More Heat than Light: Discussions about currency hedging

Recently a press release from the NZ Super Fund generated a significant amount of discussion with respect to currency hedging which has prompted this article. 

As a firm we regularly look at currency hedging from a quantitative perspective.  We understand the big picture, somewhat emotive arguments around currency hedging, and understand why people like to fall back on these:  “Most of your assets are in NZD, you should hold FX currency assets to balance these”, “A lot of your future expenditure is linked to foreign currency, you should hold assets in foreign currency”, “What about catastrophic NZD risk like Foot and Mouth disease, earthquakes etc?”  They all make intuitive sense in a fuzzy big picture way, but unless accompanied by some hard risk analysis are a poor foundation for building a portfolio on.  Should those risks be explicitly hedged?  Are there cheaper or more effective ways to hedge this kind of risk than the blunt tool of a naïve hedging policy?

Any discussion should start with a look at actual data.  While past performance is no guarantee of future performance, past performance can provide us with useful information for assessing what may happen in the future.  One caveat though, that is beyond argument:  Professional commentators have a really, really bad track record at predicting short term movements in the New Zealand dollar (there is plenty of evidence to support this, email me if you would like to see it). 

So what does the data on currency hedging tell us?  Let’s start with a simple analytical review of currency management from a NZ investor perspective over the last 30 years.  The NZD dollar was floated on 4 March 1985 at a rate versus the USD of 0.4444.  Here is the path that the NZDUSD has taken since floating: