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Currency_Hedge_Ratio_Statistical_Estimates_Russell_Nov95 (1)

Currency_Hedge_Ratio_Statistical_Estimates_Russell_Nov95...

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Research Commentary Statistical Estimates of the Normal Currency Hedge Ratio: Best Practice or Best Guess? Grant W. Gardner Douglas Stone November 1995 Russell Research Commentaries provide original research or analysis of specific topics and events. Grant W. Gardner is an analyst in Research in Tacoma. Douglas Stone is Director of Research at Nicholas Applegate in San Diego, CA. Note: This paper is based partially on research that will appear in a forthcoming article in the Financial Analysts Journal . We wish to thank Amy Barton for programming assistance. This research was begun while Douglas Stone was an analyst at Frank Russell Company.
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Statistical Estimates of the Normal Currency Hedge Ratio: Best Practice or Best Guess? 2 Russell Research Commentary 1 Introduction An essential element of currency risk management is determining a normal hedge ratio . As explained in two earlier Commentaries [Gardner (1994a,b)], the normal hedge ratio can be thought of as the fraction of a portfolio’s currency exposure that an investor would offset with forward contracts if forced to choose a permanent, constant policy. Because it is a permanent policy, the value of the normal hedge ratio is based on the long-run behavior of currencies and asset returns. If an investor uses passive currency-risk management that ignores trends and short-term fluctuations in currency values, then the normal hedge ratio should be maintained constantly. Alternatively, if the investor attempts to add value by actively managing the portfolio’s currency exposure, then the normal hedge ratio serves as the strategic benchmark used to judge the success of this active currency management. Conceptually, finding the value of the normal hedge ratio is straightforward. As explained in the earlier Commentaries , standard mean-variance optimization can be used to derive a hedge ratio that maximizes the total portfolio’s risk- adjusted return. This technique underlies the discussions of currency-risk control found in Froot and Perold (1993), Glen and Jorion (1993), Jorion (1989), Kritzman (1993), Lee (1989), and Nesbitt (1991), among others. To calculate the normal hedge ratio, an investor needs values for expected returns, variances, and covariances that reflect the long-run behavior of currency and asset returns. Of course the “true” values of these parameters are unknown and must be estimated. Even when correct statistical techniques are used and the data sample is large, the parameter estimates contain degrees of error. When these estimates are used to calculate the normal hedge ratio, this error is translated into error in the estimate of the hedge ratio. The potential size of this error is a critical issue. If the estimation error is very large, then the confidence region for the true value of the normal hedge ratio is large and the point estimate is not very useful in constructing a currency hedging strategy .
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