Optimal FX Hedge Tenor with Liquidity Risk

TL;DR

This paper presents a strategy for fund managers to optimize FX hedge tenors by balancing carry returns and liquidity risk using a time-dispersed approach and CFaR constraints, demonstrated through simulations and backtesting.

Contribution

It introduces a novel methodology for selecting FX hedge tenors that maximizes carry returns while controlling liquidity risk, incorporating a tenor-ranking method for different market conditions.

Findings

Strategy effectively manages liquidity risk within CFaR constraints.

Shorter-dated forwards yield higher carry trade returns in the example.

Monte Carlo and backtesting confirm strategy robustness.

Abstract

We develop an optimal currency hedging strategy for fund managers who own foreign assets to choose the hedge tenors that maximize their FX carry returns within a liquidity risk constraint. The strategy assumes that the offshore assets are fully hedged with FX forwards. The chosen liquidity risk metric is Cash Flow at Risk (CFaR). The strategy involves time-dispersing the total nominal hedge value into future time buckets to maximize (minimize) the expected FX carry benefit (cost), given the constraint that the CFaRs in all the future time buckets do not breach a predetermined liquidity budget. We demonstrate the methodology via an illustrative example where shorter-dated forwards are assumed to deliver higher carry trade returns (motivated by the historical experience where AUD is the domestic currency and USD is the foreign currency). We also introduce a tenor-ranking method which is useful when this assumption fails. We show by Monte Carlo simulation and by backtesting that our hedging strategy successfully operates within the liquidity budget. We provide practical insights on when and why fund managers should choose short-dated or long-dated tenors.