Currency hedging and quantitative easing: Evidence from global bond markets

• Published date: 01 June 2021
• Author: Lawrence Kryzanowski,Jie Zhang,Rui Zhong
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/irfi.12291

ORIGINAL ARTICLE

Currency hedging and quantitative easing:

Evidence from global bond markets

Lawrence Kryzanowski

1

| Jie Zhang

2

| Rui Zhong

3

1

John Molson School of Business, Concordia

University, Montreal, Quebec, Canada

2

Trent School of Business, Trent University,

Peterborough, Ontario, Canada

3

UWA Business School, University of

Western Australia, Crawley, Western

Australia, Australia

Correspondence

Jie Zhang, Trent School of Business, Trent

University, 1600 West Bank Drive,

Peterborough, Ontario K9L 0G2, Canada.

Email: jiezhang@trentu.ca

Abstract

We examine the influence of quantitative easing (QE) in the

United States on hedging effectiveness and performance

(E&P) of international bond portfolios. During the QE

period, the bond portfolios have significantly lower excess

returns and variances, and their excess returns (variances)

are positive (negative) with the U.S. Federal Reserve's

(Fed's) mortgage-backed securities holdings and are less

positive (less negative) with the Fed's Treasury holdings.

E&P is higher for optimal versus full hedging during the QE

versus pre-QE period and differs for portfolios from devel-

oped and emerging countries. Results are robust using other

hedging E&P measures and excluding countries with their

own QEs implementations.

KEYWORDS

currency hedging, Federal Reserve's security-type holdings,

international bond portfolios, quantitative easing

JEL CLASSIFICATION

E52; E58; F31; G11; G15

“We believe the Federal Reserve's large-scale asset purchase plan (so-called “quantitative easing”)

should be reconsidered and discontinued…. The planned asset purchases risk currency debasement

and inflation, …”

1

—From an open letter to Ben Bernanke

1|INTRODUCTION

The U.S. Federal Reserve (Fed) initiated an unconventional monetary policy (UMP), so-called quantitative easing

(hereafter, QE), starting from November 2008 by purchasing long-term government bonds, mortgage-backed

Received: 18 January 2019 Accepted: 20 October 2019

DOI: 10.1111/irfi.12291

© 2019 International Review of Finance Ltd. 2019

International Review of Finance. 2021;21:555–597. wileyonlinelibrary.com/journal/irfi 555

securities (MBS) and agency debts. The objective was to stimulate the economy by injecting credit and liquidity into

the financial markets (Bernanke, 2010a). According to Rodnyansky and Darmouni (2017), the Fed had accumulated

$1.75 trillion in MBS, or about 30% of the issued MBS by the end of the third QE round.

2

Figure 1 exhibits the net

effects of long-term fixed-income transactions by the Fed on its holdings during the three QE rounds.

3

Such unprecedented large-scaled purchases of fixed-income securities (specifically mortgage-backed securities

and Treasuries) by the Fed had a major impact on both domestic and international bond markets. Domestically,

the QEs significantly reduced U.S. long-term government bond yields (e.g., D'Amico & King, 2013; Gagnon,

Raskin, Remache, & Sack, 2011; Glick & Leduc, 2012; Krishnamurthy & Vissing-Jorgensen, 2011), mortgage rates

(Hancock & Passmore, 2011) and bond yields of non-financial firms in the U.S. (Gilchrist & Zakrajšek, 2013). Large

scaled purchases of MBS and Treasuries by the Fed also significantly increased global corporate bond issuances

across developed and emerging countries (Lo Duca, Nicoletti, & Martinez, 2016), and significantly reduced long-

term government bond yields in the developed countries (Gilchrist, Yue, & Zakrajšek, 2018; Neely, 2015).

