Value-At-Risk Based Approach For Currency Hedging

23 Pages Posted: 25 Jan 2021

See all articles by Rachna Khurana

Rachna Khurana

Southern Ridges Capital

Umang Khetan

University of Iowa

Date Written: January 15, 2021

Abstract

Corporate FX risk management has gained complexity with increased number of currencies involved and varying correlations among them. Existing literature has highlighted the need to account for cross-currency correlations when optimizing hedge ratios for portfolio management (Dowd, 1999). In this paper, we propose a Value-at-Risk (VaR) based model to estimate the optimal hedge ratio for a multi-national corporate that aims to minimize the cost of hedging at a given tolerance level of expected loss arising out of FX movement. The paper illustrates both parametric and historical methods of VaR estimation at a portfolio level as the first step in risk management. As a second step, an efficient-frontier is derived based on the expected VaR level at various hedge ratios, and compared with associated hedge cost. The benefits of this approach include: identification of net exposures after correlations among currencies are accounted for in order to avoid duplication of hedges, and condensation of the parameters governing hedging decision into a single, intuitively-appealing number. The paper also highlights the need to frequently update the model’s assumptions as currency correlations and corporate exposures remain dynamic.

Keywords: Value-at-Risk, FX Risk Management, Correlation, International Finance

JEL Classification: C10, F31, G32, M20

Suggested Citation

Khurana, Rachna and Khetan, Umang, Value-At-Risk Based Approach For Currency Hedging (January 15, 2021). Available at SSRN: https://ssrn.com/abstract=3767162 or http://dx.doi.org/10.2139/ssrn.3767162

Rachna Khurana

Southern Ridges Capital ( email )

767 Fifth Avenue
Newyork, NY 10153
United States
+919892188351 (Phone)

Umang Khetan (Contact Author)

University of Iowa ( email )

Iowa City, IA 52242-1000
United States

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