City Research Online

Abstract

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 the peer reviewed version of an article that will be published in final form at http://onlinelibrary.wiley.com/journal/10.1002/(ISSN)1099-1158. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Use of Self-Archived Versions. This article may not be enhanced, enriched or otherwise transformed into a derivative work, without express permission from Wiley or by statutory rights under applicable legislation. Copyright notices must not be removed, obscured or modified. The article must be linked to Wiley’s version of record on Wiley Online Library and any embedding, framing or otherwise making available the article or pages thereof by third parties from platforms, services and websites other than Wiley Online Library must be prohibited.
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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