The Effect of Structural Breaks and Long Memory on Currency Hedging
Journal of Futures Markets, Forthcoming
34 Pages Posted: 18 Jan 2010
Date Written: September 30, 2009
Empirical evidence suggests that unconditional variance of exchange rate return series is subject to occasional structural breaks that may induce spurious phenomenon of high persistence and long memory of volatility processes. In this paper, we investigate the effects of such breaks on estimated risk-minimizing hedge strategies (ratios) and their performance in currency markets. Using bivariate GARCH and fractionally integrated GARCH models, we estimate the hedge ratios for six foreign currencies in the full sample with and without controlling for breaks and each subsample of different unconditional variance regimes identified by a modified version of the Inclan and Tiao (1994) algorithm. Our findings suggest that daily currency risk can be better hedged with currency futures when controlling for unconditional variance breaks in the bivariate GARCH model.
Keywords: Structural breaks, Short and long memory GARCH models, Dynamic hedging strategy, Currency futures
JEL Classification: G13, C32
Suggested Citation: Suggested Citation