Using Cointegration to Guide Currency Hedging in International Bond Portfolios

Summary

The document raises a portfolio-hedging question: how to account for correlations between international bond returns and foreign-exchange carry returns when choosing currency hedge positions. It defines the relevant series as asset log returns and carry returns for positions that are long a foreign currency and short the domestic currency. The question references prior work on optimal hedge ratios for multi-country portfolios, then proposes cointegration analysis as a way to study shared long-run trends and inform hedge optimization.

No specific model, hedge-ratio formula, empirical result, or implementation details are supplied. The proposed cointegration approach is a brief direction from the questioner rather than a demonstrated strategy, so the document does not show that it improves hedging outcomes. Readers would need to choose a suitable portfolio and currency setup, test the time-series assumptions, and evaluate hedge performance beyond identifying a common trend.

Key ideas

• The question concerns currency hedging for an international bond portfolio.
• It frames foreign-exchange carry returns as long foreign currency and short domestic currency.
• It proposes using cointegration analysis to examine common trends between asset and currency return series.
• The document gives no hedge-ratio method or empirical evidence that cointegration improves portfolio hedging.

Tags

# Framework for hedging FX via correlation between asset returns


# Framework for hedging FX via correlation between asset returns












Can anyone point me in a direction (research paper, books, etc) which develops a framework/strategy for hedging currency exposure for an international bond portfolio?

Schmittmann's paper$^\color{magenta}{\star}$ finds optimal hedging ratios for multi country portfolios, but I want to utilize correlation between the asset returns to optimize the hedging strategy. What I'm working with is an asset return (log difference of prices) time series $x_{n,t}$ and a FX carry return for each foreign currency where the carry trade is long foreign and short domestic currency $c_{t, n}$.

I hope my question makes any sense. If not, please ask me!

$\color{magenta}{\star}$ Jochen M. Schmittmann, Currency hedging for international portfolios, International Monetary Fund, 2010.

## Answer by EternalStruggle (score 0, accepted)

https://quant.stackexchange.com/a/46871

I found what I was looking for. I'm going ahead with cointegration analysis, of the timeseries, where you analyze the common co-integration trend, to optimize hedging.

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