Hedging currency exposure
Risk managers of firms that have foreign currency exposure face the problem of optimally hedging currency risk. The familiar scenario of hedging involves the risk-manager adopting a zero variance strategy where the firm is completely hedged against currency movements. However, in this paper the manager adopts a hedging strategy that takes the risk-reward trade-off into account. We motivate a framework for solving the hedging problem that is similar to the framework for solving optimal asset allocations problems in portfolio choice theory. We view the puzzling 'forward premia regression' in a predictive regression framework and show that accounting for predictability in currency returns can be economically significant. We apply Bayesian model averaging methodology to address the issue of model uncertainty. We show that the hedging decision is an important one--under certain scenarios, completely hedging away currency risk can prove to be economically costly, while under other scenarios leaving one's position unhedged may prove very expensive. When the manager is trying to hedge its stochastic net profits, the degree of correlation between firm profits and currency movements affects the optimal hedge. We also investigate whether firms with foreign currency exposure prefer to hedge using options or forwards in an a priori expected utility framework. We find that optimal hedges using forwards dominate options hedges across many different scenarios distinguished by different return distributions, extreme loss constraints, horizons, and levels of risk aversion. Options may dominate when exposure is fully, instead of optimally, hedged and when the hedging firm is uncertain about the mean of currency returns. Our results are consistent with empirical findings that firms prefer forwards as hedging instruments.
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