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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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18.5 Managing Tracking Error in Forward Hedges

18.5.1 How Often to Rebalance?

Most hedged investors target a constant ratio between the value of the hedge (in foreign currency) and the value of the foreign asset, known as constant hedge ratio. However, if the value of the asset moves, then the effective hedge ratio deviates from target, creating tracking error. Tracking error leaves the hedger effectively with a short foreign currency (overhedged), if the underlying asset value drops. If the foreign asset price rises, the hedger is left with a long foreign currency position relative to the benchmark (underhedged), creating a potential mark-to-market risk.

The size of the tracking error depends on the volatility of the underlying asset price and the type of hedge instrument, as discussed in the previous section. For simplicity, this section assumes the investor hedges with currency forwards, which are the preferred instruments for hedgers who care about tracking error.

Figure 18.4 shows the effective hedge ratios of a Eurozone investor, who fully hedges the Citi US Government Bond Index, Citi US HY Market Index, and MSCI US with quarterly forwards, adjusting the value of the hedge back to the value of the underlying asset at the end of each quarter (quarterly rebalancing). Owing to the lower volatility of the US government bond exposure, the effective hedge ratio of bonds has been closer to the 100% target than the effective hedge ratio on US equities and high yield bonds. The daily ...

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