Optimal Foreign Exchange Risk Hedging: A Mean Variance Portfolio Approach

Abstract

This paper introduces the optimal foreign exchange risk hedging model following a standard portfolio theory. The results indicate that a lower level of risk can be achieved, given a specified level of expected return, from using optimization modeling. In the paper the expected hedging return is defined from the expected cost of the foreign currency using a specified hedging strategy minus the expected cost of the foreign currency when it is purchased form the spot market. The focal point of the technique is its ability to identify optimal combinations of hedging vehicles, those are currency options, forward contracts, leaving the position open (foreign exchange risk hedging tools suggested by the US. Department of Commerce) in a closed form.