Trading Foreign Exchange Triplets
SIAM Journal on Financial Mathematics
35 Pages Posted: 18 Oct 2017 Last revised: 27 Apr 2020
Date Written: October 17, 2017
We develop the optimal trading strategy for a Foreign Exchange (FX) broker who must liquidate a large position in an illiquid currency pair. To maximize revenues, the broker considers trading in a currency triplet which consists of the illiquid pair and two other liquid currency pairs. The liquid pairs in the triplet are chosen so that one of the pairs is redundant. The broker is risk-neutral and accounts for model ambiguity in the FX rates to make her strategy robust to model misspecification. When the broker is ambiguity neutral (averse) the trading strategy in each pair is independent (dependent) of the inventory in the other two pairs in the triplet. We employ simulations to illustrate how the robust strategies perform. For a range of ambiguity aversion parameters, we find the mean Profit and Loss (P&L) of the strategy increases and the standard deviation of the P&L decreases as ambiguity aversion increases.
Keywords: Foreign Exchange, Currency Pairs, Optimal Liquidation, Execution, Inventory Aversion, Ambiguity Aversion
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