedging is the right approach."
"A second option is to cross hedge. In one common form of cross hedging, you would sell short a different currency, effectively but imperfectly shifting your currency risk. In our example, when you buy your South Korean bond and the won with which you pay for the transaction, you decide to sell short Japanese yen as a cross hedge.But the question is: Does this second type of hedge actually reduce risk, which is your objective?As shown in the Display below, although returns were indeed higher for cross hedging over the past 10 years, the volatility profile of the two strategies was hugely different. In terms of returns, the direct hedge performed similarly to the local Korean bond market. However, the cross hedge didn’t function like a hedge at all, behaving instead in an even more volatile fashion than the security that was not hedged in any way.
[text] Hedging or Cross Hedging? It Makes a Difference - Context | AB
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