Currency Management for Offshore Investing

Abstract

We focus on the issue of currency management in the context of offshore investing with an emphasis on the selection of an appropriate currency hedge. It is shown that when seeking to minimize the risk associated with the Rand value of a foreign asset, the optimal currency hedge is strongly dependent on the correlation between the returns of the foreign asset in the original currency and the exchange rate. For very negative correlation values, currency options allow for the most efficient reduction of risk, while higher values of correlation call for the use of linear forward contracts. We outline a systematic approach to the currency hedge decision in which the statistical properties of the foreign holding are considered across correlation scenarios for a wide range of candidate currency hedges. We also show how the question of what proportion of a portfolio to invest in foreign assets can be approached via an optimization procedure that simultaneously solves for the optimal currency hedge. Such an approach allows one to take into account the correlation between the exchange rate and the domestic assets in the portfolio and leads to further risk reduction benefits. An important finding is that the particular choice of currency hedge within a balanced portfolio is potentially different to the case of considering the foreign asset in isolation. Whereas the same currency option strategy is favoured in the balanced portfolio across all foreign asset-exchange rate correlation scenarios for the example considered, the choice of hedge in the single asset case varies across correlation.