Currency hedging strategies in strategic benchmarks and the global and Euro sovereign financial crises

Abstract

This paper investigates dynamic currency hedging benefits, with a further focus on the impact of currency hedging before and during the recent financial crises originated from the subprime and the Euro sovereign bonds. We take the point of view of a Euro-based institutional investor who considers passive investment strategies in portfolios holding Euro-denominated and non-Euro (foreign) assets. We analyze the impact of the model specification to improve the risk-return trade-off when currency risk is hedged. Hedging strategies of currency risk, using exchange rate futures and driven by several multivariate GARCH models, depend on the portfolio composition and period analyzed. Dynamic covariance models provide limited evidences of a decrease in hedging ratios compared to naïve hedging strategies based on linear regressions or variance smoothing. Nevertheless, those results are coupled with better performances of dynamic covariance models in terms of hedging effectiveness and improved Sharpe ratios.