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Member question: “Does anyone use efficient frontier in the balance sheet hedging program, i.e., consider the correlations between the currency pairs to determine the hedge ratio? I would like to learn how that works in practice.”
Peer answer 1: “We do an efficient frontier light, I would say. We have different hedge ratios based on a cost per reduction of volatility metric. This is currency-by-currency, no correlation analysis.”
Member follow-up: “That’s a good point, considering the cost vs. volatility. How do you determine the threshold (or hedge target) with this metric?”
Peer response: “Our thresholds were judgmental and will generally arrive at an overall target of hedging >85% of exposure. We looked for some inflection points at the time to determine the thresholds. > -25bps per vol is hedged 100%, -25 to -50 is 75%, -50 to -100 is 50%.
- “We run this each quarter, but if a currency changes target, we will wait a quarter to see if the same signal is still there before changing. This is a starting point and we may make judgmental adjustments from there. Admittedly not highly sophisticated, but it’s easy to administer and has a VaR-ish approach.”
Peer answer 2: “We also look at a ratio of the points paid/received divided by the VaR reduction, currency by currency.
- “We do not have a set threshold; instead we look at this information along with other ones (expected trend in the exposure, etc.) to decide whether or not we should hedge a currency, which is a decision that we make for the long term.”
Note: The member spoke to another peer whose company uses an efficient frontier based on its currency exposures generated by Chatham Financial.
- “They use that as a base, but adjust based on their judgment to determine the optimal hedge plan,” the member said. “They managed to reduce the number of hedged currencies from more than a dozen to ~4, by hedging the currencies with the greatest exposure risks.”