Hedging the exchange rate risk in international portfolio diversification: Currency forwards versus currency options

Abstract

Purpose

This study seeks to examine the effectiveness of controlling the currency risk for international diversified mixed‐asset portfolios via two different hedge instruments, currency forwards and currency options. So far, currency forward has been the most common hedge tool, which will be compared here with currency options to control the foreign currency exposure risk. In this regard, several hedging strategies are evaluated and compared with one another.

Design/methodology/approach

Owing to the highly skewed return distributions of options, the application of the traditional mean‐variance framework for portfolio optimization is doubtful. To account for this problem, a mean lower partial moment model is employed. An in‐the‐sample as well as an out‐of‐the sample context is used. With in‐sample analyses, a block bootstrap test has been used to statistically test the existence of any significant performance improvement. Following that, to investigate the consistency of the results, the out‐of‐sample evaluation has been checked. In addition, currency trends are also taken into account to test the time‐trend dependence of currency movements and, therefore, the relative potential gains of risk‐controlling strategies.

Findings

Results show that European put‐in‐the‐money options have the potential to substitute the optimally forward‐hedged portfolios. Considering the composition of the portfolio in using in‐the‐money options and forwards shows that using any of these hedge tools brings a much more diversified selection of stock and bond markets than no hedging strategy. The optimal option weights imply that a put‐in‐the‐money option strategy is more active than at‐the‐money or out‐of‐the‐money put options, which implies the dependency of put strategies on the level of strike price. A very interesting point is that, just by dedicating a very small part of the investment in options, the same amount of currency risk exposure can be hedged as when one uses the optimal forward hedging. In the out‐of‐sample study, the optimally forward‐hedged strategy generally presents a much better performance than any types of put policies.

Practical implications

The research shows the risk and return implications of different currency hedging strategies. The finding could be of interest for asset managers of internationally diversified portfolios.

Originality/value

Considering the findings in the out‐of‐sample perspective, the optimally forward‐hedged minimum risk portfolio dominates all other strategies, while, in the depreciation of the local currency, this, together with the forward‐hedged tangency portfolio selection, would characterize the dominant portfolio strategies.

Citation

Maurer, R. and Valiani, S. (2007), "Hedging the exchange rate risk in international portfolio diversification: Currency forwards versus currency options", Managerial Finance, Vol. 33 No. 9, pp. 667-692. https://doi.org/10.1108/03074350710776235