Hedging with an Edge: Parametric Currency Overlay

• Published in: Management science 2022-01, Vol.68 (1), p.669-689
• Main Authors: Barroso, Pedro, Reichenecker, Jurij-Andrei, Menichetti, Marco J.
• Format: Article
• Language: English
• Subjects: benchmark risk; Costs; Currency; currency market; currency overlay; Digital currencies; foreign exchange; Hedging; Investors; margin requirements; Risk reduction; Speculation
• ISSN: 0025-1909; 1526-5501
• DOI: 10.1287/mnsc.2020.3872

We propose an optimal currency hedging strategy for global equity investors using currency value, carry, and momentum to proxy for expected currency returns. A benchmark risk constraint ensures the overlay closely mimics a fully hedged portfolio. We compare this with naïve and alternative hedges in a demanding out-of-sample test, with transaction and rebalancing costs and margin requirements. Other hedging methods generally reduce risk but at a cost. Some tend to short currencies with high returns and all incur substantial costs with frictions, mostly margin requirements and equity rebalancing costs. The proposed strategy uses predictable returns to reduce this cost. It produces a statistically significant 17% gain in Sharpe ratio and an annualized Jensen-α of 0.93% versus a fully hedged benchmark. Notably, most of the implementation costs of the strategy would be incurred by the benchmark anyway. This reduces its marginal cost and highlights a specific synergy of integrating hedging with speculation. This paper was accepted by Gustavo Manso, finance.