Based On The Exchange Rate Spot - Futures Non-jump Dynamic Hedging

Recent statistical studies on the statistical characterization for a wide variety of asset returns show that the series of returns are not continues. A sudden movement happens when the extreme news arrives. Although the likelihood of jumps is small, it can't be ignored because its relatively large size and volatility. The research shows that a jump process provides a good statistical characterization for a wide variety of asset returns. Various jump models have been successfully applied to exchange rates. Taking into account the existing of some jump in foreign exchange returns, which makes the basis of foreign exchange hedging strategy of a great change take place, changed the dynamic optimal hedge ratio.This research focuses on two aspects. First, we develop a bivariate jump and bivariate GARCH model to investigate the common jumps and independent jumps in the currency spot rate and futures basis to enrich our understanding of price movements in foreign exchange markets. Second, a dynamic hedging strategy in the presence of jumps divided into common and independent part is proposed in the context of managing currency risk.Using four foreign currencies ten years of daily data, we find independent jump part plays as important roles as common ones in the currency spot rate and futures basis, and the jump dynamics are very important in understanding the comovement between the two return series. Our out-of-sample hedging exercises show the CBP-GARCH model reduces currency portfolio variance significantly and is most efficient in managing currency risk compared to the conventional hedge, the plain GARCH hedge, and the ARJI-GARCH hedge. These results are robust to transaction costs and to total utility improvement as hedging effectiveness measure. In general, these independent and common jumps are very important for optimal hedging strategy in the foreign exchange markets.