A Stochastic Dominance Approach to Evaluating Foreign Exchange Hedging Strategies

William C. Hunter and Stephen G. Timme

Financial Management, 1992, vol. 21, issue 3

Abstract: We offer a new approach to evaluating foreign exchange hedging strategies. The approach is practical since it is couched in terms of business variables such as profits, rates of return, and revenues. It is also consistent with utility-maximizing behavior since it is based on standard stochastic dominance rules. By taking account of all points of the hedging strategies' outcome distributions, the approach avoids the problems associated with popular selection procedures such as the mean-variance criterion. These problems can occur, for example, when the hedging outcome distributions are nonnormal. A stylized example for hedging transaction exposure is presented to demonstrate how the stochastic dominance evaluation methodology is easily implemented, that it is theoretically sound, and not restrictive in terms of its underlying assumptions.

Date: 1992
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