The won-dollar exchange rate, which began this year in the 1,430 range, briefly surpassed 1,530 won following the Middle East conflict and has been moving in the high 1,400 range this month. Given the large swings and the diverse factors influencing exchange rates, even experts find dynamic currency hedging difficult. Dynamic currency hedging is a method of managing foreign exchange risk by adjusting the hedge ratio in line with exchange rate movements.
From a global asset allocation perspective, won-based investors can address the currency hedging issue without much difficulty by understanding a few stylized facts. Here, "stylized facts" refer to phenomena that do not always hold but are established with high probability through analysis of historical data.
First, investors should leave foreign currency exposure unhedged when investing in overseas equities. This is because overseas stocks and the won-dollar exchange rate show a negative correlation. Put simply, a rise (fall) in overseas stocks generally signals that "the global economy is strong (weak)," which increases the likelihood that Korean exports will improve (weaken), placing upward (downward) pressure on the won. In other words, when overseas stocks rise, the exchange rate tends to fall, and conversely, when overseas stocks fall, the exchange rate tends to rise.
This negative correlation serves to lower the volatility of won-based returns on overseas stocks below that of dollar-based returns. As a result, leaving currency exposure unhedged on overseas equity investments proves advantageous in terms of risk-adjusted returns. Recently, as U.S. interest rates have risen above Korean rates, currency hedging costs have emerged, making unhedged investment in overseas stocks the more natural choice.
In addition, there is no reason to invest in overseas government bonds. When investing in overseas sovereign bonds with currency hedging, the hedging cost offsets the interest rate differential between the two countries. In fact, as of the 4th of this month, the one-year average gap between U.S. 10-year Treasury yields and Korean 10-year government bond yields stood at 1.20%, similar to the annual currency hedging cost.
Then what about investing in overseas government bonds on an unhedged basis? While this avoids the reduction in won-converted returns from hedging, it leaves the investment fully exposed to exchange rate volatility. According to Korea Investment Management's Long-Term Capital Market Assumptions (LTCMA) for this year, the volatility of the won-dollar exchange rate stands at an annual 11.0%. Investing in U.S. 10-year Treasuries on an unhedged basis pushes volatility up to an annual 13.4%. This is higher than the 13.1% annual volatility of an unhedged investment in the Standard & Poor's 500 Index. The same phenomenon applies not only to U.S. Treasuries but also to other countries' government bonds. Ultimately, whether hedged or not, overseas bonds lose their appeal relative to Korean government bonds when it comes to sovereign bond investment.
For corporate bonds, including high-yield bonds, and emerging market dollar-denominated bonds, unhedged investment in overseas bonds is advantageous. Bonds in this sector show a negative correlation with the won-dollar exchange rate, as with overseas equities, and also offer higher yields than domestic corporate bonds.
