The term structure of currency hedge ratios

Olaf Korn and Philipp Koziol

No 09-01, CFR Working Papers from University of Cologne, Centre for Financial Research (CFR)

Abstract: Many firms face product price risk in foreign currency, uncertain costs in home currency and exchange rate risk. If prices and exchange rates in different countries interact, natural hedges of foreign exchange risk might result. If the effectiveness of such hedges depends on the hedge horizon, they might affect a firm's usage of foreign exchange derivatives and lead to a term structure of optimal hedge ratios. We analyze this issue by deriving the variance minimizing hedge position in currency forward contracts of an exporting firm that is exposed to different risks. In an empirical study, we quantify the term structure of hedge ratios for a ' typical ' German firm that is exporting either to the United States, the United Kingdom or Japan. Based on cointegrated vector autoregressive models of prices, interest rates and exchange rates, we show that the hedge ratio decreases substantially with the hedge horizon, reaching values of one half or less for a ten-years horizon. Our findings can (partly) explain the severe underhedging of long-term exchange rate exposures that is frequently observed and have important implications for the design of risk management strategies.

Keywords: corporate risk management; foreign exchange risk; hedging; cointegrated VAR model (search for similar items in EconPapers)
JEL-codes: F31 G32 (search for similar items in EconPapers)
Date: 2009
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Related works:
Journal Article: THE TERM STRUCTURE OF CURRENCY HEDGE RATIOS (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:cfrwps:0901

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