Can anyone help me understand hedging currencies when the correlation between the two are negative. In one of the CFA practice questions, it states that there is no need to hedge in the short run if correlations are negative, but what about in the long run?
Thanks!
When we talk about whether correlations are positive or negative, it is always based in the short run. For those currency pairs that have negative correlation, this means more diversification in the portfolio of currencies, therefore less risk, therefore no need to hedge. For those that have positive correlation, this means more risk, therefore must hedge.
In the long run, correlation varies because of different regimes for example, so you cannot hedge in the long run. There are too many unexpected variables to try and forecast correlation in the long run.
While this is partially correct, recall there are different kinds of exposures, not only transaction exposure regardless this one is short term character and is mostly hedged. If company has constant, thus long term, economic and translation exposure, hedge may be exactly constant and rolled forward through further periods. Regarding forecasting, nobody forecasts long term exposure than exposure for each period going forward while hedger may have long term currency movement expectations, too.
Consider a MNC type company which has 5 year project in one emerging country and during this project will be significantly economically and in translation currency exposed to emerging country currency.
Nice analysis. I didnt think of linking it to transaction exposure.
Thanks. Big companies have large Treasuries whose only responsibility is currency trading and hedging various kind of exposures to almost any international currency.