Currency Allocation Research Articles

Dynamic currency hedging with non-Gaussianity and ambiguity

This paper introduces a non-Gaussian dynamic currency hedging strategy for globally diversified investors with ambiguity. It provides theoretical and empirical evidence that, under the stylized fact of non-Gaussianity of financial returns and for a given optimal portfolio, the investor-specific ambiguity can be estimated from historical asset returns without the need for additional exogenous information. Acknowledging non-Gaussianity, we compute an optimal ambiguity-adjusted mean-variance (dynamic) currency allocation. Next, we propose an extended filtered historical simulation that combines Monte Carlo simulation based on volatility clustering patterns with the semi-parametric non-normal return distribution from historical data. This simulation allows us to incorporate investor's ambiguity into a dynamic currency hedging strategy algorithm that can numerically optimize an arbitrary risk measure, such as the expected shortfall. The out-of-sample backtest demonstrates that, for globally diversified investors, the derived non-Gaussian dynamic currency hedging strategy is stable, robust, and highly risk reductive. It outperforms the benchmarks of constant hedging as well as static/dynamic hedging approaches with Gaussianity in terms of lower maximum drawdown and higher Sharpe and Sortino ratios, net of transaction costs.

Enhancing Foreign Currency Allocation for Private Sector Development – Case of the Reserve Bank of Zimbabwe Forex Auction System

Foreign currency shortages remain a perennial challenge in Zimbabwe leading to several spillover effects such as shortages in electricity, raw materials, fuel, inflation among other market distortions. The central bank introduced the Dutch Auction system in an attempt to address forex shortages but the effectiveness of this approach has been questioned. This study employed the Vector Autoregressive (VAR) and error corrected (VECM) models in order to empirically determine how the Reserve Bank of Zimbabwe can efficiently allocate foreign currency in a manner which supports private sector development. In the short run, the auction is an effective tool to promote private sector development. However, long run analysis presents a deletions effect. This is due to a rise in round-tripping from market participants to leverage and perform arbitrage on different rates (auction and parallel), increased backlog reflecting shortages in allotments and high incidences of corruption. All this leads to a significant decrease in the confidence levels of the economy among private stakeholders. The study recommends monitoring of authorized auction dealers, improve public confidence by minimizing rent-seeking behavior, re-model exporters participation in the auction system or abandoning the auction system altogether.

Optimal carry trade portfolio choice under regime shifts

This paper studies optimal currency allocation of the carry trade in foreign exchange (FX). A number of empirical studies have documented a phenomenon referred to as the ‘forward premium puzzle’, which states that the carry trade is profitable on average. However, the carry reversal during the 2008 global crisis periods wiped out the profits earned by the trade. To account for the regime shifts in the joint distribution of returns on the carry trade with FX market portfolios, we adopt a Markov regime switching model. We find evidence of two economic regimes: one state captures periods of the forward premium puzzle and UIP being violated, whilst the other reports high FX volatility and negative return of carry trade portfolio. Furthermore, to quantify the economic significance of regimes in returns on currency portfolios, we consider their importance in investors’ optimal portfolio allocation problem. We find strong evidence that optimal currency portfolio holdings vary significantly across regimes and across short and long investment horizons, as investors anticipate a shift out of the current state. Our results also show that the regimes partially anticipate peso events as well as the changes of funding liquidity measured by the TED spreads. A strategy that accounts for regimes, thus, generates overall stronger performance than the single-state Gaussian IID model, a carry trade procedure as well as a buy-and-hold strategy.

Do central banks rebalance their currency shares?

Do central banks rebalance their currency shares? The answer matters because the dollar’s predominant role in large official reserve holdings means that widespread rebalancing requires central banks to buy (sell) a depreciating (appreciating) dollar, stabilising its value against other major currencies. We hypothesise that larger reserve holdings have led central banks to approach their investment more systematically and to make rebalancing in the face of exchange rate changes the norm. We illustrate the choice with two polar case studies: the US clearly does not rebalance its small FX reserves; Switzerland does rebalance its very large reserves, so that changes in exchange rates do not move its currency allocation. Our hypothesis finds partial support in global aggregated data. They reject both no rebalancing and full rebalancing and point to emerging market economies as the source of the aggregate result. We also test for rebalancing with panel data and find that our sample economies on average again behave in intermediate fashion, partially but not fully rebalancing. However, when observations are weighted by the size of reserves, the panel analysis finds full rebalancing. A variety of control variables and splits of the panel sample do not alter the thrust of these findings. Central banks rebalance their FX reserves extensively but not uniformly.

