EXCHANGE RISK AND INTERNATIONAL DIVERSIFICATION IN BOND AND EQUITY PORTFOLIOS

Early studies of the benefits of international diversification in equity portfolios show that there are substantial opportunities for risk reduction whether or not the investor attempts to hedge the associated currency risk. This is not true for more recent years, when exchange rate variability has been much larger. Exchange risk is potentially even more important in bond portfolios because both the level of risk and the amount by which that risk might be reduced through diversification are lower. We find that for bonds and equities, internationally diversified portfolios that do not hedge currency risk may be riskier that similar domestic portfolios. In this article we show how the exposure to currency movements and to the local currency price risk of foreign assets may be separated, and we provide empirical evidence on the opportunities for risk reduction in bond and equity portfolios when currency is completely hedged and when it is not. We also consider the problem of optimal currency holdings, in the case when the holdings of assets other than foreign currency are given. © 1991.