An efficient frontier for FX hedging

Most worry about whether their assets are going up or down in value; they rarely worry about whether their currency is going up or down.

Ray Dalio

If you have ever compared the performance of a standard asset allocation portfolio denominated in Swiss Franc with that of a US Dollar portfolio, you probably got an impression of the power of foreign exchange rates.

While diversification can often absorb the impact of adverse changes in the value of single assets, ceteris paribus, a significant appreciation of your currency will negatively affect the performance of your entire portfolio.

Many investors, therefore, implement FX hedges through currency overlays, swaps or forward contracts. However, a crude hedging policy can also result in inefficient allocations and seriously harm risk-adjusted-performance.

Interest rate differentials can make currency hedging pretty expensive over time. On top of that, investors who hedge through derivative contracts may face serious cash-flow matching and liquidity risks.

Beyond this, investors who simply consider foreign currency exposure an unwanted risk factor may unnecessarily forego diversification benefits.

Therefore, in our paper, we provide an overview of typical heuristics and important questions concerning foreign currency risks.

Building on this, I introduce an approach based on mean-variance optimization to derive optimal hedge ratios for the different base and target currencies.

The checklist approach elaborates on the following questions:

1. Which is the portfolio's true reference currency?

2. Which currency pair(s) actually drive the performance of the foreign asset?

3. How much does the FX hedge cost?

4. Can unmanaged currency exposure help diversification

5. Does the hedge induce liquidity risks, and how likely is the investor to unintentionally over-hedge?

The interactive FX Hedging Frontier on the quantamental platform provides a flexible portfolio optimizer building on the public API of investing.com and the investpy package as well as the Systematic Investor Toolbox for R.

It provides users with access to historical data for almost all currency pairs and a vast universe of investable assets and indices.

We have also developed an extended version that combines the search for an optimal FX hedge ratio with the fully-fledged optimization of a multi-asset portfolio.

Further documentation on this extension is available here.