THE USE OF CURRENCY PORTFOLIOS IN THE REDUCTION OF EXCHANGE RATE RISK - A PORTFOLIO SOLUTION FOR AN OPTIMUM CURRENCY COCKTAIL

Abstract

"THE USE OF CURRENCY PORTFOLIOS IN THE REDUCTION OF EXCHANGE RATE RISK - A PORTFOLIO SOLUTION FOR AN OPTIHAL CURRENCY COCKTAIL MIX" One method that is being used and vi11 continue to be used to cover the risk of fluctuating exchange rates, especially over periods longer than those for which forward cover is available, is the use of the so-called currency cocktail. A currency cocktail is essentially a basket of different currencies and is thought of as a unit of account. Its basic purpose is to reduce the risk exposure associated with fluctuating exchange rates. A methodology involving the use of quadratic programming (with solution by Wolfe algorithm) is presented in this study project report for determining an optimal currency cocktail mix so as to minimize exchange rate risk. A valuable application of such a cocktail is in denominating bonds, and cocktail bonds which minimize exchange rate risk for both bond issuers and purchasers are highly marketable and should become more popular in international capital markets. An empirical analysis in this study considers the weekly exchange rate data of twelve different foreign currencies (viz. US dollar, German mark, Japanese yen, French franc, British pound, Australian dollar, Dutch guilder, Italian lira, Saudi Arabian riyal, Hong Kong dollar, Thai baht and Malaysian dollar) over a five-year period 1981 - 1985. If the purpose of constructing the currency cocktail is to have a stable unit of account, then the optimal currency cocktail should be the one with the lowest variance as well as a zero expected rate of 'return' (i.e. with no expected appreciation or depreciation in its unit value). It was found that, from among the twelve foreign currencies examined, the optimal currency cocktail mix only comprises 13.55% US$, 41.15% yen, 13.89% SR and 30.81% M$. These optimal proportions simply reflect both the relative variances and covariances of the currencies, as well as their relative expected rates of 'return'.