A Scenario-Based Approach to Optimal Currency Overlay

Abstract

Currency risk is a measure of a portfolio's potential losses due to changes in the relative value securities denominated in different currencies. Currency risk can be minimized using hedging techniques. The optimal currency overlay techniques proposed in the finance literature are based on Markowitz's mean-variance framework, which has shortcomings for both general asset allocation problems and currency hedging. Practitioners have begun to adopt scenario-based methodologies for asset allocation as a substitute for the mean-variance framework. This article presents a scenario-based approach for the optimal currency overlay. Three numerical examples illustrate its practical use and show that the choice of a loss function can produce quite different optimal currency allocations.