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Currency Risk Hedging for Euro-based long-term investors: a risk-return tradeoff: Improving hedging performance with dynamic strategies

Sikma, Erwin (2010) Currency Risk Hedging for Euro-based long-term investors: a risk-return tradeoff: Improving hedging performance with dynamic strategies.

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Abstract:The report is written from the perspective of Euro-based long term institutional investors who have the Euro as their base currency. These investors primarily engage in currency risk hedging for risk management purposes. It is widely assumed that by not completely hedging currency risk additional risk is added to the portfolio for which no return is obtained. There are reasons to believe that this statement is false. The main research question is therefore formulated as follows: should a Euro-based long term institutional investor hedge its main foreign currency exposures from a risk-return perspective?” The goal of this research is to find for which periods of time and under which circumstances it is (not) useful to hedge foreign currency exposures. The first sub goal is to find evidence, derived from historical data, for not or partially hedging currency risk statically. The second sub goal is to formulate dynamic hedging strategies that can improve the currency risk hedging performance. This is done by identifying factors that influence currency movements and therefore currency risk. These factors are used to formulate dynamic strategies. Optimal values of the factor(s) are derived with in-sample data testing. Hereafter the dynamic strategies are tested using out-of-sample data and are compared to the static strategies. The in- and out-of sample data periods are derived from the historical analysis. A base and extreme scenario are defined which are used as the out-of-sample data periods. The research takes care of all the limitations of contemporary literature about this subject. By generating historical distributions and deriving extensive risk measures much more insight in the currency risk effect is obtained than the most often used mean-variance and utility methods. Historical simulation includes all types of relationships of the returns of assets. This research is much more extensive than other research on this subject. It investigates data samples from 1970 till 2010, analyzes 10 sub-periods, does this for 21 asset classes and 3 portfolios and provides historical distributions and insightful risk measures. This gives information about the distribution of returns and tail risks. The performance of several static and dynamic hedging strategies is obtained. Furthermore a new way of assessing the risk-return tradeoff is presented by introducing the performance measure. The performance measure includes the mean return, volatility, VaR and expected shortfall. It represents the intuitive relationship between risk and return, like the Sharpe ratio does. The measure however overcomes the problem of the traditional Sharpe ratio when mean returns are negative. Furthermore the research investigates absolute returns and relative returns. Relative returns incorporate the return of the liabilities, e.g. the future consumption streams. The relative return therefore measures the purchasing power of the assets. It is concluded that currency risk, or exchange rate movements, has a major effect on the performance of foreign currency denominated assets. The statement that completely hedging is always, from a risk management perspective, the best option is negated. There are periods for which completely hedging is not useful from both a risk management and risk-return perspective. Another important conclusion is that maintaining a perfect hedge is not always useful. The effort and costs associated with maintaining a 100% hedged position are high and it is shown that by hedging less than 100% the performance can sometimes already be maximized. Furthermore it is concluded that the returns of interest bearing liabilities are (co-) related with the returns of the currencies forward and spot rates, leading to lower hedge ratios for relative returns. It is concluded that there are diversification benefits when currencies are included (not hedged) in portfolios. It is shown that dynamic strategies can outperform static complete hedging up to 62.1% in the base scenario and up to 75.8% in the extreme scenario. A well-performing dynamic hedging strategy in both scenarios is the 1M forward premium strategy. Euro-based long term institutional investors should therefore actively hedge their main foreign currency exposures using dynamic hedging strategies. This will improve both the return and risk characteristics of their portfolios, and often the individual assets. The investor can lower its tail risks by dynamic hedging and will generate additional positive returns by doing so. Therefore the risk-return tradeoff is improved. This research therefore shows that institutional investors should consider to not completely hedge currency risk.
Item Type:Essay (Master)
Kempen Capital Management N.V.
Faculty:BMS: Behavioural, Management and Social Sciences
Subject:85 business administration, organizational science
Programme:Industrial Engineering and Management MSc (60029)
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