Optimal Currency Allocation to Add Alpha and Reduce Risk

We propose a framework for optimal currency allocations taken relative to a strategic benchmark, which may build in existing hedging positions. We determine optimal currency positions to obtain higher expected returns than the benchmark holding the risk constant, or to reduce risk but hold the expected return of the benchmark constant, or both. The currency exposures relative to the strategic benchmark are considered jointly across all asset classes and currencies. We make the intuition explicit in a theoretical setting without constraints and empirically illustrate the framework with two portfolios: a representative portfolio for a Wealth manager denominated in Euros and a typical pension fund portfolio denominated in Pounds. Optimal currency allocations to reduce risk tend to hedge all or a significant fraction of currency exposures for both portfolios. We find certain hedges, like to Australian dollars for the Euro Wealth investor and Japanese Yen for the GBP pension portfolio, to be optimal to maximize returns with the same risk as the strategic benchmark.

Do Central Banks Rebalance Their Currency Shares?

Do central banks rebalance their currency shares? The answer matters because the dollar’s predominant role in large official reserve holdings means that widespread rebalancing requires central banks to buy (sell) a depreciating (appreciating) dollar, stabilising its value against other major currencies. We hypothesise that larger reserve holdings have led central banks to approach their investment more systematically and to make rebalancing in the face of exchange rate changes the norm. We illustrate the choice with two polar case studies: the US clearly does not rebalance its small FX reserves; Switzerland does rebalance its very large reserves, so that changes in exchange rates do not move its currency allocation. Our hypothesis finds partial support in global aggregated data. They reject both no rebalancing and full rebalancing and point to emerging market economies as the source of the aggregate result. We also test for rebalancing with panel data and find that our sample economies on average again behave in intermediate fashion, partially but not fully rebalancing. However, when observations are weighted by the size of reserves, the panel analysis finds full rebalancing. A variety of control variables and splits of the panel sample do not alter the thrust of these findings. Central banks rebalance their FX reserves extensively but not uniformly. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Impact of Remittances on Natural Rate of Dollarization—Trends in Caucasus and Central Asia

This paper discusses migration and remittances trends, and calculates the natural (or benchmark) level of dollarization in Caucasus, Central Asia and others in the region. This natural level of dollarization is conceptually linked to the currency allocation in a portfolio of deposits to maximize welfare, in line with Ize and Levy Yeyati (2003). The fall in remittances due to the economic slowdown since the spread of COVID-19 affects the macroeconomic fundamentals that determine demand for foreign currency deposits. We calculate the natural dollarization level by integrating structural macroeconomic characteristics. We show that despite the reduction in deposit dollarization, there is still a gap with respect to the natural level of dollarization, especially in a scenario of (persistent) lower remittance inflows.

Impact of Remittances on Natural Rate of Dollarization-Trends in Caucasus and Central Asia

This paper discusses migration and remittances trends, and calculates the natural (or benchmark) level of dollarization in Caucasus, Central Asia and others in the region. This natural level of dollarization is conceptually linked to the currency allocation in a portfolio of deposits to maximize welfare, in line with Ize and Levy Yeyati (2003). The fall in remittances due to the economic slowdown since the spread of COVID-19 affects the macroeconomic fundamentals that determine demand for foreign currency deposits. We calculate the natural dollarization level by integrating structural macroeconomic characteristics. We show that despite the reduction in deposit dollarization, there is still a gap with respect to the natural level of dollarization, especially in a scenario of (persistent) lower remittance inflows.

