Hedging with an Edge: Parametric Currency Overlay

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Reference

Barroso, P., Reichenecker, J.-A., & Menichetti, M. (2021). Hedging with an Edge: Parametric Currency Overlay. Management Science, 68(1), 669-689. (ABDC_2016: A*; ABDC_2019: A*; ABS_2018: 4*; ABS_2021: 4*; FT_2016 50_2016: yes; VHB_3: A+)

Publication type

Article in Scientific Journal

Abstract

We propose an optimal currency hedging strategy for global equity investors using currency value, carry, and momentum to proxy for expected currency returns. A benchmark risk constraint ensures the overlay closely mimics a fully hedged portfolio. We compare this with naïve and alternative hedges in a demanding out-of-sample test, with transaction and rebalancing costs and margin requirements. Other hedging methods generally reduce risk but at a cost. Some tend to short currencies with high returns and all incur substantial costs with frictions, mostly margin requirements and equity rebalancing costs. The proposed strategy uses predictable returns to reduce this cost. It produces a statistically significant 17% gain in Sharpe ratio and an annualized Jensen-a of 0.93% versus a fully hedged benchmark. Notably, most of the implementation costs of the strategy would be incurred by the benchmark anyway. This reduces its marginal cost and highlights a specific synergy of integrating hedging with speculation.

Research

Enhanced Carry Trades - A new Approach in Asset Management and Trading
PhD-Thesis, February 2014 until February 2018 (finished)

Standard carry trades sell low-yield currencies and buy high-yield currencies. The trading idea is to capture the interest rate differential between currencies. The unique selection criterion of ... more ...

Persons

Organizational Units

  • Chair in Business Administration, Banking and Financial Management
  • Institute for Finance

DOI

http://dx.doi.org/https://doi.org/10.1287/mnsc.2020.3872