Optimal currency hedge and the carry trade

Abstract

This paper aims to investigate the efficiency of different hedging strategies for an investor holding a portfolio of foreign currency bonds.,The simplest strategies of no hedge and fully hedged are compared with the more sophisticated strategies of the ordinary least squares (OLS) approach and the optimal hedge ratios found by the dynamic conditional correlation-generalised autoregressive conditional heteroskedasticity approach.,The sophisticated hedging strategies are found to be superior to the simple strategies because they lower the portfolio risk in domestic currency terms and improve the Sharpe ratios for multi-asset portfolios. The analyses also show that both the OLS and dynamic hedging strategies imply holding a limited carry position by being long in high-yielding currencies but short in low-yielding currencies.,The performance of multi-currency portfolios is examined using more realistic assumptions than in the previous literature, including a weekly frequency and a constraint of no short selling. Furthermore, carry trades are shown to be part of an optimal portfolio.