Algorithms for Worst-Case Design and Applications to Risk Management

By Berç Rustem; Melendres Howe | Go to book overview

Chapter 11
Robust currency management

In this chapter we discuss currency management. We consider the strategic point of view where a currency benchmark is identified. We also consider the tactical point of view where the frequent re-balancing of a portfolio's currency hedge is managed in order for the portfolio to benefit from short- and mediumterm currency fluctuations. Currency benchmark identification is important in finding the long-term optimal hedge ratio that a portfolio should adopt in order to minimize the negative impact of any currency depreciation in the medium and long term. We discuss benchmark identification, first, for a pure currency portfolio as this simplifies and clarifies the role of strategic currency management, and second, for an international asset portfolio as this clarifies the use of currency hedging as a tool for managing the currency exposure of such a portfolio. The tactical management of a currency portfolio involves currency trades that cause fluctuations about the strategic benchmark. These trades represent short- to medium-term adjustments to the optimal hedge ratio in order to maximize returns and accumulate short-term gains. We consider both the strategic and tactical formulations.


1 INTRODUCTION

The financial modeling of the behavior of currencies has gained attention as portfolios become increasingly international. Currency modeling has been a major focus of research as more and more market participants realize the impact of currencies on the value of their portfolios. By investing in the equity market of a foreign country, a portfolio manager not only receives local market returns but also the currency return associated with a foreign currency-denominated equity market. The manager needs to appraise the local equity market to judge whether the investment is worth the risk. Additionally, she needs to appraise the potential performance of the foreign currency to judge whether the exposure to that foreign currency would yield a desirable return. A positive appraisal of the currency may motivate her to maintain the exposure to that foreign currency whereas a negative appraisal may cause her to hedge the currency risk (see CN 1). Local market forecasting and currency forecasting become essential in this appraisal process. The

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