5/2014 Fabio Filipozzi and Kersti Harkmann. Currency hedge – Walking on the edge?
Working Papers of Eesti Pank 5/2014
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.
JEL Codes: C32, C58, G11, G15, G23, G32
Keywords: optimal hedge ratios, portfolio risk hedging
Corresponding author's e-mail address: kersti.harkmann [at] eestipank.ee.
The views expressed are those of the authors and do not necessarily represent the official views of Eesti Pank.