Cross hedging the Italian Lira/US dollar exchange rate with deutsch mark futures

Abstract

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.Francesco S . Braga is a doctoral candidate at the University of Guelph.

Using derivatives in major currencies for cross-hedging currency risks in Asian emergency markets

“…Eaker et al (1993) examined simple, multiple, portfolio, and commodity cross hedges, and showed that for the major currencies, cross hedging offered opportunities for risk reduction but was less effective than traditional similar-asset hedges. However, in assessing the U.S. dollar performance of a hedging strategy where German mark futures were used to cross hedge the Italian lira, Braga, Martin, and Meilke (1989) found, using stochastic dominance rules to assess out-of-sample trading results, that, on average, the German mark cross-hedge strategy was much cheaper than the traditional forward market hedge. Kroner and Sultan (1993) confirm that currency hedging can significantly improve portfolio returns and that more optimum hedge ratios can be estimated 3 In its simplest form cross hedging entails the use of a futures contract in only one commodity or instrument; multiple cross hedging involves the use of futures contracts in more than one commodity.…”

“…As in Braga et al (1989), each alternative differs in its payoff. If the first strategy is chosen, the payoff for this unhedged strategy in U.S. dollars per FC is…”

“…In addition, to estimate the effects of any instability in cross-hedge ratios on hedging performance, the first-period estimated hedge ratios are used in the second subperiod to evaluate the out-of-sample cross-hedging effectiveness of currency futures and options. The out-of-sample hedging effectiveness in the test period is expected to be significantly lower than the in-sample hedging performance in the estimation period or the entire study period [e.g., Lypny (1988); Braga et al (1989)].…”

Out of sample effectiveness of a joint commodity and currency hedge: The case of soybean meal in Italy

“…The problem of offshore commodity hedging has been recently analyzed, among others, by Thompson and Bond, and Sheales and Tomek for the case of Australian wheat exports, and Braga and Martin for the case of the EC variable import levy. The problem of cross-hedging the US$/Italian lira exchange rate using the International Monetary Market Deutsche mark futures is analyzed by Braga, Martin, and Meilke (1989), who proved its feasibility and effectiveness for a short lira hedge.5 More general techniques for the estimation of the optimal hedge ratio have been proposed, among others, by Myers and Thompson (1987), Myers (1988), Herbst, Kare, and Caples (1989). Although these approaches constitute interesting suggestions for further empirical work, it may be argued that the complexity of these models represents a substantial barrier to their empirical application, in particular if the target market is rather unsophisticated, as is the 'Practically speaking, an extremely risk averse hedger may not want to consider a speculative position.…”

“…Following Braga, Martin, and Meilke (1989), the IMM Deutsche mark futures are used to hedge the exchange rate risk; eq. (4) may then be written as (4'):…”