Evaluating hedging strategies in the foreign exchange market with the stochastic dominance approach

Abstract

This study uses stochastic dominance theory, which is distribution free, to evaluate eight foreign exchange hedging strategies for six currencies in terms of US Dollar from 1990 to 2007. Our results show that ‘always hedge’ is the best performing strategy for European currencies such as British Pound, Euro and Swiss Franc. However, the Forward Hedge Rule (hedging when forward rate is at a premium) generally outperforms the other seven strategies for currencies such as Canadian Dollar, Hong Kong Dollar and Japanese Yen. Our results can be a reference for decision makers to design their hedging strategies in the foreign exchange market.

Acknowledgements

This work was supported by the National Science Council, Taiwan, ROC. under Grant NSC 99-2410-H-035-025.

Notes

¹Swaps contracts can be considered as a portfolio of forward contracts.

² The premium is large if the absolute value of the forward premium is larger than previous 24-month moving average of the absolute value of forward premiums.

³ Following Morey and Simpson (2001) and Simpson (2004).

⁴ We also try other time periods such as 36-month moving average of the absolute value of the forward premium in this study. The results are similar and are not reported.

⁵ We also use the 36-month to construct the moving average in this study. The results are similar and are not reported.

⁶ The stochastic dominance rules given here are slightly modified from Levy and Kroll (1979), Levy and Lerman (1985) and Seyhun (1993). The reader interested in stochastic dominance theory should consult Levy and Kroll (1976, 1978), Kroll and Levy (1980), Levy (1992) and Post (2003).

⁷ That is, for every u in , and for every u in and , and for every u in .

⁸ In order to save space, only the results of BP are shown in Table 3.

⁹ EUR is only discussed in the sub-period of 2000s because it was created in 2002.

¹⁰ EUR was discussed in the sub-period of 2000s.