Optimal hedging of stock portfolios against foreign exchange risk: theory and applications

Abstract

This paper applies a formula for the optimal hedge in a mean-variance framework to an investment in the Nikkei 225. It is shown that through hedging U.S. investors can construct a portfolio long in the Nikkei whose dollar excess return has the same volatility as the yen excess return of the Nikkei. There seems to be little gain from improving estimates of the exposure of the Nikkei to the dollar-yen exchange rate; in contrast, the performance of portfolios can be enhanced substantially by obtaining better forecasts of exchange rate changes. © 1992.