Browsing by Subject "currency overlay"

Currency risk is an important yet neglected consideration for investors holding internationally diversified investment portfolios. The foreign exchange market is an extremely liquid and efficient market, with daily transaction volumes exceeding the equivalent of several trillion euros. International investors have to decide upon the level of exposure on various currency risks typically by hedging some or all of the underlying currency exposure with currency derivative contracts. The currency overlay refers to an approach where the aggregate currency exposure from the investment portfolio is managed with a separate derivatives strategy, aimed at improving the overall portfolio’s risk adjusted returns. In this thesis, we develop a novel systematic, data-driven approach to manage the currency risk of investors holding diversified bond-equity portfolios, accounting for both risk minimization and expected returns maximization objectives on the portfolio level. The model is based upon modern portfolio theory, leveraging findings from prior literature in covariance modelling and expected currency returns. The focus of this thesis is in ensuring efficient risk diversification through the use of accurate covariance estimates fed by high-frequency data on exchange rates, bonds and equity indexes. As to the expected returns estimate, we identify purchasing power parity (PPP) and carry signals as credible alternatives to improve the expected risk-adjusted returns of the strategy. A block bootstrap simulation methodology is used to conduct empirical tests on different specifications of the developed dynamic overlay model. We find that dynamic risk-minimizing strategies significantly decrease portfolio risk relative to either unhedged or fully hedged portfolios. Using high-freqency data based returns covariance estimates is likely to improve portfolio diversification relative to a simple daily data-based estimator. The empirical results are much less clear in terms of risk adjusted returns. We find tentative evidence that the tested dynamic strategies improve risk adjusted returns. Due to the limited data sample used in this study, the findings regarding expected returns are highly uncertain. Nevertheless, considering evidence from prior research covering much longer time-horizons, we expect that both the risk-minimizing and returns maximizing components of the developed model are likely to improve portfolio-level risk adjusted returns. We recommend using the developed model as an input to support the currency risk management decision for investors with globally diversified investment portfolios, along with other relevant considerations such as solvency or discretionary market views.