Computational Economics, 2015, 45, 151-181. Libo Yin*, Liyan Han

This paper proposes an option-based portfolio insurance (OBPI) method for international foreign exchange risk hedging. Each investor is assumed to maximize the expected utility of his/her portfolio which includes international risky assets and foreign currency index derivatives. The optimal investment is determined for quite general utility functions and hedging constraints. Our results show how and why foreign currency derivatives should be introduced in the investment portfolio to hedge currency risks. The main conclusion of the paper is that new types of options which combine both equity assets and foreign currency derivatives should be used, contrary to the current practice which considers two separate option markets.

The numerical studies verify the efficiency of CNYX-related derivatives in portfolio optimization and currency risk hedging. The main policy proposal of the results is that new type of options which combines both equity and CNYX-related derivatives should be introduced, contrary to traditional wisdom which considers two separate financial asset markets. This idea is in line with the discussion on other currency index derivatives.

We should note that the optimal portfolio is determined for quite general utility functions (CRRA and the Cobb-Douglas utility functions), and the hedging constraints envisaged on the terminal portfolios’ value are quite general and can be applied to a large variety of practical cases. This will be a topic for future research.