Optimal Currency Hedging Research Articles

Hedging with an Edge: Parametric Currency Overlay

We propose an optimal currency hedging strategy for global equity investors using currency value, carry, and momentum to proxy for expected currency returns. A benchmark risk constraint ensures the overlay closely mimics a fully hedged portfolio. We compare this with naïve and alternative hedges in a demanding out-of-sample test, with transaction and rebalancing costs and margin requirements. Other hedging methods generally reduce risk but at a cost. Some tend to short currencies with high returns and all incur substantial costs with frictions, mostly margin requirements and equity rebalancing costs. The proposed strategy uses predictable returns to reduce this cost. It produces a statistically significant 17% gain in Sharpe ratio and an annualized Jensen-α of 0.93% versus a fully hedged benchmark. Notably, most of the implementation costs of the strategy would be incurred by the benchmark anyway. This reduces its marginal cost and highlights a specific synergy of integrating hedging with speculation. This paper was accepted by Gustavo Manso, finance.

Optimal foreign exchange hedge tenor with liquidity risk

We develop an optimal currency hedging strategy that allows fund managers who own foreign assets to choose the hedge tenors that will maximize their foreign exchange (FX) carry returns within a liquidity risk constraint. The strategy assumes that the offshore assets are fully hedged with FX forwards. The chosen liquidity risk metric is cashflow at risk (CFaR). The strategy involves time-dispersing the total nominal hedge value into future time buckets to maximize (minimize) the expected FX carry benefit (cost), given the constraint that the CFaRs in all the future time buckets are well managed within a liquidity budget. We show by Monte Carlo simulation and by backtesting that our hedging strategy successfully delivers good carry trade returns with little liquidity risk. We also provide practical insights on when and why fund managers should choose short-dated or long-dated tenors.

Optimal Currency Hedging for International Equity Portfolios

This study explores optimal currency exposures in international equity portfolios through the lens of a modified mean–variance optimization framework. We decomposed the optimal currency portfolio into a “hedge portfolio” that uses a dynamic risk model to minimize equity volatility and an “alpha-seeking portfolio” based on the well-documented currency styles of value, momentum, fundamental momentum, and carry. This method is an integrated and economically intuitive approach to currency management that simultaneously provides lower risk and higher returns than either hedged or unhedged benchmarks. Crucially, the solution is practical, with realistic and implementable leverage, turnover, and tail-risk characteristics.

Optimal Currency Hedging for International Equity Portfolios

We explore optimal currency exposures in international equity portfolios through the lens of a modified mean-variance optimization framework. We decompose the optimal currency portfolio into a “hedge portfolio” which minimizes equity volatility using a dynamic risk model and an “alpha seeking portfolio” based on the well-documented currency styles of value, momentum and carry. This is an integrated and economically intuitive approach to currency management that simultaneously provides lower risk and higher returns compared to both hedged and unhedged benchmarks. Crucially, the solution is practical with realistic and implementable leverage, turnover and tail risk characteristics.

Long-Only Momentum, Currency Hedging and Transaction Costs: Implications for a Swiss Equity Investor

This study investigates the efficiency of European capital markets by examining the profitability of four long-only momentum strategies, after transaction costs of 0.5%, from the perspective of a Swiss equity investor. The investment universe considered in this study includes securities denominated in CHF, EUR, and GBP. In a first step, momentum strategies are evaluated over a period of fifteen years without hedging exchange rate risk of EUR and GBP. In a second step, the performance of full- and optimal currency hedging strategies is assessed. Results show that momentum strategies, after having considered transaction costs, do not significantly outperform a simple buy-and-hold strategy in risk-adjusted terms. Nevertheless, currency hedging strategies do significantly reduce the return volatility of portfolios.

Optimal currency hedging in- and out-of-sample

The optimal currency hedging policy for portfolios with foreign asset exposure is easily determined by mean-variance analysis, yet many investors choose inefficient hedging policies. Some investors reject the mean-variance approach because they believe the required inputs are not sufficiently stable to generate satisfactory out-of-sample results, whereas other investors blindly choose a 50 per cent uniform hedging policy in order to minimise ‘regret risk’. We present results that are relevant both to foreign equity managers and to plan sponsors with liability obligations, and these results demonstrate that naively determined inputs to mean-variance analysis are sufficiently stable to reduce out-of-sample portfolio risk. We then challenge the minimum regret solution for three reasons: it implies an implausible utility function; its empirical validity is confounded by errors in means and even if investors have such an implausible utility function, a variant of mean-variance analysis yields a solution that is superior to a constant 50 per cent hedge ratio. Finally, we investigate the economic rationale that gives rise to varying optimal hedging polices across countries.

