Hedging of market risks in an internationally diversified portfolio

The international financial markets have been characterised by high volatility and uncertainty this millennium due to crises such as the dotcom bubble, the financial crisis in 2007, and the euro crisis, and ultimately the consequences of the Covid-19 pandemic and the war in Ukraine. Investors try to hedge against adverse portfolio movements by diversification and through derivatives. This study thus investigates to what extent international diversification reduces unsystematic risk and whether the use of derivatives such as forwards and futures can reduce systematic risks in the form of market risk, exchange rate risk, and interest rate risk. The results of the research suggest that naive international diversification is able to reduce the unsystematic risk. Market risk and exchange rate risk could be significantly reduced by hedging them separately using forwards and futures, while hedging interest rate risk worked only marginally. The simultaneous hedging of all risks for the entire portfolio was able to remarkably reduce volatility and generate profits at the same time. The outcomes of the backtesting may vary depending on the portfolio, the period under review and the instruments used, but nevertheless, this thesis provides valuable insights for investors and portfolio managers to navigate through volatile markets and highlights the importance of diversification and the use of derivatives.