An Alternative Futures Hedge for Minor Currencies

Abstract

In a world of trade among nations using different currencies, every exchange of goods, services, or assets taking place between economic actors of different nations requires an accompanying currency transaction. If foreign exchange rates were fixed, this would be little more than a formality and not a potential source of market distortion. In the current world, however, the currency exchange rates are often very volatile and can affect market prices when viewed from outside the economy. Individuals with risk-averse preferences seek to minimize the potential losses possible from their currency positions through the use of currency hedging tools. When a nation‘s currency hedging instrument (e.g. a currency futures contract) is traded in liquid market, it is easy to hedge the risk posed by holding a foreign currency position. In these market situations, currency futures contracts can be purchased for hedging the currency position. However, when a nation‘s currency hedging instrument is not traded in liquid markets, it is impossible to hedge the risk by the direct hedging. Hence, a proxy for the currencies of small economies (i.e. minor currencies) must be found. This study examines five nations‘ currencies, the Fiji Dollar, Cyprus Pound, Maltese Lira, Taiwanese Dollar, and South Korea Won in order to determine an effective currency futures hedge for the three minor currencies in the above list : the Fiji Dollar, the Cyprus Pound, and the Maltese Lira. The results of this study‘s tests indicate that multiple futures contract hedge proposed in this study is an appropriate hedging tool for both the Fiji Dollar and the Cyprus Pound. In the case of the Maltese Lira, the results are less conclusive and suggest that the selection of the appropriate futures contracts should be improved.