HEDGING CURRENCY RISK IN PORTFOLIO OF INTERNATIONAL REAL ESTATE INVESTMENTS: ARTIFICIAL HEDGE OR NATURAL HEDGE?

Abstract

Currency fluctuations can severely affect the risk-return characteristics of an international real estate investment. It is therefore essential to take appropriate measures to hedge against exchange rate risk. This study proposes a forward-looking investment appraisal framework to compare the effectiveness of two strategies in hedging against currency risk in a portfolio of international real estate investments. A strategy of applying an artificial hedging instrument to a selected portfolio is compared with a strategy of investing in a portfolio with the "natural hedge" characteristic of a currency cocktail. Monte Carlo simulation is used to simulate future exchange rates for three scenarios: low, moderate and high currency variability. The findings indicate that while both strategies dampen exchange rate volatility, the currency swap strategy is superior to the "currency-adjusted composition" strategy on a mean-variance basis. This leads to the conclusion that employing an artificial hedging tool may be a better hedging plan than the "natural hedge" approach, especially if the portfolio is not sufficiently diversified.