We develop a novel method to dynamically hedge foreign exchange exposure in international equity and bond portfolios. The method exploits the time-series predictability of currency returns, which we show emerges from exploiting a forecastable component in global factor returns. The hedging strategy outperforms leading alternative approaches to currency hedging across a large set of out-of-sample performance metrics. Moreover, we find that exploiting currency return predictability via an independent currency portfolio delivers a high risk-adjusted return and provides superior diversification gains to global equity and bond investors relative to currency carry, value, and momentum investment strategies.
Keywords: global currency hedging, currency risk factors, currency returns, international portfolio diversification, mean-variance optimization.
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