Hedging the fx risk: the role of correlation

Hedging financial risk is an essential issue but is far from trivial to implement. By continuing a previous study, we analyze an investment where the traditional hedging strategy may lead to a riskier portfolio than the naked position. The basic problem is well-known for portfolio and risk managers: we hedge the foreign exchange risk of a foreign stock investment with the help of a forward position. With some simulations, we show how the correlation between the stock price and the exchange rate can (or should) influence the decision about the forward position’s volume. We emphasize that also regulators should initiate more sophisticated definitions in the field of financial hedging.