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This paper examines the benefits from hedging the currency exposure of international investments in single- and multi-country equity and bond portfolios from the perspectives of German, Japanese, British and American investors. Over the period 1975 to 2009, hedging of currency risk substantially reduced the volatility of foreign investments at a quarterly investment horizon. Contrary to previous studies, the paper finds that at longer investment horizons of up to five years the case for hedging for risk reduction purposes remained strong.In addition to its impact on risk, hedging affected returns in economically meaningful magnitudes in some cases.
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... On the other hand, hedging for the purpose of risk minimization mitigates estimation risk, as the covariance structure is found to be estimated with higher precision. Schmittmann (2010) analyzed constant hedging strategies in comparison to the static variance minimizing hedging ratios calculated with ordinary least squares, while De Roon, Eiling, Gerard, and Hillion (2011) included currency positions as a further asset class and pointed out that risk hedging and speculative benefits are two motivations for internationally diversified portfolios. Overall, the studies provide supporting evidence showing that currency hedging reduces risk in multi-currency portfolios. ...
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This paper addresses the question of optimal currency exposure for a risk-and-ambiguity-averse international investor. A robust mean-variance model with smooth ambiguity preferences is used to derive the optimal currency exposure. In the theoretical part, we show that the sample-efficient currency demand can be calculated as the solution to a generalized ridge regression. Through the lens of these results, we demonstrate that our ambiguity-based model offers a new explanation of the home currency bias. The investor's dislike for model uncertainty induces a disproportionately high currency hedging demand. The empirical analysis of currency overlay strategies employs the foreign exchange, equity, and bond returns over the period from 1999 to 2018. Our out-of-sample back-tests illustrate that accounting for ambiguity enhances the stability of estimated optimal currency exposures and significantly improves the portfolio performance net of transaction costs.
... Specifically, the UEP predicts that stock market increases in a country are associated with a currency depreciation resulting from capital outflows. Though Hau and Rey (2006) preclude a role for currency hedging, there is an empirical research agenda related to international capital flows in and out of asset markets that address the practical question of how international investors should manage exchange associated rate risk (Solnik, 1974;Campbell et al., 2010;Froot, 1993;Schmittmann, 2010). ...
Thesis
This thesis is a collection of three self-contained chapters applying empirical methods to explore international asset return comovement, the nature of cross-asset market spillovers, and the drivers of asset prices. The first chapter explores the extent of bidirectional linkages between currency returns and country-specific commodity price index returns for a set of large commodity exporting countries comprising Australia, Canada and New Zealand. Results show that a large portion of variation in both currency and commodity price returns is driven by shocks that are common across all markets and countries. For each category of returns, market specific shocks are also important. The results do not show evidence of significant cross-market impacts in either direction. However, when the model of currency and commodity returns is extended to include the countries' equity markets feedback between all three markets become apparent. The results provide evidence of spillovers from the commodity market to the currency returns, which supports the classification of the exchange rates of these countries as `commodity currencies'. These spillovers became more prevalent since the onset of the mid 2000s resource boom. Spillovers from the currency market to commodity prices have a relatively small but significant impact, suggesting the countries have may some degree of market pricing power on a collective basis. Spillovers from the equity market to the Australian and Canadian exchange rate returns and to Australian and Canadian commodity returns are relatively large, though there is evidence that this channel has diminished over time. The magnitude of the commodity market spillover to the equity returns of the three countries grows over time. The currency market spillover to the equity market is significant but relatively small. The second chapter explores how the interaction between commodity, currency and equity market differs for countries classified as significant commodity exporters compared to a sample of OECD counterparts by examining both the size and direction of cross-market spillovers. There has been a large amount of research characterising the relationship between currency and equity returns. A relatively recent proposition focuses on linkages forged by the behaviour of optimising international investors; specifically predicting that currency and equity returns correlations are negative due to portfolio rebalancing activities. Previous empirical evidence appearing to support this mechanism has not been extended to large commodity exporting countries and it is suggested the interruption may be due to the impact of the commodity market on the equity -- currency return relationship. However, the results obtained do not support the portfolio rebalancing mechanism for either group of countries. In addition, the results suggest that there are large spillover effects from the commodity market to the currency and equity markets of the group of other OECD countries as well as the group of large commodity exporters. The third chapter examines the determinants of currency, equity, bond and house price returns across a set of 9 OECD countries. The results show that there is a significant component in asset return volatility that is common across countries and asset markets. Bond and equity markets are found to be especially connected internationally. The impact of policy variables, per capita consumption, labour productivity, commodity prices and macroeconomic sentiment on asset prices is assessed in order to draw inferences about the variables that drive cross-country asset market connections. Results demonstrate that commonalities in productivity growth, changes in consumer and business sentiment and fiscal policy variables across countries are important channels of international asset price linkages. Commodity price movements appear to play a role in generating asset market linkages within countries.
