Risk Management: Foundations for a Changing Financial World

CHAPTER 38

STRATEGIES FOR HEDGING^al

Mark P. Kritzman, CFA

Simultaneously maximizing absolute returns on an underlying portfolio and relative returns on a currency benchmark moves global investors from the efficient frontier to the efficient surface. This joint optimization in three dimensions—expected return, volatility, and tracking error—almost always produces better results than constrained mean-variance analysis. Nonlinear hedging strategies are an effective method for managing currency risk, but obtaining some of these instruments—contingent currency options and hybrid collars—can be difficult and expensive.

Determining the appropriate hedging strategy involves understanding the motivation for currency-risk management, knowing that the relevant correlation is that between foreign asset returns in the investor’s base currency and currency returns, evaluating linear and nonlinear hedging strategies and available hedging instruments (forwards, traditional options, contingent options, and hybrid collars), and assessing the cash flow implications of currency-hedging strategies.

Although the motivation for currency-risk management is to maximize expected utility, institutional investors may seek to define utility in absolute terms, relative terms, or both. How a currency’s correlation with local foreign asset returns is mapped onto its correlation with base-currency-denominated foreign asset returns significantly affects the minimum-risk hedge ratio. Determining the appropriate ...