Currency Hedging Policies For minimum Probability of Default

Abstract

Currency hedge ratios are studied from the perspective of minimum probability of default. In determining the no-market-view benchmark currency composition policy of multilateral financial institutions like IBRD or ADB, the minimum probability of default may be a good criterion. Similarly, the minimum probability of depletion could be a good criterion for a benchmark currency allocation policy on foreign reserves of a central bank. Under the assumption of the same risks of assets across currencies, i.e. assets in USD and assets in Euro, the optimal currency composition of equity for minimum probability of default turns out to vary depending upon the currency composition of assets. Here the currency composition of equity is defined as the currency composition of assets minus the currency composition of debts. For the purpose of comparison, the optimal currency composition for minimum variance of equity value is also examined. The currency composition of equity for minimum variance of equity turns out to be 100% domestic currency. The results of this paper imply that the benchmark currency composition policy of a non-profit multilateral organization whose main objective is to continue operations may well be different from that of a private company whose shareholders do not like excessive volatility of their share values. With hindsight, equity of a firm is to absorb unexpected losses from assets, so the currency composition of equity for minimum probability of default may well be related to the currency composition of assets.