Rethinking Currency Hedging for Overseas Investment: Varying Notional FX Forward as an Alternative to Plain Vanilla Forward
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This paper studies the issues related to finite-period overseas investment, foreign exchange rate, and currency hedging by foreign exchange forward contract. It is demonstrated that foreign exchange rate should be as important as foreign asset as far as overseas investment decision is concerned and that the decision ought to be made by considering the two factors conjunctionally, rather than separately. In contrast to a common perception, plain vanilla foreign exchange forward is inadequate to deal with currency hedging in many actual situations, due to its notional mismatch, costly forward point, and implicit leverage in it. As a remedy, a new structure called varying notional FX forward is proposed and its pricing is analytically derived. It turns out that the strike price of the varying notional FX forward tends to be not too different from the forward rate and most importantly it can cope with the notional mismatch problem thus eliminates the possibility of more loss than initial principal. Empirical illustrations are presented for the equity market investment into three developed and four emerging market countries from Korea and the US to highlight representative features of plain vanilla forward hedging and the varying notional FX forward hedging.
Abstract
This paper studies the issues related to finite-period overseas investment, foreign exchange rate, and currency hedging by foreign exchange forward contract. It is demonstrated that foreign exchange rate should be as important as foreign asset as far as overseas investment decision is concerned and that the decision ought to be made by considering the two factors conjunctionally, rather than separately. In contrast to a common perception, plain vanilla foreign exchange forward is inadequate to deal with currency hedging in many actual situations, due to its notional mismatch, costly forward point, and implicit leverage in it. As a remedy, a new structure called varying notional FX forward is proposed and its pricing is analytically derived. It turns out that the strike price of the varying notional FX forward tends to be not too different from the forward rate and most importantly it can cope with the notional mismatch problem thus eliminates the possibility of more loss than initial principal. Empirical illustrations are presented for the equity market investment into three developed and four emerging market countries from Korea and the US to highlight representative features of plain vanilla forward hedging and the varying notional FX forward hedging.
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