Currency Substitution in Laos

This study investigates the determinants of currency substitution in Laos based on the function of money demand. The empirical model is estimated using the autoregressive distributed lag approach to cointegration for the period 1993–2012. Our estimation results indicate that the interest rate differential is a significant currency substitution determinant in the Laos economy. Moreover, there is evidence supporting the existence of a ratchet effect in the currency allocation of deposits, implying that particularly strong policies should be pursued over an extended period of time in order to convince depositors to switch back to kip‐denominated assets.

CHOOSING THE CURRENCY STRUCTURE OF FOREIGN‐CURRENCY DEBT: A REVIEW OF POLICY APPROACHES

AbstractStarting from the constraints and incentives that cause countries to issue debt in foreign currency, this paper provides an overview of policy approaches for choosing the optimal currency structure of sovereign foreign‐currency debt. The objective of sovereign debt managers generally includes both risk and cost minimisation, while constraints to foreign‐currency debt allocation originate in the parameters of the domestic macroeconomy, the shocks it faces and the initial conditions. Overall, the main parameters that drive the solutions for optimal currency allocation of foreign‐currency debt are the covariances of macrovariables with exchange rates and the variances of different exchange rates. Both the covariances and the exchange rate volatility can be deceptive when a fixed exchange rate regime is maintained, however. To adequately capture the expected covariances in the context of managed exchange rate regimes, we suggest that sovereign debt managers work with equilibrium instead of actual exchange rates. For the same reason and because the estimates of relative exchange rate variances should be forward looking, we suggest using synchronisation indicators in the policy analysis to better capture the underlying drivers of exchange rate volatility across currencies. Copyright © 2010 John Wiley & Sons, Ltd.

Relative Numeraire Risk and the Currency Allocation of Sovereign Portfolios

Abating dominance of the US Dollars (US$) as an asset class notwithstanding, the truly structural question is whether it ought to remain the universal numeraire by which sizes and risk-return performances of international reserves and sovereign wealth funds (henceforth sovereign portfolios) are measured and examined in the international arena. Compelling though a normative case may be for optimising the sovereign portfolio’s currency allocation (benchmark) against risk-return objectives as measured in the relevant local numeraire be it the sovereign domestic currency unit, an index of international import/liability exposures, or any amalgam of anticipated future cross-border transaction needs, fact remains that professional analysts and observers in practice anchor sovereign portfolio analytics in some monetary quanta, which for the foreseeable future will be none other than the US$.

Managing Currency Risks for Global Families

In a world of increased mobility and globalized business, many families face increasing complexity in the area of currency risk management. This article describes the sources of currency risks for global families and suggests ways to manage them for both ongoing living expenses and cash flows as well as the long-term investment portfolio. In the presence of highly uncertain future consumption, hedging foreign currency risks may become less favorable and a more generic currency allocation to optimize long-term risk–return benefits may be applied. The authors test several of these approaches and find that a consumptionweighted currency basket or equal-weighted baskets may perform best. <b>TOPICS:</b>Currency, risk management, global, wealth management

International Reserves Management and Currency Allocation: A New Optimisation Framework Based on a Measure of Relative Numeraire Risk (RNR)

This paper addresses the challenges involved in optimising the currency allocation of international reserves portfolios based on ex ante risk-return statistics measured in one numeraire (e.g. chosen to reflect the economy’s import currency composition), while reserves size continues to be scrutinised ex post in another numeraire (i.e. USD). This paper proposes the Relative Numeraire Risk (RNR) measure to capture quantitatively (basis points) how Pareto-suboptimal efficient frontier in one optimisation numeraire will appear in different report numeraire(s) and outlines the RNR reserves management framework. Experiments entailed 6 numeraire choices on weekly (2000 to H1-2009) FX/government bond data in 4 reserves currencies.

Currency Allocation of Public External Debt and Synchronization Indicators of Exchange Rate Volatility

This paper uses synchronization indicators of domestic and foreign fundamentals to choose suitable currency allocation of public external debt. The selection of explanatory variables for exchange rate volatility is motivated using a New Keynesian Policy model that predicts that not only traditional optimum currency area (OCA) variables, but also variables considered by the literature on currency preferences, such as money velocity, should be relevant for explaining exchange rate volatility. I find that measures of inflation synchronization, money velocity synchronization and interest rate synchronization are useful indicators for deciding on the currency denomination of public external debt.

