Dynamic hedging of foreign exchange risk using stochastic model predictive control

A risk management system for foreign exchange (FX) brokers is described. Stochastic model predictive control (SMPC) is used to reduce positions in foreign holdings over a receding horizon, while minimising a mean-variance cost function. Computation of the broker´s position incorporates elements which model client flow, transaction costs, market impact, and exchange rate. Using both synthetic and historical data, the technique is shown to outperform two simple hedging strategies on a risk-cost Pareto frontier. Prediction of client and market behaviour are shown to further enhance the hedging outcome.