Daily exchange rate behaviour and hedging of currency risk
Exchange rates typically exhibit time-varying patterns in both means and variances. The histograms of such series indicate heavy tails. In this paper we construct models which enable a decision-maker to analyze the implications of such time series patterns for currency risk management. Our approach is Bayesian where extensive use is made of Markov chain Monte Carlo methods. The effects of several model characteristics (unit roots, GARCH, stochastic volatility, heavy tailed disturbance densities) are investigated in relation to the hedging decision strategies. Consequently, we can make a distinction between statistical relevance of model specifications, and the economic consequences from a risk management point of view. The empirical results suggest that econometric modelling of heavy tails and time-varying means and variances pays off compared to a efficient markets model. The different ways to measure persistence and changing volatilities appear to strongly influence the hedging decision the investor faces.
|Keywords||Bayesian decision making, GARCH, econometric modelling, exchange rates, forward contracts, risk management, stochastic volatility|
Bos, C.S., Mahieu, R.J., & van Dijk, H.K.. (1999). Daily exchange rate behaviour and hedging of currency risk (No. EI 9936/A). Report / Econometric Institute, Erasmus University Rotterdam. Retrieved from http://hdl.handle.net/1765/1605