Hedging with an Edge: Parametric Currency Overlay

We propose an optimal currency hedging strategy for global equity investors using currency value, carry, and momentum to proxy for expected currency returns. A benchmark risk constraint ensures the overlay closely mimics a fully hedged portfolio. We compare this with naïve and alternative hedges in a demanding out-of-sample test, with transaction and rebalancing costs and margin requirements. Other hedging methods generally reduce risk but at a cost. Some tend to short currencies with high returns and all incur substantial costs with frictions, mostly margin requirements and equity rebalancing costs. The proposed strategy uses predictable returns to reduce this cost. It produces a statistically significant 17% gain in Sharpe ratio and an annualized Jensen-α of 0.93% versus a fully hedged benchmark. Notably, most of the implementation costs of the strategy would be incurred by the benchmark anyway. This reduces its marginal cost and highlights a specific synergy of integrating hedging with speculation. This paper was accepted by Gustavo Manso, finance.

International Standards for Derivatives Trading and Clearing

This chapter discusses the elemental regimes on derivatives trading and clearing. These international standards remained rather ‘thin’ due to the absence of pace-setting jurisdictions and the foot-dragging of some jurisdictions; disagreements amongst regulators; and the push back from the financial industry. Furthermore, exchange and platform trading were not crucial to mitigate systemic risk. Clearing via central counterparties was crucial to mitigate systemic risk. However, other interlinked standards, notably, bank capital and margin requirements, were used to promote central clearing. Precise, stringent, and consistent international standards were not sponsored by the ‘great powers’, which adopted instead domestic regulatory reforms that had considerable extraterritoriality. Securities market regulators gathered in the IOSCO found it difficult to reconcile different views among more than one hundred member jurisdictions. Furthermore, these regulatory reforms—first and foremost centralized trading—were contested by parts of the financial industry because of their distributional implications.