Often, investors fully hedge their portfolios for currency risk. This can lead to significant drag in performance for currencies with negative carry. However, not hedging the foreign currency exposure can lead to significant drawdowns, especially for conservative investments. In this paper, we consider a conservative, global tactical asset allocation strategy implemented in US dollar-denominated securities for a hypothetical European investor and highlight the benefits of dynamic currency hedging over static hedging. Using a parsimonious model for hedge ratio based on multiple features of merit and an explicit check for maximum allowed under-hedging, we show that a cost-aware, dynamic hedging strategy can reduce the hedging costs substantially while keeping the portfolio risk within mandate specifications.
In Optimal hedging with higher moments, the authors have looked at a general class of utility functions, HARA, and tried to optimize hedging rules to maximize that set of utility functions. The main contribution of that paper is to point out that if the strategy that is being hedged has significant positive skew or if the securities we are hedging with have a skewed distribution of returns, then we should look at higher moments in computing the hedge ratio.
As opposed to traditional OLS hedge ratios, a hedge ratio computed by HARA utility functions would exhibit lower risks and better hedging in out-of-sample data. The methods we have outlined here can be extended to higher moments as well. While others have highlighted that for a global multi-asset portfolio, making currency-hedging decisions asset by asset rather than for the overall portfolio could be sub-optimal, the actual optimal hedging calculation is done under long-term capital market assumptions, considering strategic portfolios.
Dynamic maximum allowed under-hedging – In this case, we propose a time-varying maximum allowed under-hedging, and that it should be a function of the expected volatility of the respective currency ( in this case).
We found that around 24% constant under-hedging achieves similar risk as the assumed risk guidance. All the features other than the difference in equity returns did better than the static hedging strategy in terms of performance, both in terms of returns and drawdown. These normalized features were generated with absolutely no look-ahead.
We found that if not using any optimization, the optimal results are obtained with all the weight given to the best feature 10 year yield difference. Since the equal-weighted feature combination has similar performance and is much more robust against any potential overfitting, we did not try to add regularization. Another important observation is that the performance of the dynamic hedging strategy based on short-term interest rate spread with and without look-ahead is quite similar, reinforcing the value of short-term interest rate spread in successfully predicting future cost of hedging.