... Briys and Solnik (1992) used a continuous-time setting to successfully decompose an optimal currency hedge into five distinct components, thereby demonstrating that interest-rate risk mattered. Schmittmann (2010) examined the benefits of future hedging for the period 1975-2009 from the perspectives of German, Japanese, British, and American investors, and found that currency hedging substantially reduced the volatility of foreign investment at a quarterly investment horizon and affected returns by meaningful amounts. Campbell et al. (2010) made a significant contribution to the research on optimal currency hedging with their proposal of an ''optimal currency portfolio," which minimized risky behavior by international investors. ...
We propose a dynamic and efficient global currency portfolio that can significantly decrease the risk of an exogenous portfolio of world equities. We demonstrate that our dynamic conditional correlation model, which is an application of Engle (2002), can decrease the estimated return variance of a portfolio of global equities by about 20 percent relative to the static model of Campbell et al. (2010). The Euro, the US Dollar, the Swiss Franc, and the Japanese Yen all move in a manner opposite to the world equity market, implying that they are safe-haven currencies. However, since the US financial crisis, the importance of the Japanese Yen in a global currency portfolio has grown, whereas that of the Euro has diminished. Increases in foreign-exchange-market volatility and US stock-market volatility have increased the importance of safe-haven currencies in optimal currency portfolios, and the impact of foreign-exchange-market volatility is more significant than that of US stock-market volatility. We also find a spillover effect from both US stock-market and US foreign-exchange-market volatilities to the foreign-exchange-market volatility of other currencies.
Purpose Banks in Indonesia offer two currency-hedging mechanisms to business players to hedge their portfolio against exchange rate risk, namely, Islamic hedging and conventional hedging. Taking into account that Islamic finance stakeholders in Indonesia want to accelerate Islamic hedging transactions, assessing the feasibility of Islamic hedging to serve the business players is very important. Thus, this paper aims to compare the conventional and Islamic currency-hedging mechanisms, particularly to identify which one to be preferred by the business players, identify terms and conditions if Islamic hedging is more preferable, give information regarding the estimated profit and payment of the premium in adopting currency-hedging (both conventional and Islamic hedgings) and prove the workability of Islamic currency-hedging as a new hedging mechanism for the business players. Design/methodology/approach The paper uses qualitative research methodology by comparing Islamic and conventional hedging and a quantitative research method by using a forward contract formula. Technically, the paper conducts a static simulation of the forward transactions by using both conventional and Islamic hedgings to hedge the foreign exchange (forex) credit received by business players from banks. The forward contract simulation uses US dollar (USD) against Indonesian rupiah (IDR) from December 2003 to February 2019 and the forward premium uses both Islamic and conventional money market rates called PUAB (conventional interbank money market) rate and PUAS (Islamic interbank money market) rate. Findings The paper finds that Islamic hedging is more preferable to conventional one due to some considerations which are the number of profitable months, the minimum payment of premium and the highest payment of profit. However, even though the Islamic hedging mechanism has the advantage of having a higher Islamic money market rate than the conventional one, the economic condition (particularly the movement of IDR exchange rate) has to be considered as well particularly during the volatile exchange rate movement. Research limitations/implications The paper has not occupied macroeconomic variables such as inflation, GDP, international trade, as they might influence the movement of IDR exchange rate. In addition, it uses static simulation rather than a dynamic one. Originality/value This is the first paper assessing both Islamic and conventional hedging mechanisms in the case of Indonesia
Article
This article proposes a model for discrete-time currency hedging based on continuous-time movements in portfolio and foreign exchange rate returns. The vector of optimal currency exposures is given by the negative realized regression coefficients from a one-period conditional expectation of the intraperiod quadratic covariation matrix for portfolio and exchange rate returns. Empirical results from an extensive hedging exercise for equity investments illustrate that currency exposures exhibit important time variation, leading to substantial volatility reductions when hedging, without sacrificing returns. A risk-averse investor is willing to pay several hundred annual basis points to switch from existing hedging methods to the proposed dynamic strategies.
