Robust Optimization of Currency Portfolios
AbstractWe study a currency investment strategy, where we maximize the return on a portfolio of foreign currencies relative to any appreciation of the corresponding foreign exchange rates. Given the uncertainty in the estimation of the future currency values, we employ robust optimization techniques to maximize the return on the portfolio for the worst-case foreign exchange rate scenario. Currency portfolios differ from stock only portfolios in that a triangular relationship exists among foreign exchange rates to avoid arbitrage. Although the inclusion of such a constraint in the model would lead to a nonconvex problem, we show that by choosing appropriate uncertainty sets for the exchange and the cross exchange rates, we obtain a convex model that can be solved efficiently. Alongside robust optimization, an additional guarantee is explored by investing in currency options to cover the eventuality that foreign exchange rates materialize outside the specified uncertainty sets. We present numerical results that show the relationship between the size of the uncertainty sets and the distribution of the investment among currencies and options, and the overall performance of the model in a series of backtesting experiments.
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Bibliographic InfoPaper provided by COMISEF in its series Working Papers with number 012.
Length: 20 pages
Date of creation: 26 Aug 2009
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Web page: http://www.comisef.eu
robust optimization; portfolio optimization; currency hedging; second-order cone programming;
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