Stochastic Interest Rates, Transaction Costs and Immunizing Foreign Currency Risk

Since the deregulation of foreign currency markets in 1973, the volatility of foreign exchange rates has increased substantially. Owing to this increased volatility in exchange rates it has become increasingly important to hedge foreign currency exposure. This paper provides a self-financing hedging strategy which incorporates the use of a synthetic put. Using domestic and foreign bonds to replicate the option payoff, the strategy can work for non-major currencies where there is no exchange traded options. In addition, we develop hedging strategies which allow for transaction costs in the case of stochastic interest rates by extending the Leland model.