Article
Purpose This paper aims to investigate the efficiency of different hedging strategies for an investor holding a portfolio of foreign currency bonds. Design/methodology/approach The simplest strategies of no hedge and fully hedged are compared with the more sophisticated strategies of the ordinary least squares (OLS) approach and the optimal hedge ratios found by the dynamic conditional correlation-generalised autoregressive conditional heteroskedasticity approach. Findings The sophisticated hedging strategies are found to be superior to the simple strategies because they lower the portfolio risk in domestic currency terms and improve the Sharpe ratios for multi-asset portfolios. The analyses also show that both the OLS and dynamic hedging strategies imply holding a limited carry position by being long in high-yielding currencies but short in low-yielding currencies. Originality/value The performance of multi-currency portfolios is examined using more realistic assumptions than in the previous literature, including a weekly frequency and a constraint of no short selling. Furthermore, carry trades are shown to be part of an optimal portfolio.
Article
Purpose The purpose of this paper is to measure the effectiveness of the hedging with futures currency contracts. Measuring the effectiveness of hedging has become mandatory for Indian companies as the new Indian accounting standards, Ind-AS, specify that the effectiveness of hedges taken by the companies should be evaluated using quantitative methods but leaves it to the company to choose a method of evaluation. Design/methodology/approach The paper compares three models for evaluating the effectiveness of hedge – ordinary least square (OLS), vector error correction model (VECM) and dynamic conditional correlation multivariate GARCH (DCC-MGARCH) model. The OLS and VECM are the static models, whereas DCC-MGARCH is a dynamic model. Findings The overall results of the study show that dynamic model (DCC-MGARCH) is a better model for calculating the hedge effectiveness as it outperforms OLS and VECM models. Practical implications The new Indian accounting standards (Ind-AS) mandates the calculation of hedge effectiveness. The results of this study are useful for the treasurers in identifying appropriate method for evaluation of hedge effectiveness. Similarly, policymakers and auditors are benefitted as the study provides clarity on different methods of evaluation of hedging effectiveness. Originality/value Many previous studies have evaluated the efficiency of the Indian currency futures market, but with rising importance of hedging in the Indian companies, Reserve Bank of India’s initiatives and encouragement for the use of futures for hedging the currency risk and now the mandatory accounting requirement for measuring hedging effectiveness, it has become more relevant to evaluate the effectiveness of hedge. To the authors’ best knowledge, this is one of the first few papers which evaluate the effectiveness of the currency future hedging.
Article
We develop a novel method to dynamically hedge foreign exchange exposure in international equity and bond portfolios. The method exploits the time-series predictability of currency returns, which we show emerges from exploiting a forecastable component in global factor returns. The hedging strategy outperforms leading alternative approaches to currency hedging across a large set of performance metrics. Moreover, we find that exploiting currency return predictability via an independent currency portfolio delivers a high risk-adjusted return and provides superior diversification gains to global equity and bond investors relative to currency carry, value, and momentum investment strategies.
