Cross hedging the Italian Lira/US dollar exchange rate with deutsch mark futures
✍ Scribed by Francesco S. Braga; Larry J. Martin; Karl D. Meilke
- Publisher
- John Wiley and Sons
- Year
- 1989
- Tongue
- English
- Weight
- 776 KB
- Volume
- 9
- Category
- Article
- ISSN
- 0270-7314
No coin nor oath required. For personal study only.
✦ Synopsis
he recent volatility of the Italian lira/US dollar exchange rate introduces a sub-T stantial exchange rate risk for traders and investors with a portfolio including the two currencies. As will be explained later, due to foreign exchange controls in Italy, this risk can be managed using a rather limited set of traditional instruments. From this situation emerges the importance of investigating new exchange rate hedging strategies. The objeztive of this paper is to assess the empirical performance of a strategy using the Deutsch mark (dm) futures to cross hedge the Italian lira/US$ exchange rate.
That a currency cross hedge can be considered when "there are no futures or forward markets in a currency" (Eaker and Grant, p. 85) is a common idea in the literature. Implicit in this statement is the assumption that the results of a currency futures (or forward) cross hedge are inferior to that of a direct hedge. However, this assumption may not be true in the case of the Italian lira/US$ exchange rate. To substantiate this claim, two broad questions are considered. Is the dm futures cross hedge an effective hedging strategy? How does it compare with the traditional Italian lira/US$ forward market hedge?
The first question is investigated by adopting Johnson's (1960) portfolio model for three different hedge lengths: 1, 2, and 4 weeks, and using stochastic dominance (SD) rules to rank the results of the 4 week futures and forward hedges. The empirical results show that for a long US dollar hedge the dm futures strategies are, on average, much cheaper than the traditional forward market, and that at least one cross hedge strategy is always in the optimal set.
'The paper considers only the lira/US$ exchange rate risk. The results are, therefore, general in scope and the hedge ratios may not be optimal for the solution of the specific portfolio problem of an individual investor or entrepreneur importing or exporting goods or services.