Risk Management for International Investment Portfolios using forward contracts and Options∗

We present a framework for managing international investment portfolios. There are two different risk factors affecting this problem; the market risk and the currency risk. We develop models that address these risk factors in an integrated manner. Our framework has three fundamental components. The first component is the scenario generation procedure. The scenarios are generated so that the first four marginal moments and correlations of our random variables, which are the asset returns and exchange rates, match prespecified target values. These target values are the historical moments and correlations. The second component is the development and implementation of scenario-based stochastic programming models for international portfolios, where selective hedging strategies are used to control the exposure to the risk factors. Forward contacts are used to hedge the currency risk, while stock options hedge the market risk of the positions. Thus, the third component is the pricing of these options consistently with the postulated scenarios of the underlying assets, and their incorporation in stochastic programming models. Two classes of options are considered. The unhedged and fully protected options (quantos). We investigate the ex ante and ex post performance of international portfolios. The results indicate that increasingly integrated views towards risks are more effective compared to totaly naked positions. Overall, incorporating derivative securities is an efficient way of minimizing the downside risk, while improving the performance of international portfolios.