Dynamic Global Currency Hedging

Bent Jesper Christensen, Rasmus T. Varneskov

Research output: Working paper/Preprint Working paperResearch

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Abstract

This paper proposes a model for discrete-time hedging based on continuous-time movements in portfolio and foreign currency exchange rate returns. In particular, the vector of optimal currency exposures is shown to be given by the negative realized regression coefficients from a one-period conditional expectation of the intra-period quadratic covariation matrix for portfolio and foreign exchange rate returns. These are labelled the realized currency betas. The model, hence, facilitates dynamic hedging strategies that depend exclusively on the dynamic evolution of the ex-post quadratic covariation matrix. These hedging strategies are suggested implemented using modern, yet simple, non-parametric techniques to accurately measure and dynamically model historical quadratic covariation matrices. The empirical results from an extensive hedging exercise for equity investments illustrate that the realized currency betas exhibit important time variation, leading to substantial economic, as well as statistically significant, volatility reductions from the proposed hedging strategies, compared to existing benchmarks, without sacrificing returns. As a result, a risk-averse investor is shown to be willing to pay several hundred basis points to switch from existing hedging methods to the proposed realized currency beta approach. Interestingly, the empirical analysis strongly suggests that the superior performance of the latter during the most recent global financial crisis of 2008 is, at least partially, funded by carry traders.
Original languageEnglish
Place of publicationAarhus
Number of pages63
Publication statusPublished - 19 Jan 2016
SeriesCREATES Research Paper
Number2016-03

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