Behavioral currency hedging for international portfolios

The purpose of this paper is to incorporate behavioral issues as it relates to the active currency hedging of international portfolios in the context of traditional expected utility maximization approach. The uniqueness of the approach is that separate risk aversion parameters are introduced for asset and currency markets. The paper is similar in spirit to Black (Black, F. 1989, Universal hedging, Financial Analysts Journal (July–August), 16–22.), who argued that a portion of foreign equity investments should be permanently unhedged, which is basically postulating that one should take a buy-and-hold position in currency with a fraction of the capital. The behavioral twist included in the traditional expected utility maximization approach results in lower hedge ratios, ceteris paribus, partly due to the asymmetric nature of the compensation structure of currency managers. Since the asymmetric nature of incentive schemes of asset and currency managers dictates how one optimizes the investment portfolio of a pension or endowment fund, the unusual behavior of a given institutional fund manager should not be called “irrational,” only because the optimal currency hedging level deviates from the one derived under rational expectations. This only justifies the use of different hedging strategies by various institutional investors. We describe in detail how the level of hedging should be revised downwards because of behavioral factors. Conclusions are in the context of what people would predict to see in the market, if certain investors behave in an “irrational” way.

Optimal currency hedging

This paper characterizes optimal currency hedging in several models of downside risk. We consider, in turn, three models of hedging: (i) a firm that chooses its hedging policy in the presence of bankruptcy costs; (ii) an all-equity firm that faces a convex tax schedule; and (iii) a firm whose manager is subject to loss aversion. In all these models, and contrary to conventional wisdom, we show that forwards dominate options as hedges of downside risk.

Preference-Based Strategic Currency Hedging

This article considers the value to a given investor of volatility reduction through currency hedging relative to taking an unhedged position. Included is a decision framework to help international investors analyze how the potential risk reduction benefits of hedging interact with the investor's beliefs about the currency risk premium, risk aversion, and investment constraints to determine an optimal currency-hedging strategy. In our framework, investors choose from nine hedging strategies, each of which may be optimal under a specific set of assumptions. The article concludes that a unitary hedge strategy is best for investors who do not forecast currency returns. For those who make strategic currency-return forecasts, our aggregated results suggest an optimized hedge strategy using expected return inputs from an asset-pricing model.

An Empirical Study of Portfolio Selection for Optimally Hedged Portfolios

This paper reports a study into the performance of currency-hedged portfolios constructed using mean-variance optimization methods. The method is to carry out optimization relative to a benchmark portfolio, which consists of the real assets, and simultaneously to determine the optimal exposures to each currency future. This is done at various levels of risk along the efficient frontier. A study into a portfolio of international stock and bond indices viewed from a US Dollar perspective indicates that, for the period studied, optimal currency hedging has the potential to add value in terms of additional expected return and excess return on a risk-adjusted basis. The results also demonstrate the superiority of strategies in which the hedge ratio is optimally determined over those with a fixed hedge ratio.

Global Asset Allocation

In this overview of global asset allocation opportunities, the authors tout the “three Ps:” philosophy, process, and performance. The questions they examine along the way include: the performance of global asset allocation; whether equity market correlations have been increasing; the relationship of investment horizons to the benefit of international diversification; country-industry and value-growth comparisons; and optimal currency hedging strategies. “Only by studying world equity markets in conjunction with the economic, social, and political aspects of world affairs” can portfolio managers be informed on this issue, they say.

Optimal Currency Hedging Under Loss Aversion

This paper characterizes optimal currency hedging in several models of downside risk. We consider, in turn, three models of hedging: (i) a firm that chooses its hedging policy in the presence of bankruptcy costs; (ii) an all equity firm that faces a convex tax schedule; and (iii) a firm whose manager is subject to loss aversion. In all these models, and contrary to conventional wisdom, we show that forwards dominate options as hedges of downside risk.

A Simple Solution for Optimal Currency Hedging

Rather than relying on historical experience to determine the optimal currency hedging strategy for portfolios that include foreign assets, one can use a simple procedure adapted from portfolio management theory. This procedure specifies the utility of a portfolio, given the investor's risk tolerance, asset and currency returns, standard deviations, weights and covariances. The sensitivity of the portfolio's utility can then be measured as a function of currency exposure. The portfolio's exposure to each currency to which utility is related positively is increased, and its exposure to each currency to which utility is related negatively is decreased. The portfolio's exposure to the currency with the largest sensitivity (in absolute terms) is iteratively adjusted until all the portfolio's sensitivities equal zero. This currency exposure represents the optimal portfolio-the one that offers the highest return for the chosen risk level. In some special cases, the optimal hedging strategy can be determined more directly. For example, the minimum-risk strategy for a single foreign asset can be identified by measuring the currency's beta relative to the underlying portfolio. For a portfolio with several foreign assets, the minimum-risk strategy can be defined by regressing the portfolio's returns on the currencies' returns. The basic procedure can also be adjusted to take inflation into account and to incorporate liabilities.