Open AccessVALUE-AT-RISK BASED APPROACH FOR CURRENCY HEDGING
Author(s) -
Rachna Khurana,
Umang Khetan
Publication year - 2021
Publication title -
indian journal of finance and banking
Language(s) - English
Resource type - Journals
eISSN - 2574-609X
pISSN - 2574-6081
DOI - 10.46281/ijfb.v5i1.961
Subject(s) - hedge , portfolio , econometrics , currency , value at risk , risk management , economics , value (mathematics) , basis risk , actuarial science , computer science , financial economics , mathematics , capital asset pricing model , statistics , monetary economics , finance , ecology , biology
Corporate FX risk management has gained complexity with an increased number of currencies involved and varying correlations among them. Existing literature has highlighted the need to account for cross-currency correlations when optimizing hedge ratios for portfolio management (Dowd, 1999). In this paper, we propose a Value-at-Risk (VaR) based model to estimate the optimal hedge ratio for a multi-national corporate that aims to minimize the cost of hedging at a given tolerance level of expected loss arising out of FX movement. The paper illustrates both parametric and historical methods of VaR estimation at a portfolio level as the first step in risk management. As a second step, an efficient-frontier is derived based on the expected VaR level at various hedge ratios and compared with associated hedge cost. The benefits of this approach include: identification of net exposures after correlations among currencies are accounted for in order to avoid duplication of hedges, and condensation of the parameters governing hedging decision into a single, intuitively-appealing number. The paper also highlights the need to frequently update the model’s assumptions as currency correlations and corporate exposures remain dynamic.
JEL Classification Codes: C10, F31, G32, M20.