Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures

TLDR

Hedging research often ignores the long‑run cointegrating relationship between assets and the dynamic nature of their distributions. The study aims to demonstrate that neglecting cointegration and distribution dynamics harms hedging performance and to propose an alternative model and dynamic strategy that mitigates this. The authors estimate risk‑minimizing futures hedge ratios for several currencies using a bivariate error‑correction model with a GARCH error structure. The proposed model achieves greater risk reduction than conventional models, and its dynamic hedging strategy can offset transaction costs for most investors.

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.