Optimal currency risk hedging

This paper investigates the optimal hedging strategy of a domestic expected utility maximizer endowed with a temporarily non-traded position in a foreign investment. The domestic and foreign yield curves, the exchange rate between the two involved currencies, and the foreign investment value are stochastic and obey fairly general diffusion processes. We compare the hedger's optimal strategies using either exchange rate forward contracts or futures contracts. For both strategies, the optimal number of contracts held can be broken down into several components having clear economic interpretations. However, while futures contracts are known in such a context to be more difficult to price than their forward counterparts, the optimal strategy using them is simpler. This is due to the fact that, when forward contracts are used, incurred profits or losses that accrue to the investor's wealth at each instant are locked-in in the forward position up to the contract maturity. Thus discounting these gains or losses back at the current date brings about an interest rate risk. Therefore the investor's hedging strategy itself generates an additional risk, which in turn induces the need for additional hedging. The magnitude of the difference between the two hedge ratios may be significant under a set of plausible assumptions. Since in general financial markets are not complete, the additional interest rate risk cannot be perfectly hedged. Hence the marking-to-market mechanism that characterizes futures contracts and allows for the complete elimination of this risk is valuable for risk averse agents. (C) 2002 Elsevier Science Ltd. All rights reserved.