Deutsche Bank-FX Special Report Unlocking Value with Dynamic FX Hedging-110476280

25 September 2024Deutsche BankResearch Global Foreign Exchange FX Special Report Date Unlocking Value with Dynamic FX Hedging Our earlier study laid down the foundational framework for the simplest form of currency hedging, that of future cash flows. Our approach was based on the idea that the objective function for corporates seeking to hedge foreign currency exposures in future cash flows is to minimise uncertainty subject to cost. Our analysis showed that both for US and European exporters, a hedging rule that incorporates past momentum of spot realizations versus forward (momentum strategy) generates superior outcomes to naïve (full) hedging.In this paper, we build on this work by applying hedging rules based on our popular spot valuation models: the PPP and DBeer models. Our PPP model quantifies currency valuation on the notion that nominal exchange rates should move in line with inflation differentials. Our DBeer model, on the other hand, expands on PPP by quantifying currency valuations on the basis of long-term relationship between exchange rates and key macroeconomic variables such as productivity differentials, terms of trade, and openness.Our valuation models enhance our framework by generating higher realized gains for longer hedging tenors. A hedging rule that combines currency valuations with momentum often leads to better returns with lowest downside risk – measured as the 95% Value at Risk (VaR). Here, VaR captures the maximum probable loss from a hedging strategy with a given level of confidence. Ideally, we like hedging strategies that result in positive returns with lowest downside risk. We therefore argue that the most optimal solution for hedging is a combination of momentum and valuation models, with a higher weight to valuation models as hedging tenor increases.Hedging currency risk is most costly to US and European exporters during the dollar or euro down cycle. Our hedging rule based on a combined momentum + valuation framework consistently leads to realized gains across different cycles. This strategy is able to adjust hedge ratios more dynamically, with three possible outcomes: 0% hedged, 50% hedged and 100% hedged. Our results highlight that applying hedge ratios determined more dynamically consistently generate superior outcomes over a static hedge ratio of 1.Rohini Grover, Ph.D.Strategist+44-20-75475907Deutsche Bank AGIMPORTANT RESEARCH DISCLOSURES AND ANALYST CERTIFICATIONS LOCATED IN APPENDIX 1. MCI (P) 041/10/2023. UNTIL 19th MARCH 2021 INCOMPLETE DISCLOSURE INFORMATION MAY HAVE BEEN DISPLAYED, PLEASE SEE APPENDIX 1 FOR FURTHER DETAILS.Distributed on: 25/09/2024 12:37:06 GMT7T2se3r0Ot6kwoPa25 September 2024FX Special ReportPage 2Deutsche Bank AGTable Of Contents1. Introduction...................................................................................................32. Measuring expected cost of hedging.............................................................43. Hedging strategies based on