The Effect of Structural Breaks and Long Memory on Currency Hedging

Journal of Futures Markets, Forthcoming

34 Pages Posted: 18 Jan 2010

See all articles by Donald D. Lien

Donald D. Lien

University of Texas at San Antonio - College of Business - Department of Economics

Li Yang

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Date Written: September 30, 2009

Abstract

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

Lien, Donald and Yang, Li, The Effect of Structural Breaks and Long Memory on Currency Hedging (September 30, 2009). Journal of Futures Markets, Forthcoming . Available at SSRN: https://ssrn.com/abstract=1480503

Donald Lien

University of Texas at San Antonio - College of Business - Department of Economics ( email )

6900 North Loop 1604 West
San Antonio, TX 78249
United States
210-458-4313 (Phone)
210-458-4308 (Fax)

Li Yang (Contact Author)

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+610293855857 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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