Risk Management for International Investment Portfolios using forward contracts and Options

In this paper we develop an integrated modelling framework that can address in aunified and comprehensive manner a number of inter-related decisions in internationalportfolio management (i.e., optimal selection of a diversified portfolio and associated decisions for controlling market and currency risks in a unified manner). We price and incorporateoptions in stochastic programming models for risk management purposes. Thesetools provide the means to investigate the performance of alternative tactics to mitigate market risk, including popular strategies that enforce specific combinations of stock indexoptions. We extend a valuation procedure to price quantos; these are fixed exchange rate options on a foreign equity. They are used to treat jointly the market and currency risksof a position in a foreign equity index. The goal is to control the portfolio's total riskexposure and to attain an e_ective balance between portfolio risk and expected return. We find that the inclusion of options in the portfolio can materially reduce the downside risk. Portfolios that include options have return distributions with significantly lower tailsand exhibit (more) positive skewness in contrast to the distributions of portfolios withoutoptions. Our empirical results show that quantos, due to their integrative nature, provide particularly e_ective instruments for risk hedging purposes. Overall, we observe that progressively integrated views towards risk management are increasingly more e_ective. That is, incremental benefits in terms of reducing risk or generating cumulative profits canbe gained as more risk factors are progressively controlled through appropriate hedgingstrategies. Hence, we demonstrate that integrated consideration of market and currency risks can yield substantial benefits for international investors. Information: Thierry Post, gtpost@few.eur.nl