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Foreign exchange hedging using regime‐switching models: The case of pound sterling

Lee, T. ORCID: 0000-0002-4989-619X, Moutzouris, I. C. ORCID: 0000-0002-6954-9961, Papapostolou, N. C. ORCID: 0000-0003-4529-1182 & Fatouh, M. (2023). Foreign exchange hedging using regime‐switching models: The case of pound sterling. International Journal of Finance and Economics, doi: 10.1002/ijfe.2893


We develop a four-state regime-switching model for optimal foreign exchange (FX) hedging using forward contracts. The states reflect four possible market conditions, defined by the direction and magnitude of deviation of the prevailing FX spot rate from its long-term trends. The model’s performance is tested for five currencies against Pound Sterling for various horizons. Our analysis compares the hedging outcomes of the proposed model to those of other frequently used hedging approaches. The empirical results suggest that our model demonstrates the highest level of risk reduction for the US dollar, Euro, Japanese yen and Turkish lira and the second-best performance for the Indian rupee. The risk reduction is significantly higher for lira, which suggests that the proposed model might be able to provide much more effective hedging for highly volatile currencies. The improved performance of the model can be attributed to the adjustability of the estimation horizon for the optimal hedge ratio based on the prevailing market conditions. This, in turn, allows it to better capture fat-tail properties that are frequently observed in FX returns. Our findings suggest that FX investors tend to use short-term memory during low market conditions and long-term memory in high ones. This could be useful for policy makers to understand of how FX risk evolves with the market mode. It would be also useful to build a better understanding of how investor behaviour depends on market conditions and mitigate the adverse behavioural implications of short-term memory, such as panic.

Publication Type: Article
Additional Information: This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided the original work is properly cited. © 2023 Bank of England and The Authors. International Journal of Finance & Economics published by John Wiley & Sons Ltd.
Publisher Keywords: Regime-switching, Foreign Exchange Hedging, Hedging Effectiveness, High-volatility Currencies, Forward Hedging
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School > Finance
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