Journal of System Science and Complexity, 7 Jun 2015, Libo Yin*, Liyan Han
When investing international portfolios, managers are faced with both market risk and currency risk exposure in multiple currencies, so how to mitigate them in a holistic view is a challenging issue. Generally, these exposures would be hedged by using individual strategies for each currency or each asset. However, basket options, which can jointly control the combined market risks and currency risks, may be a more appropriate one for investors with multiple risk exposures. They can be used to build exchange-rate-adjusted assets strategy that is almost always less expensively than the portfolio of the individual strategies. Therefore, the purpose of this paper is to study the role of basket options in strategic international portfolio optimization and risk management.
To fulfill the purpose, we have three principal objectives. First, we try to develop an effective solution for the optimal portfolio choice and dynamic risk management problem with basket options. Secondly, we measure and analyze the performance of basket options in jointly control of combined risk exposures, and gain some insights into improved measures of alternative trading strategies. Thirdly, we also compare the performance of risk management using basket options and vanilla options. In this study, basket options are not only well-suited to protect the value of positions in risky portfolios in the event of specific variations in market prices, but also can be used for a speculative purpose to take bets on specific direction and magnitude of changes in the price of underlying portfolios.
To the best of our knowledge, few papers to date have attempted to study and to obtain quantitative solutions for dynamic strategic asset allocation across multi-currency assets and basket options. Our approach is inspired by the most recent stream by Topaloglou et al. (2011), who propose a stochastic programming model for market risk hedging with vanilla options and currency risk hedging with quanto options, establishing the superiority of the mechanism over traditional approaches. We therefore take the advantage of this approach and try to investigate the role of basket options in the context of international asset allocation and risk management. To summarize, the primary features of our model are: a multi-period decision framework taking account of evolving information and decision dynamics, dynamic adjustments of portfolio positions and selective risk control in response to prevailing economic environment, state-contingent decisions in consistent with the projected outcomes of the random variables, application of basket options to mitigate combined risks for each asset and each currency, a holistic view for decision interactions and total risk exposure control, and then consideration of transaction costs.
Our empirical results indicate that basket options provide as effective tools for risk management. The first novel finding is that, judicious choices of basket options in the portfolio can materially reduce the downside risk and improve the upside potential. The returns of portfolios that include basket options have lower tails and exhibit more positively skewed distributions in contrast to the distribution of portfolios without options. The second novel result is that, substantial improvements, in terms of risk reduction and wealth accumulation, can be obtained by progressively integrated treatment of combined risks. This result could be applied to other portfolio management problems that are governed by multiple risk factors.