Reserve Currency Allocation: An Alternative Methodology

This paper provides a quantitative framework for choosing the composition of reserve currencies. Assuming that the central bank's performance objectives are defined in terms of ex post returns in different currency numeraires, the currency allocation problem is formulated as a multi-objective optimisation problem. The advantage of the proposed methodology is that it does not require any explicit assumptions about the risk preferences of the central bank or knowledge of the currency numeraire. Using some proxy values for the possible range of ex post returns measured in different currency numeraires, the study shows how the currency allocation problem can be solved. In particular, the proposed method borrows the concept of the degree of satisfaction from fuzzy decision theory and maximises such a function defined on the least favourable return outcome. In this sense, the proposed method differs from standard utility-based approaches which look for solutions that are best on average. The results of the study indicate that central banks on average are dollar-based investors on the basis of current allocations. Further, the study also indicates that if central banks consider an ex post return profile that safeguards the purchasing power of the reserves, then the currency distribution of reserves should more closely resemble the SDR basket.

Global Asset Allocation in Fixed Income Markets

Many global investors are faced with the problem of choosing an appropriate currency allocation of their assets in the capital markets. This paper addresses the asset allocation problem under the assumption that the investment universe is comprised of unhedged risk-free bonds in different countries. In general, the total return arising from holding an unhedged bond portfolio is comprised of two components. One component of the return arises from the bond price changes resulting from yield curve movements and the other component arises from exchange rate fluctuations. In this paper, bond price changes are assumed to be governed by a one factor interest rate term structure model. The return arising from exchange rate changes is extracted by modelling the evolution of exchange rates as a jump stochastic process. The jump process is assumed to occur in the volatility of exchange rate returns. This model is consistent with the empirical evidence that the volatility of currency returns exhibits GARCH behaviour. Using the models that describe the evolution of interest rates and exchange rates, the optimal portfolio allocation problem is solved in a mean-variance setting by Monte Carlo simulation. The out-of-sample performance of the portfolios selected is also presented and is compared against those obtained using other existing methods.

Consistency management in Deno

We describe a new replicateddobject protocol designed for use in mobile and weaklydconnected environments. The protocol differs from previous protocols in combining epidemic information propagation with voting, and in using fixed perdobject currencies for voting. The advantage of epidemic protocols is that data movement only requires pairdwise communication. Hence, there is no need for a majority quorum to be available and simultaneously connected at any single time. The protocols increase availability by using voting, rather than primarydcopy or primarydcommit schemes. Finally, the use of perdobject currencies allows voting to take place in an entirely decentralized fashion, without any server having complete knowledge of group membership. We show that currency allocation can be used to implement diverse policies. For example, uniform currency distributions emulate traditional voting schemes, while allocating all currency to a single server emulates a primarydcopy scheme. We present simulation results showing both schemes, as well as the performance advantages of using currency proxies to temporarily reallocate currency during planned disconnections. Furthermore, we discuss an initial design of the underlying replicateddobject system and present a basic API.

Tactical Currency Allocation Revisited

This paper analyzes four previously documented regularities in the currency futures markets and develops four simple trading rules based on these regularities. These trading rules are examined both separately and in combination, and all but one generate significant profits over the full sample period from January 1978 through May 1996. The trading rules appear to be losing their power, however, and become less profitable over the more recent from January 1992 through May 1996.

Rachet Effects in Currency Substitution: An Application to the Kyrgyz Republic

Currency substitution is now a common issue in the design of monetary policy in most transition economies. This paper analyzes the persistence of this phenomenon in the Kyrgyz Republic by including a ratchet variable in the model specification. The main conclusion of the paper is that, while some degree of persistence is present in the allocation of bank deposit, currency substitution in the economy at large has not yet reached a point where reversing it would be difficult. In this regard, there is still room for monetary policy to influence currency allocation in the private sector.

Tactical Currency Allocation

(1993). Tactical Currency Allocation. Financial Analysts Journal: Vol. 49, No. 5, pp. 47-52.