Publication: Currency Hedging Strategies Using Dynamic Multivariate GARCH
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2012-02
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Abstract
This paper examines the effectiveness of using futures contracts as hedging instruments of: (1) alternative models of volatility for estimating conditional variances and covariances; (2) alternative currencies; and (3) alternative maturities of futures contracts.
For this purpose, daily data of futures and spot exchange rates of three major international currencies, Euro, British pound and Japanese yen, against the American dollar, are used to analyze hedge ratios and hedging effectiveness resulting from using
two different maturity currency contracts, near-month and next-to-near-month contract. Following Chang et al. [17], we estimate four multivariate volatility models (namely CCC, VARMA-AGARCH, DCC and BEKK), and calculate optimal portfolio weights
and optimal hedge ratios to identify appropriate currency hedging strategies. The hedging effectiveness index suggests that the best results in terms of reducing the variance of the portfolio are for the USD/GBP exchange rate. The empirical results
show that futures hedging strategies are slightly more effective when the near-month future contract is used for the USD/GBP and USD/JPY currencies. Moreover, the CCC and AGARCH models provide similar hedging effectiveness, which suggests that
dynamic asymmetry may not be crucial empirically, although some differences appear when the DCC and BEKK models are used.
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The authors are most grateful for the helpful comments and suggestions of Michael McAleer, Teodosio Perez Amaral, two referees, and participants at the international Conference on Risk Modelling and Management, Madrid, Spain, June 2011. The first author is most grateful for the financial support of the National Science Council, Taiwan, and the second author acknowledges the financial support of the Ministerio de Ciencia y Tecnología and Comunidad de Madrid, Spain.
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