Using Conventional Wisdom That Conservative Investors Should Avoid Exposure On Foreign Currency Risks

Using Conventional Wisdom That Conservative Investors Should Avoid Exposure On Foreign Currency Risks

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Question 1) In relation to the article abstract, conventional wisdom that conservative investors should avoid exposure to foreign currency risks is wrong in relation to long-term investors. As with any investment, if there is any concern that the investment or currency for that matter could depreciate or decrease, hedging the initial investment with an investment in a different market can potentially reduce risk. Currency diversification will further the effects of hedging in case of market shocks in similar economies and additionally emphasizes the importance of inflation risk. In addition, the safety and security of currency diversification, differs from country to country, " a stable currency will be a safer investment than a currency that is subject to large changes in real value (2)".
While, Solnik, (1974), believes that the "optimal portfolio is internationally diversified, in equities but home based in currencies"(2). The issue with this theory is that it does not take into account that investments in foreign countries should be hedged to protect against potential shocks in home markets and foreign currency is meant to be used for tactical reasons to enhance returns. In the short run this theory is correct because domestic currency is almost riskless but this does not hold true in the long run due to real interest rates varying over time (3).
Academics down the line oppose the ideas of Solnik. Froot (1993) argues that even with more secure economies like the US, "equity returns are correlated with exchange rate movements over long horizons, not short horizons"(3). Dornbusch (1976) shows that decline in domestic interest rates, will cause domestic currency to decrease as well. To combat this potential loss an invest...


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...tries Germany, Japan, the U.K and the United States, focusing on just these areas does not provide sufficient information on the entire foreign currency system.
We hold another small conceptual disagreement with one of the alternatives to foreign currency hedging near the beginning of the article. At 3/3 in the article, the writer mentions that inflation-indexed bonds are a good way to hedge interest rate fluctuations. This is true, however, inflation-indexed bonds are known to offer far lower coupon payments due to their extra riskless properties. As a result, an investor can use these to hedge interest rate risk, but it is not a favorable method because generally these types of securities offer so little return that it is hardly worth the investment. The specific type of risk that we are talking about is generally not great enough to sacrifice this much return.


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