Optimal Currency Hedging: Horizon Matters

18 Pages Posted: 14 Jun 2019

See all articles by Nelson Arruda

Nelson Arruda

Mackenzie Investments

Alain Bergeron

Mackenzie Investments

Mark Kritzman

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: June 07, 2019

Abstract

Investors have long debated what fraction, if any, of their portfolio’s currency exposure they should hedge. Although the answers cover a broad range, often with dubious rationale, most informed investors agree that the solution should be based on mean-variance optimization, deployed either to maximize expected utility for cases in which the investor has non-zero expectations for the mean currency returns, or to minimize risk when the means are assumed to equal 0. This approach presents a serious challenge, however, because it depends on how currencies co-vary with each other and with the underlying portfolio, and these covariances themselves vary significantly with the return interval used to estimate them. The authors show that monthly covariances produce unreliable results for horizons that are longer than one month.

Keywords: Auto-correlation, Cross-correlation, Interval error, Mean-variance optimization, Optimal currency hedge ratio

JEL Classification: C13, C18, C61, G11

Suggested Citation

Arruda, Nelson and Bergeron, Alain and Kritzman, Mark, Optimal Currency Hedging: Horizon Matters (June 07, 2019). MIT Sloan Research Paper No. 5810-19, June 2019. Available at SSRN: https://ssrn.com/abstract=3403759 or http://dx.doi.org/10.2139/ssrn.3403759

Nelson Arruda

Mackenzie Investments ( email )

180 Queen Street West
Toronto,, ON M5V 3K1
Canada

Alain Bergeron

Mackenzie Investments ( email )

180 Queen Street West
Toronto,, ON M5V 3K1
Canada

Mark Kritzman (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

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