Optimal foreign exchange hedge tenor with liquidity risk

Rongju Zhang, Mark Aarons, Gregoire Loeper

Research output: Contribution to journalArticleResearchpeer-review


We develop an optimal currency hedging strategy that allows fund managers who own foreign assets to choose the hedge tenors that will maximize their foreign exchange (FX) carry returns within a liquidity risk constraint. The strategy assumes that the offshore assets are fully hedged with FX forwards. The chosen liquidity risk metric is cashflow at risk (CFaR). The strategy involves time-dispersing the total nominal hedge value into future time buckets to maximize (minimize) the expected FX carry benefit (cost), given the constraint that the CFaRs in all the future time buckets are well managed within a liquidity budget. We show by Monte Carlo simulation and by backtesting that our hedging strategy successfully delivers good carry trade returns with little liquidity risk. We also provide practical insights on when and why fund managers should choose short-dated or long-dated tenors.

Original languageEnglish
Pages (from-to)1-29
Number of pages29
JournalJournal of Risk
Issue number3
Publication statusPublished - Feb 2021


  • Carry trade
  • Cashflow at risk
  • Foreign exchange hedging
  • Liquidity risk
  • Optimal hedge tenor

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