Foreign Exchange Volatility Shifts and Futures Hedging: An ICSS-GARCH Approach

Iqbal Mansur (), Steven J. Cochran () and David Shaffer ()
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Iqbal Mansur: School of Business Administration, Widener University, Chester, PA 19013, USA
Steven J. Cochran: Department of Finance, Villanova School of Business, Villanova University, Villanova, PA 19085, USA
David Shaffer: Department of Finance, Villanova School of Business, Villanova University, Villanova, PA 19085, USA

Review of Pacific Basin Financial Markets and Policies (RPBFMP), 2007, vol. 10, issue 03, 349-388

Abstract: In this study, the impact of volatility regime shifts on volatility persistence and hedge ratio estimation is determined for four major currencies using an iterated cumulative sums of squares (ICSS)-GARCH model. Employing a standard GARCH (1,1) model as the benchmark, within-sample results demonstrate that the inclusion of volatility shifts substantially reduces volatility persistence and the significance of the ARCH and GARCH coefficients. In terms of hedging effectiveness, the ICSS-GARCH model outperforms the standard GARCH model for all four currencies. In comparison to two constant volatility models, the standard GARCH model yields the lowest performance, whereas the ICSS-GARCH model performs at least as well as these models. In out-of-sample analysis, the GARCH model provides substantial variance reductions relative to the constant volatility models. Moreover, the ICSS-GARCH model yields positive variance reductions relative to all competing models, including the standard GARCH model. The results suggest that in cases where dynamic hedging is important, sudden shifts in volatility should not be ignored.

Keywords: ICSS; GARCH; foreign exchange; dynamic hedging; JEL Classification: C32; JEL Classification: F31; JEL Classification: G13 (search for similar items in EconPapers)
JEL-codes: G1 G2 G3 (search for similar items in EconPapers)
Date: 2007
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Citations: View citations in EconPapers (3)

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DOI: 10.1142/S0219091507001112

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