Post by fireopal on Mar 5, 2009 0:05:11 GMT 4
The Term Structure of Currency Hedge Ratios
Olaf Korn
Georg-August-Universität Göttingen
Philipp Koziol
Deutsche Bundesbank; Georg-August-Universität Göttingen
February 15, 2009
Abstract:
Many firms face product price risk in foreign currency, uncertain costs in home currency and exchange rate risk. If prices and exchange rates in different countries interact, natural hedges of foreign exchange risk might result. If the effectiveness of such hedges depends on the hedge horizon, they might affect a firm's usage of foreign exchange derivatives and lead to a term structure of optimal hedge ratios. We analyze this issue by deriving the variance minimizing hedge position in currency forward contracts of an exporting firm that is exposed to different risks. In an empirical study, we quantify the term structure of hedge ratios for a "typical'' German firm that is exporting either to the United States, the United Kingdom or Japan. Based on cointegrated vector auto regressive models of prices, interest rates and exchange rates, we show that the hedge ratio decreases substantially with the hedge horizon, reaching values of one half or less for a ten-years horizon. Our findings can (partly) explain the severe under hedging of long-term exchange rate exposures that is frequently observed and have important implications for the design of risk management strategies.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1343614_code490419.pdf?abstractid=1343614&mirid=1
Olaf Korn
Georg-August-Universität Göttingen
Philipp Koziol
Deutsche Bundesbank; Georg-August-Universität Göttingen
February 15, 2009
Abstract:
Many firms face product price risk in foreign currency, uncertain costs in home currency and exchange rate risk. If prices and exchange rates in different countries interact, natural hedges of foreign exchange risk might result. If the effectiveness of such hedges depends on the hedge horizon, they might affect a firm's usage of foreign exchange derivatives and lead to a term structure of optimal hedge ratios. We analyze this issue by deriving the variance minimizing hedge position in currency forward contracts of an exporting firm that is exposed to different risks. In an empirical study, we quantify the term structure of hedge ratios for a "typical'' German firm that is exporting either to the United States, the United Kingdom or Japan. Based on cointegrated vector auto regressive models of prices, interest rates and exchange rates, we show that the hedge ratio decreases substantially with the hedge horizon, reaching values of one half or less for a ten-years horizon. Our findings can (partly) explain the severe under hedging of long-term exchange rate exposures that is frequently observed and have important implications for the design of risk management strategies.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1343614_code490419.pdf?abstractid=1343614&mirid=1