Optimal currency forward market hedge ratios: Hedging or concealed speculation?

Abstract

Finance literature in recent years has contained numerous papers dealing with the issue of optimal hedging ratios. The traditional approach to hedging with futures contracts had been to use a 1:l ratio of futures to spot positions. The more recent portfolio methodology determines the optimal hedge ratio by regressing the cash price, cash price change, or logarithm of cash price relative on the corresponding futures price, change, or logarithm. This procedure, following Johnson [7], Stein [lo], and Ederington [2], finds the minimum variance hedge ratio, which is the regression slope term, generally to be other than l:l, depending on whether the spot:futures/forward relationship is one of positive or negative carrying costs. Swanson and Caples [ll] and Herbst, Kare, and Caples [5] extend the portfolio methodology by using a Box-Jenkins autoregressive, integrated moving average procedure (ARIMA) to explicitly incorporate the effects of serial correlation. This extension yields optimal hedge ratios for major currencies which are lower than those found in the earlier portfolio studies, enlarging the difference in magnitude between traditional and portfolio determined optimal hedging ratios. Most of the studies have focused on risk reduction relating to interest rates and physical commodities. For example, Ederington [2] and Franckle (31 analyzed T-Bill futures while French [4] studied spot copper and silver prices in the United States and forward prices in England. More recently, Toevs and Jacob [13] reevaluated estimation techniques for calculating hedge ratios for interest rate risk and concluded that simple duration-based hedges can dominate regressionbased hedges. Their work thus questions the validity of the portfolio methodology. Less work has been done on foreign currency futures. Cornell and Reinganum [l] compared hedging in the forward and futures market for foreign currencies, and Hill and Schneeweis [6] attempted to measure hedging effectiveness for five major currencies using the foreign currency futures market. Park