An Application of Optimal Dynamic Hedging in International Asset Allocation

The portfolio decision problem for global investments involves a joint choice over the financial assets and currencies. This paper investigates currency risk hedging when the volatilities and the correlations of forward currency contracts with the financial assets, are all time-varying. In order to capture the dynamic structure of the volatilities and correlations, a multivariate GARCH model with time-varying correlation, has been adopted. The dynamic optimization is estimated for different international portfolios over the time period of January 1985 till December 2002. The optimized dynamic hedge strategy can capture reasonably the currency fluctuations and significantly reduce the currency risk exposures and therefore enhance the risk-adjusted performance of the international portfolios. Our study deals with a German investor investing in the equity markets of United Kingdom, Japan and U.S.A