TITLE:
Optimal Foreign Exchange Risk Hedging: Closed Form Solutions Maximizing Leontief Utility Function
AUTHORS:
Yun-Yeong Kim
KEYWORDS:
Foreign Exchange, Risk, Optimal Hedging, Closed Form Solution
JOURNAL NAME:
Theoretical Economics Letters,
Vol.8 No.14,
October
19,
2018
ABSTRACT: In this paper, we extend Kim (2013)for the optimal foreign exchange (FX) risk hedging
solution to the multiple FX rates and suggest its application method. First,
the generalized optimal hedging method of selling/buying of multiple foreign
currencies is introduced. Second, the cost of handling forward contracts is
included. Third, as a criterion of hedging performance evaluation, there is
consideration of the Leontief utility function, which represents the risk
averseness of a hedger. Fourth, specific steps are introduced about what is needed
to proceed with hedging. There is a computation of the weighting ratios of the
optimal combinations of three conventional hedging vehicles, i.e., call/put currency options, forward
contracts, and leaving the position open. The closed form solution of
mathematical optimization may achieve a lower level of foreign exchange risk for
a specified level of expected return. Furthermore, there is also a suggestion provided
about a procedure that may be conducted in the business fields by means of Excel.