Currency exchange rate risk hedging strategies using MXN/USD MexDer futures contracts

Abstract

The use of futures contracts to hedge exchange rate risk rapidly gained importance after the Bretton Woods Agreement was abandoned in 1973. However, one of the technical difficulties of using futures contracts is the determination of the optimal hedge ratio that minimises risk. This work studies and compares eight possible hedging strategies to identify the optimal hedge ratio for a long position in US Dollar, from the perspective of a hedger whose currency of interest is the Mexican Peso. Two of the strategies use a constant hedge ratio (a naive 'one-to-one' strategy, and an OLS-based hedge ratio). The other six use bivariate GARCH models, including: a diagonal VECH model; a constant conditional correlation model; and a BEKK model. Results show that the OLS-based strategy outperforms the alternative strategies in terms of volatility reduction as measured by a hedging effective index (HEI), by value at risk (VaR) and conditional VaR (CVaR) criteria.