After 20 years of hard work, the theory of universal hedging, final piece in Fischer’s monetary theory fell into place. According to the CAPM, you will always earn the same return when holding the world market portfolio, regardless of your location and currency. However, the problem is that the world is not in equilibrium and the currencies fluctuate over time. Thus, investors want to hedge their foreign currency exposure in order to avoid big losses due to exchange rates. During his years at Goldman Sachs, Fischer found a formula to hedge the currency exposure, that he named the “Universal Hedging Formula”.
The key of this result is that, according to their specific country, people measure their wealth with different price indexes. Consequently, “real” returns differ based on the currency used. Nevertheless, if the same mix of goods and services are consumed by everybody in the world, at the same price everywhere, it will be useless to use hedging.
Many practitioners and academics argued that Fischer’s result was based on too many unrealistic assumptions about the world (i.e. the world is always in full international CAPM equilibrium). But even if the world may not literally be in equilibrium, the search for profit is always pushing in that direction.
A for Jamon.
ReplyDeleteExchange rates aren't unimportant in finance - a good chunk of the back of your book is about them. But ... we don't cover them in this class (or really anywhere at SUU). So it's a little hard to get the point of all this.
Anyway, Black's goal with all this is to bring international transactions under the same CAPM umbrella which he uses to describe domestic stock purchases. Internationally, diversification is through currency hedging (buying futures to lock in your gains).
Empirically, you find that every stock you hold that is international must be hedged individually, because each stock has different exposure to each country.
What Black showed is that this is a statistical artifact: the degree of hedging required is constant, and what we observe empirically is just statistical variation around that constant. And ... if it's that simple ... then everyone can do it, and they can all improve their position.