Chapter
For the asset management industry, the last decade is characterized by a strong focus on the creation of “alpha” by various approaches (Gupta et al. 2016) and methodologies. Despite this, we have all heard at one point or another that asset allocation is an important, if not the most important, decision when investing one’s wealth. Various studies1 have attempted to disentangle the magnitude of the contribution of allocation versus security selection as drivers of the risk and return profile of a portfolio. The debate is around a 90% contribution. Regardless of the number, we observe that the majority of the effort by asset managers (capital and resources allocated) focuses on generating alpha, while alpha accounts for only a residual part of portfolio performance.
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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.
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most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result qualifies as an anomaly if it is difficult to "rationalize," or if implausible assumptions are necessary to explain it within the paradigm. This column will present a series of such anomalies. Readers are invited to suggest topics for future columns by sending a note with some reference to (or better yet copies of) the relevant research. Comments on anomalies printed here are also welcome. The address
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We apply regret theory, an axiomatic behavioral theory, to derive closed-form solutions to optimal currency hedging choices. Investors experience regret of not having chosen the ex post optimal hedging decision. Hence, investors anticipate their future experience of regret and incorporate it in their objective function. We derive a model of financial decision-making with two components of risk: traditional risk (volatility) and regret risk. We find results that are in sharp contrast with traditional expected utility, loss aversion, or disappointment aversion theories. We discuss the empirical implications of our model and its ability to explain observed hedging behavior.
Article
Investment professionals face a tough climate. Fixed income yields are at near lows. U.S. equity markets have been depressed for the past three years. Given the recent geopolitical uncertainties, the foreign currency markets have been in turmoil. What little returns that can be achieved by investment managers need protection. The investing public more and more is reaching out to global markets to make money and the issue of protecting investment returns from foreign exchange risk becomes critical. Explaining Currency Risk A key difference between investing in domestic and foreign assets is that the latter exposes the investor to a currency risk. Over the years, most investors have not been careful in characterizing this risk to returns from unhedged portfolios. One simplistic view was to measure the return in domestic currency terms and compare it with returns in local currency terms, and characterize the difference as the "currency effect." The reasoning was that if the exchange rate remains constant from the time of purchase of the foreign asset to its sale, then the currency risk has had zero impact. On the other hand, if the domestic currency has weakened (strengthened) against the foreign currency, the exposure would result in a gain (loss). In August 1998, the Association for Investment Management Research (AIMR) argued that the use of changes in spot exchange rates (over the investment period) as a measure of the influence of currency risk on foreign asset returns was misleading. AIMR preferred an alternate approach, one that involved splitting the currency effect into components: expected or known effect captured by forward premium or discount; and unexpected or surprise effect as defined below.
Article
This practical study focuses on different aspects of determining a currency policy for a balanced portfolio manager. The first part tries to determine the strategic long-term optimal hedge ratio, based on two crucial assumptions, a long-term expected return of zero and a long-term expected correlation of zero versus both equities and bonds. The study then shifts from a strategic to a tactical focus. Valuation models based on PPP, interest rate and economic growth differentials combined with short-term technical analysis tools are able to add value in the tactical allocation process.Journal of Asset Management (2001) 2, 35-46; doi:10.1057/palgrave.jam.2240033
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This paper examines the rationale for strategic hedging policy, whereby some fixed proportion of the currency exposure associated with international assets is hedged. We begin with a review of both the theoretical and empirical literature on hedging policy. This literature provides a strong case for hedging some portion of the currency exposure associated with international investing. Differences in opinion remain, however, as to the appropriate methodology to use when constructing hedge ratios in practice. We advocate the use of portfolio optimisation methods and provide examples, along with caveats and guidelines, for the calculation of hedge ratios from a number of different currency perspectives.Journal of Asset Management (2001) 2, 9-21; doi:10.1057/palgrave.jam.2240031