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Title: Dynamic currency hedging strategy with a common market factor non-Gaussian returns model Authors:  Urban Ulrych - University of Zurich and Swiss Finance Institute (Switzerland) [presenting]
Walter Farkas - University of Zurich (Switzerland)
Pawel Polak - Columbia University (United States)
Abstract: A new foreign currency hedging strategy for international investors is motivated and studied. Model-free optimal foreign currency exposures for a risk averse investor are derived. Based on those, and assuming a very flexible non-Gaussian returns model for currency and portfolio returns, we build a dynamic currency hedging strategy. 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. It is shown that this mixing random variable plays the role of ambiguity (uncertainty about the return distribution), where its magnitude is expressed through the size of the market factor's conditional variance. Using the derived theoretical model and the proposed dynamic hedging strategy, an out of sample back test on the historical market data is performed. The results show that the approach yields a robust and highly risk reductive hedging strategy, obtainable with low transaction costs.