Optimal hedging of the currency exchange risk exposure of dynamically balanced strategic asset allocations

Abstract

This paper presents theoretical and empirical results on the magnitude of optimal hedge ratios for a dynamically balanced strategic asset allocation with multiple currencies. Optimality refers to a mean-variance objective function with a time-varying risk-aversion parameter. A data-driven choice of this parameter is proposed, which is suggested by a Sharpe ratio maximisation criterion and renders the vector of optimal hedge ratios scale invariant. Empirical results are given for a European Monetary Union (EMU)-based investor with USD, GBP and JPY assets and a US-based investor with assets in EUR, GBP and JPY. Since the vector of optimal hedge ratios depends on the conditional variance–covari..