being completely hedged to being completely unhedged. For example, a euro investor's foreign bond volatility increases from about 4 percent to almost 10 percent when the portfolio shifts from being completely hedged to being completely unhedged. The same point can be made using a portfolio risk decomposition, or hot spots, analysis (see Chapter 3). Rather than focus on portfolio volatility, this method looks at the marginal contribution to risk (expressed in percentage terms) of currency positions at different levels of currency hedging. The results are illustrated in Figure 11.4, which uses the same portfolio volatility levels, alternative currency perspectives, and separate foreign equity and foreign bond portfolio analyses as Figure 11.3. Figure 11.4 shows that open currency positions contribute (at the margin) significantly larger portfolio risk to foreign bond portfolios than to foreign equity portfolios, irrespective of base currency. In fact, currency accounts for more than 80 percent of the risk in a completely unhedged foreign bond portfolio, regardless of base currency, but no more than 40 percent of portfolio volatility (at the margin) in a completely unhedged foreign equity portfolio. How can investors use the information in Figure 11.4? Suppose an investor wants no more than 20 percent of a foreign asset portfolio's volatility to be associated with currency. An investor would need to hedge at least 75 percent of the currency exposure in their foreign bond portfolio (irrespective of base currency) but no more than 50 percent in their foreign equity portfolio. Because currency dramatically affects foreign fixed income, we recommend that investors hedge 100 percent of the currency exposure in their foreign bond portfolios. Figure 11.4 also suggests that currency hedging affects foreign equity portfolio risk much more dramatically for euro-, sterling-, and yen-based investors than it does for investors using U.S. dollars. In fact, currency contributes little risk to a U.S. investor's foreign equity portfolio, which may explain why many U.S. investors set unhedged global equity benchmarks. Figures 11.3 and 11.4 gauge currency hedging's impact on portfolios that have foreign equity and foreign bond holdings only. Most investors, of course, hold domestic as well as foreign assets. How does currency hedging affect a portfolio that includes both domestic and foreign assets? To answer this question, let's first look at a portfolio such as the portfolio of global equities and global bonds held in their global capitalization weighted proportions. As shown in Chapter 8, most of the value of global asset markets is concentrated in U.S. dollar-denominated assets. Although most investors' assets don't mirror global capitalization weights, these allocations can provide a useful neutral reference point for portfolio analysis. Our objective is to isolate a neutral reference point hedge ratio. Suppose investors in each region hold their assets according to their global capitalization weighted proportions. We could easily assess how different levels of currency hedging affect portfolio volatility. And we could quickly measure currency's contribution, at the margin, to overall portfolio risk at different currency hedging levels. The four graphs in Figure 11.5 show how currency hedge levels affect portfolio volatility (assuming that all investors are holding their assets according to global capitalization weights). For each currency hedge level, the graphs plot portfolio