Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures

Abstract Most research on hedging has disregarded both the long-run cointegrating relationship between financial assets and the dynamic nature of the distributions of the assets. This study argues that neglecting these affects the hedging performance of the existing models and proposes an alternative model that accounts for both of them. Using a bivariate error correction model with a GARCH error structure, the risk-minimizing futures hedge ratios for several currencies are estimated. Both within-sample comparisons and out-of-sample comparisons reveal that the proposed model provides greater risk reduction than the conventional models. Furthermore, a dynamic hedging strategy is proposed in which the potential risk reduction is more than enough to offset the transactions costs for most investors.

[1]  R. Chou,et al.  ARCH modeling in finance: A review of the theory and empirical evidence , 1992 .

[2]  Robert J. Myers,et al.  Bivariate garch estimation of the optimal commodity futures Hedge , 1991 .

[3]  K. Kroner,et al.  Optimal dynamic hedging portfolios and the currency composition of external debt , 1991 .

[4]  Patrick Minford,et al.  The Foreign Exchange Market: Theory and Econometric Evidence , 1990 .

[5]  T. Bollerslev,et al.  Modelling the Coherence in Short-run Nominal Exchange Rates: A Multivariate Generalized ARCH Model , 1990 .

[6]  R. Baillie,et al.  Common Stochastic Trends in a System of Exchange Rates , 1989 .

[7]  Craig S. Hakkio,et al.  Market efficiency and cointegration: an application to the sterling and deutschemark exchange markets , 1989 .

[8]  Richard T. Baillie,et al.  ECONOMETRIC TESTS OF RATIONALITY AND MARKET EFFICIENCY , 1989 .

[9]  David Hsieh.  Testing for Nonlinear Dependence in Daily Foreign Exchange Rates , 1989 .

[10]  M. Wickens.  Econometric tests of rationality and market efficiency , 1989 .

[11]  R. Chou.  Volatility persistence and stock valuations: Some empirical evidence using garch , 1988 .

[12]  James H. Stock,et al.  Asymptotic Properties of Least Squares Estimators of Cointegrating Vectors , 1987 .

[13]  C. Granger,et al.  Co-integration and error correction: representation, estimation and testing , 1987 .

[14]  R. Engle,et al.  COINTEGRATION AND ERROR CORRECTION: REPRESENTATION , 1987 .

[15]  Thomas H. McCurdy,et al.  Testing the Martingale Hypothesis in Deutsche Mark Futures with Models Specifying the Form of Heteroskedasticity , 1988 .

[16]  P. Phillips.  Testing for a Unit Root in Time Series Regression , 1988 .

[17]  Stephen Figlewski,et al.  Hedging with stock index futures: Theory and application in a new market , 1985 .

[18]  J. Poterba,et al.  The Persistence of Volatility and Stock Market Fluctuations , 1984 .

[19]  M. Sarnat,et al.  Saving, Investment, and Capital Markets in an Inflationary Economy , 1983 .

[20]  Theoharry Grammatikos,et al.  Stability and the hedging performance of foreign currency futures , 1983 .

[21]  R. Engle.  Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom inflation , 1982 .

[22]  T. Schneeweis,et al.  The Hedging Effectiveness Of Foreign Currency Futures , 1982 .

[23]  Sanford J. Grossman,et al.  The Determinants of the Variability of Stock Market Prices , 1980 .

[24]  L. Ederington,et al.  The Hedging Performance of the New Futures Markets , 1979 .

[25]  Leland L. Johnson,et al.  The Theory of Hedging and Speculation in Commodity Futures , 1960 .