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

As past researches suggest, currency exposure risk is a main source of the overall risk in the international diversified portfolios. Therefore, controlling the currency risk becomes an important task in order to improve the performance of international investments. This study examines the effectiveness of controlling the currency risk for international diversified mixed asset portfolios via two different hedge instruments, currency forwards and currency options. So far currency forward has been the most common hedge tool which here will be compared with currency options to control the foreign currency exposure risk. In this regard several hedging strategies were evaluated and compared with each other. The considered international portfolio consists of the stock and bond markets of United Kingdom, Germany, Japan, Switzerland, and the U.S.A, in the time period from January 1985 till December 2002. This is done from the viewpoint of a German investor. Due to the highly skewed return distributions of options, the application of the traditional mean-variance framework for portfolio optimization is doubtful. To account for this problem, a mean-LPM model is employed. Results show that European put in the money options have a high potential to substitute the forwards. In the context of ex-post analysis, a block bootstrap test has been applied to statistically test the existence of any significant difference in the respective policy performances and later on to investigate the consistency of results, the ex-ante evaluation has been checked. In addition, currency trends are also taken into account to check for the time trend dependence of currency movements and therefore the relative potential gains of risk controlling strategies