Investments, tenth edition

 Figure 25.2 

Stock market returns in U.S. dollars and local currencies for 2010 

  Source: Datastream,   online.thomsonreuters.com/datastream   .  

of returns on U.S. large stocks for the same period was 16%. Hence, exchange rate 

volatility was roughly 70% that of the volatility on stocks. Clearly, an active investor 

who believes that a foreign stock is underpriced but has no information about any mis-

pricing of its currency should consider hedging the currency risk exposure when tilt-

ing the portfolio toward the stock. Exchange rate risk of the major currencies has been 

relatively high so far in this century. For example, a study by Solnik (1999) for the 

period 1971–1998 finds lower standard deviations, ranging from 4.8% (Canadian dollar) 

to 12% (Japanese yen).   

 In the context of international portfolios, exchange rate risk may be mostly diversifi-

able. This is evident from the low correlation coefficients in  Table 25.3 , panel B. (There 

are notable exceptions in the table, though, and this observation will be reinforced when 

we compare the risk of hedged and unhedged country portfolios in a later section.) Thus, 

passive investors with well-diversified international portfolios need not be concerned with 

hedging exposure to foreign currencies. 

 The effect of exchange rate fluctuations also shows up in  Table 25.3 , panel C, which 

presents the returns on money market investments in different countries. While these invest-

ments are virtually risk-free in local currency, they are risky in dollar terms because of 

exchange rate risk. International investment flows by currency speculators should roughly 

equalize the expected dollar returns in various currencies, adjusted for risk. Moreover, 

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