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|Title||Dynamic Currency Hedging Using Non-Gaussian Returns Model|
|Institution||University of Zurich|
|Abstract Text||A new foreign currency hedging strategy for international investors is motivated and studied. Model-free optimal foreign currency exposures for a risk averse investor are derived. Based on those, and assuming a very flexible non-Gaussian returns model for currency and portfolio returns, we build a dynamic currency hedging strategy. In the context of our model, each element of the vector return at time t is endowed with a common univariate shock, interpretable as a common market factor. It is shown that this mixing random variable plays the role of ambiguity (uncertainty about the return distribution), where its magnitude is expressed through the size of the market factor’s conditional variance. Using the derived theoretical model we propose a semi-parametric extended filtered historical simulation approach to model the future distribution of optimal currency exposures. Based on those, a dynamic hedging strategy is proposed, and an out-of-sample back test on the historical market data is performed. The results show that our method yields a robust and highly risk reductive hedging strategy. It outperforms the benchmarks of constant hedging as well as equivalent approaches based on GARCH modelling, and is obtainable with low transaction costs.|
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