Portfolio insurance for foreign exchange risk management

Abstract

Since the advent of floating exchange rates in the early 1970s management of exchange exposure has received much attention. Adler and Dumas [1, 21 and Dufey and Srinivasulu [14] contend that, because of imperfect markets for real goods and services and financial assets, exchange rate risk is relevant. Because of informational inefficiencies, exchange rate risk should be managed at the corporate rather than the shareholder level. Logue and Oldfield [22] and others suggest that hedging should be focused on cash flow rather than financial statement exposure. Several studies have evaluated and compared hedging alternatives that employ currency forward or futures contracts. Hill and Schneeweis 1191 compared the hedging capabilities of forward and futures contracts, finding no significant differences for the Deutschmark or British pound, but superior forward hedging for the Japanese yen. Babbel[5] used a mean-variance approach to compare the hedging effectiveness of the forward hedge and the money market hedge, Calderon-Rossel [12] provided a framework for choosing between either of these alternatives or not hedging. Swanson and Caples (291, Grammatikos [17], and others attempt to determine the optimal hedge ratio in currency futures and forward markets. Chang and Shanker [13] show that a synthetic futures contract generally exhibits less hedging effectiveness than currency futures contracts. And Eun and Resnick 1151, examining the hedging of interna~on~y diversified stock portfolios, report that substantial reductions in exchange rate risk obtain via forward contract hedging. While forward, futures, and ~ternational money market hedges effectively remove downside exchange risk, they also preclude the possibility of upside potential when exchange rates move in a favorable direction. An alternative