A Study On The Optimal Hedge Ratio Based On Dynamic Copula-GARCH Models In Exchange Rate Risk Management

More and more economic subjects are exposed in the exchange rate risk in the background of economic globalization, especially after China’s entered into the WTO. Moreover, because of the reform of the marketization of exchange rate in China, the fluctuation of exchange rate in China becomes more volatile and its trend is harder to be predicted. In addition, the financial market in China is still in its early stage, so management of exchange rate risk in China is not well-rounded. In these backgrounds, the research of exchange risk management is very urgent and critical. Using financial derivatives to hedge exchange rate risk is a front managerial approach in the world. This thesis focuses on the core of hedging:determination of the optimal hedge ratio.This thesis tries to establish Copula-BGARCH model to estimate the optimal hedge ratio, based on Copula theory and GARCH theory. Noticing the prices of spot and futures can explain each other very well, this model adds both lagged price series as explaining variables in each mean equation of GARCH, which turns into BGARCH. Moreover, this model uses Copula function to simulate the dynamic correlation between the prices of spot and futures with BGARCH models as marginals, which overcomes the problem of assuming constant correlation between the prices of spot and futures in the literature.In the empirical analysis, as RMB currency futures market is not available in China, the thesis uses US dollar as the domestic currency, and the two major Asian-Pacific currencies-the Japanese Yen and Australian dollar as the foreign currencies. It employs different models including Copula-BGARCH to determine the optimal hedge ratio. The result shows Copula-BGARCH provides greater risk reduction than the strategies of naive, OLS, and BGARCH. In addition, GARCH performs better than OLS when a currency has greater volatility, and Copula shows its superiority when an emergency such as the financial crisis in2008causes radical changes to one currency’s exchange rates.