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Currency hedge – walking on the edge?

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  • Fabio Filipozzi
  • Kersti Harkmann

Abstract

We study whether it is possible to find optimal hedge ratios for a foreign currency bond portfolio to lower significantly the risk and increase the risk adjusted return of a portfolio. The analysis is conducted from the perspective of euro area based investors to whom short-selling restrictions might apply. The ordinary least squares approach is challenged with the optimal hedge ratios found by the DCC-GARCH approach in order to investigate whether time-varying hedging is superior to the standard constant hedge ratios found by OLS. We find that hedging significantly lowers the portfolio risk in domestic currency terms and improves the Sharpe ratios for both single instrument and equally weighted multi asset portfolios. Optimal hedging using the standard OLS approach and using time-varying hedging give similar results, the latter being superior to the first in terms of risk-adjusted return.

Suggested Citation

  • Fabio Filipozzi & Kersti Harkmann, 2014. "Currency hedge – walking on the edge?," Bank of Estonia Working Papers wp2014-5, Bank of Estonia, revised 10 Oct 2014.
    • Handle: RePEc:eea:boewps:wp2014-5
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    optimal hedge ratios; portfolio risk hedging;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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