Hedging versus not hedging: strategies for managing foreign exchange transaction exposure

Abstract

This paper compares a number of strategies for managing foreign exchange exposures. The strategies are never hedging, hedging every exposure using a forward exchange contract, and hedging on selective occasions using a forward exchange contract. With regard to the selective hedging, the decision as to whether to hedge or not depends on the future spot exchange rate as determined by a number of forecasting techniques. The techniques include the random walk, the large premia model and a volatility model. The paper considers the USD vis a vis the AUD, SGD and JPY. The results are mixed and show that for the period 1992 to 2003 the Australian exporter is better off always hedging while the Singapore and Japanese exporters are better off never hedging. The various management strategies are compared using Sharpe’s model and the minimum variance model though it seems the results are not sensitive to use of either.Selective foreign exchange currency hedging; random walk; large premia model;