Title: Dynamic currency hedging using non-Gaussian returns model
Authors: Urban Ulrych - University of Zurich and Swiss Finance Institute (Switzerland) [presenting]
Pawel Polak - Stony Brook University (United States)
Abstract: Managing a portfolio with foreign currency exposure is a critical aspect of international asset allocation. A new foreign currency hedging strategy for international investors is motivated and studied. In the theoretical part of the work we start with the model-free optimal currency exposures and assume a very flexible non-Gaussian returns model for currency and portfolio returns. In the context of our model, each element of the vector return at time $t$ is endowed with a common univariate shock, interpretable as a common market factor. We show that this mixing random variable plays the role of ambiguity (uncertainty about the return distribution), whereby its magnitude is expressed through the size of the market factor's conditional variance. Building on the derived theoretical model we propose a semi-parametric extended filtered historical simulation approach to model the future distribution of asset and currency returns. Based on this, we introduce an algorithm for dynamic currency hedging that can be used to numerically optimize any coherent risk measure, such as Expected Shortfall (ES). The out-of-sample back-test results show that the optimal ES hedging strategy outperforms the benchmarks of constant hedging as well as equivalent approaches based on GARCH modelling net of transaction costs.