Exchange Rate Dynamics and Forex Hedging Strategies

Abstract

In the world of globalization, most business enterprises operate in more than one country, receiving foreign currency for exports and paying foreign currency for imports, and this exposes them to foreign exchange risk. Each entity and/or individual that has exposure to foreign exchange rate risk will have specific foreign exchange hedging needs; on the other hand, the effectiveness of different hedging techniques depends on the specific purposes they serve. The present study extends the analysis of Dash et al. (2008) in comparing the performance of four different Forex hedging strategies, approaching the problem from the point of view of exchange rate dynamics, using a model for exchange rate movements. Based on the results of the simulation of this model, the hedging strategies which yielded the highest returns and the lowest variability of returns were identified. The results of the study suggest that when cash inflows only are to be hedged, options hedging using out-of-the-money currency put options yields best results; when cash outflows only are to be hedged, options hedging using out-of-themoney currency call options yields best results, and when both cash inflows and outflows are to be hedged, options hedging using out-of-the-money currency put options for inflows and out-of-the-money currency call options for outflows yields best results. Finally, the results of the study show that it is always risky to remain unhedged against foreign exchange rate fluctuations. These strategies can be used by business enterprises that have significant exposure to foreign exchange rate volatility.