Frida Holmberg och Rasmus Thunberg: Looking Over the Hedge, Currency Hedging of Stochastic Cash Flows

This thesis investigates different views on and outcomes of currency hedging of stochastic investments denoted in foreign currency. Two different kinds of investors are presented; one that wants to avoid the downside of changes in the future expected exchange rate and one that wants to avoid the downside of the entire portfolio (the investment together with the currency position). Estimates are made, based on data for three different currencies, and Lower partial moments is used as a risk measure. The results show that it is in most cases profitable to include options in the hedge regardless of what strategy is used. The results also show that the result due to changes in the future expected exchange rate can be affected to a much larger extent than the downside of the entire portfolio. When the models are stress tested on a situation identical to that of the recent financial crisis but with reversed correlations between assets and currencies, it is still in most cases favourable to include options in the hedge. We also see that the approach that minimizes the lower partial moments of the entire portfolio is much more sensitive to changes in the correlation structure than the approach of trying to avoid results due to changes in the expected future exchange rate.