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Hedging Foreign Exchange Risk - An Evaluation of the Optimal Hedge Ratio Determined by VaR

Fredriksson, Kim and Johansson, Carina (2011) NEKM07 20111
Department of Economics
Abstract
The purpose of this study is to examine the optimal hedge ratio for the currency exposure of foreign investments. The optimal hedge ratio is determined after evaluating our portfolios from the three perspectives; ex-ante, ex-post and profit/loss. The ex-ante perspective is examined by the usage of historical simulation to calculate VaR on 11 portfolio pairs. Each pair consists of a portfolio with the total investment and its hedges, and the other portfolio consisting of only the hedges. The ex-post perspective is used in order to evaluate the accuracy of these VaR estimates, measured in number of violations. The return of the hedging portfolio, which only contains the hedges, is measured in terms of profit/loss. This is given by the... (More)
The purpose of this study is to examine the optimal hedge ratio for the currency exposure of foreign investments. The optimal hedge ratio is determined after evaluating our portfolios from the three perspectives; ex-ante, ex-post and profit/loss. The ex-ante perspective is examined by the usage of historical simulation to calculate VaR on 11 portfolio pairs. Each pair consists of a portfolio with the total investment and its hedges, and the other portfolio consisting of only the hedges. The ex-post perspective is used in order to evaluate the accuracy of these VaR estimates, measured in number of violations. The return of the hedging portfolio, which only contains the hedges, is measured in terms of profit/loss. This is given by the difference between the forward rate and the spot rate at maturity over a one-month period. We find that a 100 percent currency hedge is the most optimal portfolio ex-ante and a 30 percent hedge is the most optimal ex-post. From a return point of view, there is no optimal portfolio since we get a negative result on all of the three currencies. We conclude that there is no optimal portfolio from both a return and a risk perspective. The optimal portfolio is thus given by the investors attitude towards risk. (Less)
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author
Fredriksson, Kim and Johansson, Carina
supervisor
organization
course
NEKM07 20111
year
type
H2 - Master's Degree (Two Years)
subject
keywords
VaR, Foreign Exchange Hedging, Optimal Hedge Ratio, Forward Contracts, Historical Simulation
language
English
id
1976131
date added to LUP
2011-06-17 12:29:30
date last changed
2011-06-17 12:29:30
@misc{1976131,
  abstract     = {The purpose of this study is to examine the optimal hedge ratio for the currency exposure of foreign investments. The optimal hedge ratio is determined after evaluating our portfolios from the three perspectives; ex-ante, ex-post and profit/loss. The ex-ante perspective is examined by the usage of historical simulation to calculate VaR on 11 portfolio pairs. Each pair consists of a portfolio with the total investment and its hedges, and the other portfolio consisting of only the hedges. The ex-post perspective is used in order to evaluate the accuracy of these VaR estimates, measured in number of violations. The return of the hedging portfolio, which only contains the hedges, is measured in terms of profit/loss. This is given by the difference between the forward rate and the spot rate at maturity over a one-month period. We find that a 100 percent currency hedge is the most optimal portfolio ex-ante and a 30 percent hedge is the most optimal ex-post. From a return point of view, there is no optimal portfolio since we get a negative result on all of the three currencies. We conclude that there is no optimal portfolio from both a return and a risk perspective. The optimal portfolio is thus given by the investors attitude towards risk.},
  author       = {Fredriksson, Kim and Johansson, Carina},
  keyword      = {VaR,Foreign Exchange Hedging,Optimal Hedge Ratio,Forward Contracts,Historical Simulation},
  language     = {eng},
  note         = {Student Paper},
  title        = {Hedging Foreign Exchange Risk - An Evaluation of the Optimal Hedge Ratio Determined by VaR},
  year         = {2011},
}