Hedging the Exchange Rate Risk in International Portfolio Diversification:Currency Forwards versus Currency Options

As past research suggest, currency exposure risk is a main source of overall risk of internationaldiversified portfolios. Thus, controlling the currency risk is an important instrument forcontrolling and improving investment performance of international investments. This studyexamines the effectiveness of controlling the currency risk for international diversified mixedasset portfolios via different hedge tools. Several hedging strategies, using currency forwardsand currency options, were evaluated and compared with each other. Therefore, the stock andbond markets of the, United Kingdom, Germany, Japan, Switzerland, and the U.S, in the timeperiod of January 1985 till December 2002, are considered. This is done form the point ofview of a German investor. Due to highly skewed return distributions of options, the applicationof the traditional mean-variance framework for portfolio optimization is doubtful whenoptions are considered. To account for this problem, a mean-LPM model is employed. Currencytrends are also taken into account to check for the general dependence of time trends ofcurrency movements and the relative potential gains of risk controlling strategies.