Hedging Foreign Currency Portfolios

Abstract

This paper investigates the dynamic and portfolio effects in a multi-currency hedging problem which incorporates both risk-reduction and speculative components for the futures demand. We model the joint evolution of daily spot portfolio returns and log-differences of the corresponding futures prices in a trivariate GARCH system allowing time-varying covariability between all the components of the system. Hedging performance is evaluated from both risk-minimization and a utility standpoint. Our results show that accounting for portfolio effects in constructing a multi-currency hedge leads to efficiency and utility gains.

Keywords: Hedging, GARCH, portfolio effects, risk-minimization, covariance