Currency Hedge Design: Accounting for Uncertain Correlation and Volatility

Abstract

In previous Peregrine Securities work, it was shown that currency hedge selection can be approached in an optimization framework and that the particular choice of hedge is strongly dependent on the correlation between the exchange rate and the foreign asset. Unfortunately, correlations between assets are generally unstable and it can be difficult to forecast an appropriate value to use as input to the optimizer. In this work we outline an approach to the determination of an optimal currency hedge in the presence of non-constant volatility and correlation. It is shown that implementation of the dynamic conditional correlation (DCC) model in a simulation framework allows one to incorporate the effects of time-varying parameters into the hedge selection process in a systematic and quantitative manner. An important finding is that the particular choice of short-term hedge depends to a large extent on the current value of correlation, emphasising the need for a modelling framework that provides accurate estimates of time-varying correlation.

Keywords: currency hedging, dynamic conditional correlation, DCC model, portfolio hedging, portfolio optimization

JEL Classification: C15, C4, C5, C32, G13