Dynamic Conditional Currency Hedging

Abstract

We propose a simple and dynamic approach to hedge currency risk which can directly be applied by international investors in diverse asset classes. Other than current mean-variance approaches it is robust to overfitting and can thus better anticipate optimal currency hedging for global equity, bond and commodity investors out-of-sample. Furthermore, we document that correlations between currencies, equities, and commodities vary over time and can be predicted by implied FX volatility. This allows investors to significantly reduce their risk compared to hedging alternatives without giving up on Sharpe ratio, particularly during crisis periods.

Keywords: currency hedging, mean-variance analysis, implied volatility, overfitting

JEL Classification: F31, G11, G15