Over the past two decades, foreign investors have increased their holdings of USD securities – but by how much? Amy Wang Huber, assistant professor of finance at Wharton, gets to the bottom of dollar asset holding and hedging around the globe in her 2023 paper, co-authored with Wenxin Du. In this enlightening interview, Assistant Professor Huber discusses her findings and what they mean for the financial community.
One of your paper’s key findings is that foreign investors have increased their investments in USD securities by six times. Why is it important for people to know about this figure? Can you give an example of how this increase in foreign USD security investment might affect an everyday investor?
Amy Wang Huber: The US dollar is the world’s most widely used currency and dollar-denominated securities are in the portfolio of investors around the globe. Yet there is limited understanding of how USD securities factor into foreign investors’ portfolio choice. My co-author Wenxin Du and I therefore conducted the first thorough investigation into foreign investors’ holdings and hedging of USD securities.
We found that the amount of USD bonds and equities held by foreign investors has increased six times in the last two decades. This is important because it contrasts with the popular narrative that foreign official institutions have been reducing their holdings of US Treasury securities. Instead, our result highlights a persistent and robust appetite for USD securities across investor groups. In our study, we examined USD security holdings by seven different investors groups, including mutual funds, insurance, and pensions. We found that these investors not only increased the total amount of USD security held, but also increased the share of their portfolios that they allocate to USD securities, underscoring an increasing preference for USD securities from foreign investors broadly defined.
For the everyday investor, a diverse investor base for USD securities is good news. When USD securities are held by many different investors, the returns of these securities are less likely to be affected by isolated shocks to a single investor. In other words, the increasing – and increasingly diverse – foreign holding of USD securities makes the market ever more resilient.
The $2 trillion annual spending on hedging by insurance, pensions, and mutual funds is a striking figure. Can you explain how this figure relates to our understanding of insurance and investments?
Amy Wang Huber: Foreign Exchange (FX) hedging involves exchanging a predetermined amount of dollars back to a foreign investor’s local currency at a pre-established rate. This is not like buying insurance, where only the downside is eliminated; rather, FX hedge is more like barter, where the foreign investor gives up exchange rate fluctuation completely, in good times and in bad.
Because foreign investors are inherently exposed to exchange rate fluctuations when they hold USD assets, we expected to see some FX hedging undertaken by foreign investors, but we did not expect the extent to which they hedge. On average, the hedge ratio – the share of foreign investors’ USD holdings that is FX hedged – is 44% in insurance, 35% in pension, and 21% in mutual funds. Even more striking, within foreign mutual funds, fixed income mutual funds hedge close to 50% of the USD exposure associated with their security holdings. This contrasts with the behavior of US fixed income mutual funds, who hedge only 18% of their foreign currency exposure.
Why may foreign investors want to hedge away the dollar exposure they have through their dollar asset holdings? It’s about the risk-return trade-off. The return of having dollar exposure is that the dollar tends to appreciate in value. But, the risk is that fluctuations in exchange rates can increase the overall risk of the portfolio.
We analyzed the empirical covariance, or correlation, between the return from holding the dollar as currency, and the return that a foreign investor would get by holding their domestic asset, such as local bonds or equity in their specific country. We found that often, the covariance in returns is positive between holding dollars as currency and holding local bonds, such as a German bund. That is an important factor in driving foreign investors’ hedging behavior.
The financial crisis of 2007-2009 was a difficult time around the world. How did the behavior of foreign investors during and after that period impact your findings?
Amy Wang Huber: An important consideration in portfolio allocation is how assets perform in times of crisis. During the global financial crisis of 2007-2009 (GFC), the dollar appreciated relative to many other currencies, generating positive returns for foreigners who had dollar exposure. This positive return is particularly valuable because it occurred at a time when many other assets performed poorly. One might therefore think that after the financial crisis, foreign investors would reduce FX hedging and welcome with open arms the dollar exposure they obtain through their USD assets.
In fact, hedge ratios have increased by almost 8 percentage points from pre-GFC to post-GFC. This increase in hedging may seem puzzling, but is actually what a rational agent would do if she cared about both the risk and the return of her portfolio. The crux lies in seeing hedging in conjunction with holding. We show in our model that when a mean-variance optimizing agent expects higher return from USD assets, she would increase her portfolio allocation to USD assets. She would also increase her dollar exposure, but not as much as she increases her holding, leading to a net increase in FX hedging.
What kind of impact do you hope your research will have on the financial community?
Amy Wang Huber: USD securities play an increasingly vital role in international investors’ portfolios, and sound management of FX risk is thus ever more crucial. We document that foreign investors want USD securities, but they don’t want all the dollar exposure that comes with it. This leads us to provide a framework for thinking about drivers of investors’ hedging decisions, and we show that foreign investors’ increased hedging over time is, in fact, quite rational when the effect from expected return on both holding and hedging is considered.
Our framework contrasts with the typical wisdom that hedging is all about portfolio variance reduction. We hope the new data we collected and the model that we sketched out can enrich both the empirical and theoretical understanding of international portfolio allocation.