Optimal foreign exchange hedge tenor with liquidity risk

Rongju Zhang; Mark Aarons; Gregoire Loeper

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Need to know

Liquidity risk generated from FX hedging offshore investments was a major issue for many asset owners and fund managers during the 2008-9 financial crisis and again in the Covid-related market turmoil of 2020.
We develop a framework to determine the optimal FX hedge tenors to maximize carry trade returns and manage the liquidity risk of hedge settlements, measured by cashflow at risk.
We mitigate this liquidity risk by optimally staggering the hedge settlement dates over a long period of time.
The simulation study and backtesting results show that our hedging strategy can manage the liquidity risk very well within the liquidity budget.

Abstract

We develop an optimal currency hedging strategy that allows fund managers who own foreign assets to choose the hedge tenors that will maximize their foreign exchange (FX) carry returns within a liquidity risk constraint. The strategy assumes that the offshore assets are fully hedged with FX forwards. The chosen liquidity risk metric is cashflow at risk (CFaR). The strategy involves time-dispersing the total nominal hedge value into future time buckets to maximize (minimize) the expected FX carry benefit (cost), given the constraint that the CFaRs in all the future time buckets are well managed within a liquidity budget. We show by Monte Carlo simulation and by backtesting that our hedging strategy successfully delivers good carry trade returns with little liquidity risk.We also provide practical insights on when and why fund managers should choose short-dated or long-dated tenors.

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