PORTFOLIO DOLLARIZATION AND CURRENCY HEDGING STRATEGIES IN EMERGING MARKETS

Abstract

Investors in emerging markets frequently incorporate dollar-denominated assets into their portfolios to mitigate currency risk, stabilize wealth, and enhance diversification. Empirical research shows that exposure to the U.S. dollar reduces portfolio volatility for investors subject to exchange-rate instability and political uncertainty, such as those in Brazil. Dollarization benefits arise from the negative correlation between domestic political or macroeconomic stress and local-currency depreciation, which increases the domestic value of foreign assets. Implementation strategies—including physical dollars, international ETFs and BDRs, and currency-hedged funds—differ in costs, liquidity, and embedded risks. Academic literature also documents that political-risk shocks and institutional fragility are strong predictors of increased foreign-currency allocation. Nevertheless, dollarization involves trade-offs, including potential opportunity costs during domestic-currency appreciation and basis or liquidity risks in derivative-based hedging. Evidence suggests that disciplined and moderate dollar exposure can improve downside protection and long-term risk–return performance for emerging-market investors, though optimal allocations are regime-dependent and sensitive to macroeconomic conditions.