Risk management and portfolio allocation deal with two main principles: minimizing portfolio risk and efficient hedging strategies. The literature on the former principle goes back to Markowitz’s theory on portfolio diversification, Markowitz (1952). In a realistic setting with transaction costs and illiquid markets, however, investors deal with practical questions such as how much should be hedged and how to implement hedging. In this paper, we propose a flexible approach to model equity portfolio risk involving exchange rate risks. This model lends itself to adaptable definitions of risk and various structures of hedging. Specifically, we refer to the volatility transmission between exchange rate and equity returns. This approach allows us to specify the interactions between variances / covariances of exchange rate and equity returns and how these relations evolve across time.
Our methodology differs from the traditional definition of hedging which focuses on the determination of optimal portfolio weights. Between the two extremes of full or no hedging, a variety of combinations of partial hedging are conceivable. The main goal of this paper is to provide an effective method to implement partial hedging. Facing the trade-off between diversification needs and hedging costs, we assume that our agent decides to target a well-defined configuration of portfolio risk. In particular, we take the standpoint of a representative US investor holding a diversified portfolio of international equity shares of companies active in different sectors. While all equities are quoted in US dollars, our representative investor is concerned by two main sources of risk: currency and sector risk.
The former relates to the unexpected outcomes of foreign companies. The latter comes from the common exposure to sector-wide factors. Our model enables the representative investor to measure and hedge any combination of portfolio risk. Three main aggregations of the variance-covariance matrix are considered: all elements, the diagonal elements, and blocks of elements according to the companies’ sectors. The economic meaning of the first approach is the total portfolio risk, while the second case refers to a fully diversified portfolio in which only the sys-tematic risk matters.
The block-wide approach captures the entire spectrum of partial hedging. Of particular interest is spillover risk, i.e. the danger of adverse transmissions of return variances and covariances from one specific asset category to another. In other terms, we consider how sector-specific and currency risks interact within and across asset classes and across time. These aspects are particularly relevant for international equity shares such as American Depositary Receipt (ADRs).
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Hedging risk spillovers in international equity portfolios
