How can the quantitative approach help in building an optimal FX hedge portfolio?


We are used to dynamically adjusting our equity portfolios based on market conditions, but we rarely do this for the FX hedging portfolio and even when we do, we do so based on gut feeling rather than a robust quantitative approach consequences.

For example, based on market conditions, we adjust our allocation to cash, large cap, mid cap and small cap. The aim is to maximize the return per unit of risk taken.

In other words, chasing the allocation with the best Sharpe ratio, or technically at the efficient frontier.

Similarly, we can adjust the composition of our hedging portfolio to optimize hedging performance.

It is always optimal to have a mix of hedging instruments in our portfolio, such as B. Forwards, Risk Reversals (RRs), Plain Vanilla Options or even Exotics (in case of non-retail users according to RBI classification).

How much to hedge through which instrument depends on the prevailing market conditions (e.g. forward points and volatility) and the outlook.

In the case of exporters, it is advisable to increase allocation to easy puts when USD/INR is at the bottom of the range, increase allocation to RRs when it is in the middle of the range and allocation to forwards up increase if it is at the high end of the range. In the case of importers, it is prudent to increase allocation to forwards at the low end of the range, allocation to RRs in the middle of the range and plain vanilla calls at the high end of the range.

While the above is fairly intuitive, it can be tricky to implement as it’s quite subjective what the low, middle, or high end of the range is.

It therefore helps eliminate human bias and rely on the rigorously backtested data that suggests the determination of the optimal hedge portfolio composition at any point in time.

Additionally, when making hedging decisions, we tend to place an overweight on Spot. We do not take forward points (carry) and volatility into account. The interplay between spot, forwards and vols can be difficult to assess if not done quantitatively.

In general, it can be seen that when the patch is depressed, vols are attenuated and front dots are raised, and when the patch is lifted, vols are raised and front dots are compressed.

To illustrate this point, we backtested the optimal hedging strategy for importers to cover 6 month exposures. We found that volatility was an important factor that helped improve hedging instrument choice. This is because volatility inherently tends to mean revert and in the case of USD/INR, spot volatility correlation has historically been positive.

We observed that forwards outperformed RRs (buy call ATMF and sell put ATMS) and plain vanilla ATMF buy calls when 6-month ATMF implied volumes were below 6%.

However, when 6M ATMF implied volumes were above 6%, RRs outperformed forwards and plain vanilla calls on a risk-adjusted basis.

Plain vanilla calls underperformed even during times when the spot was elevated as volumes were also elevated at the time making the plain vanilla ATMF call very expensive.

The average 6-month forward points during the period was 175p. Executing an RR instead of a forward would have resulted in an average saving of 18 paise. This is a 10.3% savings on such instances. There were 65 out of a total of 115 instances where the RR outperformed forward.

The strategy of hedging RRs when ATMF volumes were above 6% and hedging forwards when volume levels were below 6% would have helped the importer earn a cumulative sum of Rs 11.7 crs for a 10-month period years to $10 million with 6-month rolling term backups taken each month.

If the importer were able and willing to take a little more risk, he would have had a 50-50% combination of RRs and out-of-the-money forward call options (e.g. 40 Delta) on average can save 35 paise compared to forwards when 6 month volumes were over 6%.

This would have resulted in a cumulative saving of Rs 22.7 crs for a 10 year period on USD 10 million in bookings made each month on a rolling 6 month tenor basis (~20% compared to Forwards at times when 6-month volumes were above 6%) over 10 years, while 6-month exposures are hedged on a rolling basis each month.

While ATMF options are expensive, out-of-the-money forward options are cheaper due to lower moneyness.

Because the spot tends to peak when vols deviate significantly from the mean, the out-of-the-money call option is less likely to be exercised.

By taking out this option, one is able to buy protection at a cheaper rate compared to ATMF and participate in case of rupee appreciation.

However, if the rupee is above the ATMF level at maturity, the importer will not be hedged at the forward rate but at a higher rate as the strike price is higher. That’s the risk.

If we further shifted the allocation towards out-of-the-money forward vanilla calls when 6-month volumes are above 6%, the potential savings would be even greater, albeit with greater risk.

The case study above is a fairly simplified illustration of how a hedging strategy can be refined using quant and backtesting.

Whenever we engage with clients, we encourage them to assess their ability and willingness to take risk, and once this is established, we advise them on the optimal composition of their hedging portfolio.

Such a hedging approach is systematic in our view and can help to more consistently outperform ad hoc, discretionary hedging decisions.

The results of our backtest are attached in the table below:


(The author is Founder and CEO IFA Global)

(Disclaimer: Recommendations, suggestions, views and opinions of experts are their own. These do not represent the views of Economic Times)

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