European Investor Currency Hedging: Forwards or Options in International Portfolios

University essay from Lunds universitet/Nationalekonomiska institutionen

Abstract: The hedging effectiveness of currency forward contracts and currency put option for three different portfolios—Portfolio of Emerging Markets, Portfolio of Developed Countries, and the International Portfolio—are examined from the viewpoint of European investors. European Union (EU), United States (US), United Kingdom (UK), Switzerland (SF), Sweden (SE), Denmark (DK), Norway (NK), and Japan (JAP) are considered in the developed countries. China (CH), India (IN), Malaysia (MA), and Thailand (THAI) are the emerging markets in this study. And a combination of these two groups, which formed an international portfolio, is studied as well. As the data of the stock returns, bond returns, and exchange rate returns exhibit asymmetrical characteristics, the downside risk measurement methodology Conditional Value-at-Risk (CVaR) is applied. The significance of the hedging instrument contributes to the portfolio performance in reducing the risks and enhancing the returns simultaneously has been confirmed in all portfolios. In the Portfolio of Emerging Markets, the hedging strategy with 10% strike price put option yield a better result. While under the Portfolio of Developed Countries, although hedging with the 10% strike price put option yields the highest portfolio return, the uncertainty and fluctuant in returns is much lower in 5% option. In the portfolio of internationally diversified investment, there is no clear conclusion of which hedging instrument is over performing the other.

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