The optimal derivative instrument for a New Zealand exporter in hedging transaction exposure to currency risk : the hedging effectiveness approach

Abstract

The survey on derivatives usage and financial risk management in New Zealand documents that the currency forward is the most widely used derivative in hedging transaction exposure, with the over-the-counter (OTC) option occupying a distant second spot. Does the forward contract perform better than the OTC option for a NZ exporter in hedging transaction exposure to currency risk? This research aims at scrutinizing this issue by adopting Hsin, Kuo and Lee's (1994) model of hedging effectiveness, defined as the difference of the certainty equivalent returns between the hedged and the unhedged spot position. The test is to evaluate the ex-ante hedging effectiveness provided by the forward markets and by the option markets in hedging transaction exposure to the NZD/USD and NZD/GBP.

For the purpose of comparison, the European OTC options, which are simulated using the simple Garman-Kohlhagen's (1983) options pricing model, are combined to construct the options synthetic forwards. The optimal hedge ratios for the forwards and synthetic forwards are determined by maximizing the exporter's expected negative exponential utility function. When longer estimation periods are used, the error correction model (ECM) is also employed to estimate the optimal hedge ratio as the dynamic hedge ratio is postulated to improve on the static hedge ratio.

Empirical results show that in a less volatile exchange rate environment, both derivatives are equally effective in hedging short term transaction exposure. In the event of impulsive exchange rate fluctuations, however, the options markets are more effective. Meanwhile, if the exporter's transaction exposures are on a long term basis, the exporter should always choose the forward markets. These findings are reasonably robust to the exporter's degree of risk aversion and to the length of the estimation periods. When longer estimation periods are employed, the exporter should adopt the simple static optimal hedge ratio rather than the complicated dynamic optimal hedge ratio in deciding which currency derivative is more effective.