Optimal hedge ratio for currency exposure

Discussion in 'Forex' started by tpxtrd, Feb 25, 2006.

  1. tpxtrd



    If I have a portfolio that is comprised of only Japanese stocks but my home country is the U.S., what is the optimal hedge ratio for the currency exposure I face?

    I have read various papers which argue for different levels of hedging, ranging from 100% hedged to completely unhedged.

    Let's say my personal preference and thought is that I do not want to take on currency risk regardless of whether or not I may theoretically be adequately compensated for it. I simply want to reduce my portfolio volatility and concentrate on generating alpha through stock picking. But to what extent should I be hedging? Also, if I am shorting fwd contracts as my hedging vehicle, how often should I realistically be entering into these shorts and how far out should they be rolled?

    For example, say I start with a portfolio of 1 bln yen worth of Japanese stocks. 25% of this portfolio is comprised of companies whose revenues are highly dependent on foreign exports to the U.S. and Europe(i.e. Sony, Toyota, etc) and the other 75% have revenues driven by domestic activity. Already I am faced with the problem of whether or not I should sell forward all 1 bln yen to truly hedge away all currency risk, or only part of that because it is expected that the stock performance of multinational companies like Sony and Toyota will clearly be affected by exchange rates anyway. To continue this example, let's say I sell fwd all 1 bln yen. How far out should I be selling to(I am under the impression that 3-6 months is common practice among fund managers), because won't adverse unexpected changes in U.S. interest rates result in missed opportunity for better pricing of fwd? Now to continue further, let's say I just decide to sell fwd 6 mths out. Now, I am completely hedged with no currency bias one way or the other. But over time, the value of my portfolio changes, let's say I see a 5% increase in 2 weeks and at the same time I also use more of my own funds to purchase an additional 50mm yen worth of Jpn stocks. So I have an additional 100mm total yen exposure now, total portfolio size of 1.1bln yen. I believe this means I effectively have a 1/11, or 9.1%, position in yen. Is there some optimal point at which I should be maintaining a complete hedge? Everyday? Any time yen exposure assumes >1% position? etc.

    I appreciate any help on this subject. Thanks.
  2. In that case hedge 100% in the spot market,
    your-home-currency/JPY. Hedge at a broker
    that pays decent roll interest like Oanda or
    IBFX. If your home currency is USD you will
    be earning a decent amount in roll interest
    to supplement your earnings from your stock
    picking skill.

    You don't have to worry about adjusting the
    hedge, a 100% hedge is self adjusting.