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This thesis dissertation analyses the correlation structure of foreign equity returns and exchange rate returns, and explores the impact of hedging exchange rate risk on international equity portfolios, using a principal component analysis – the study comprises the period from January 1992 to December 2013. We hedged an equally weighted equity portfolio by adding currency positions in an overlay fashion. By doing so, we increased portfolio returns but also volatility. Nevertheless, we found that the risk-reward ratio improved. When comparing this methodology to an OLS hedging, where both returns and volatility decreased, we observe a higher increase of risk-reward ratio in the PCA hedging. In addition, it improves skewness, while in OLS hedging it deteriorates, and decreases kurtosis.
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Principal component analysis Currency risk Exchange rates Equity markets Correlation Portfolio hedging