Major Taiwanese Pension Funds' International Investments and Currency Hedging Strategies

Abstract

International investments constitute more than 40% of the assets of major pension funds in Taiwan. However, exchange rate fluctuations also affect funds' short-term returns significantly. Taiwanese pension funds' managers use their experience and intuition to determine whether to and how much to hedge currency risks. In this paper, we follow the framework of Campbell et al. (2010) and combine information on international financial markets and major Taiwanese pension funds' asset allocation to produce the currency hedge ratios which minimize the variance of quarterly returns of each fund. For foreign bond investment, the risk-minimizing strategy is basically 100% hedge. The risk-minimizing hedge ratios of foreign stock portfolios depend on the respective stock markets and currencies. Exposures on the US and Japan stock markets should not be hedged, while exposures on Australia and Canada should be over-hedged. Using actual asset allocations of pension funds in January 2016, we suggest that managers do not need to hedge USD exposure. These results are striking, as they differ significantly from managers' intuition and current practice. We demonstrate a model to determine currency hedging strategies for pension funds. We shed light on potentially huge hedging cost savings as well as portfolio risk reductions.