Investors hedging currency exposures have many decisions to make, from establishing hedge ratios and strategic benchmarks to setting counterparty concentration thresholds. The composition of an investor's currency exposure may also warrant the use of proxy hedging, where one foreign currency is substituted for another currency of the same notional amount in an overlay program. This augmentation of a currency hedge may benefit the investor by reducing the number of trades and improving costs by avoiding relatively illiquid currencies while maintaining a low tracking error relative to the currency hedge benchmark. However, the cyclicality of the economy can also decouple otherwise stable correlations, motivating investors to take a holistic approach that goes beyond correlations.

Key highlights of this paper:

  1. Use of currency proxies
  2. What makes a good proxy?
  3. Proxy hedging in a volatile environment
  4. Emerging market currencies

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