The U.S. QEs are not only associated with a depreciation of the U.S. dollar against various foreign currencies,

such as the Euro, Australian dollar, Pound Sterling, Brazilian real, and the Indian rupee (see Figure 2) but are also

expected to have an impact on the currency risk exposure, expected returns and covariances of international bond

portfolios through the portfolio rebalancing and risk-shifting channels. However, little is known about the effect of a

QE on the effectiveness and performance of the risk management strategies for international bond portfolios. To fill

this gap in the literature, we examine the spillover effects of the evolution of the holdings of the Fed prior to and

during the QEs on the effectiveness and performance of unhedged and hedged international bond portfolios from

the perspective of U.S. investors.

4

Based on the portfolio rebalancing channel, central bank purchases of long-term securities depress term pre-

miums and longer-term interest rates which are associated with the public holdings of longer-term assets (Yellen,

2011), and also can be transmitted to asset prices across market segments and countries (e.g., Bernanke, 2012;

Fratzscher, Lo Duca, & Straub, 2016). Investors which are crowded out by central bank purchases rebalance their

portfolios by switching into close substitute assets with better risk-adjusted return prospects, which leads to addi-

tional price effects for a broad variety of assets (Fratzscher et al., 2016).

Furthermore, according to the preferred-habitat model (e.g., Greenwood & Vayanos, 2010; Vayanos & Vila,

2009), investors have preferences for specific maturities. Since the interest rate for a given maturity is determined

by the demand of investors with those preferences and the supply of bonds with that maturity, an increase in

demand for long-term bonds, for example, by the Fed, raises long-term bond prices and reduces their yields. If the

preferred habitat model works together with the international portfolio rebalancing channel, we would expect that

the yields of long-term government bonds across countries are reduced. Since government treasury yields are one of

FIGURE 1 The securities holdings by

the U.S. Federal Reserve with respect to

maturities for over 5 years or over

10 years. Note: The numbers of MBS5Y

and MBS10Y are very close to each other,

so the two lines are almost overlapping.

The percent that a security type

represents of the total security holdings

of the Fed is represented on the y-axis

556 KRYZANOWSKI ET AL.

the key determinants of the yields for various types of bonds (such as sovereign debts and corporate bonds), the

large scale of purchases during a QE are expected to inevitably affect the effectiveness and performance of the risk

management strategies adopted by investors to manage their international bond portfolios.

As discussed more fully in Section 2.3, we measure the hedging effectiveness and hedging performance of cur-

rency hedging strategies by the percentage changes of the variances and the differences of the Sharpe ratios

between hedged and the unhedged portfolios, respectively. We employ currency forwards to hedge currency risk by

adopting two hedging strategies that are commonly used in the currency risk management of investment portfolios

5

:

Panel A: Developed Countries

Panel B: Emerging Countries

U.S. Dollar/Australian Dollar

2003 2005 2008 2010 2012 2014

0.6

0.7

0.8

0.9

1

1.1

U.S. Dollar/Pound Sterling

2003 2005 2008 2010 2012 2014

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2

2.1

U.S. Dollar/Euro

2003 2005 2008 2010 2012 2014

1.1

1.2

1.3

1.4

1.5

1.6

U.S. Dollar/Japanese Yen

2003 2005 2008 2010 2012 2014

0.008

0.009

0.01

0.011

0.012

0.013

0.014

U.S. Dollar/Brazilian Real

2003 2005 2008 2010 2012 2014

0.3

0.35

0.4

0.45

0.5

0.55

0.6

0.65

U.S. Dollar/Hungarian Forint

2003 2005 2008 2010 2012 2014

4

4.5

5

5.5

6

6.5

7x 10-3

U.S. Dollar/Indian Rupee

2003 2005 2008 2010 2012 2014

0.014

0.016

0.018

0.02

0.022

0.024

0.026

U.S. Dollar/South African rand

2003 2005 2008 2010 2012 2014

0.08

0.1

0.12

0.14

0.16

0.18

FIGURE 2 Exchange rates around and during the quantitative easings (QEs). This figure depicts the exchange

rates of U.S. dollars to the currencies in some major developed (Panel A) and emerging countries (Panel B) for the

period from September 2003 to October 2014 at a weekly frequency. The shaded areas indicate the QE periods

designated by the Federal Reserve in the U.S

KRYZANOWSKI ET AL.557