The Effect of Structural Breaks and Long Memory on Currency Hedging

Empirical evidence suggests that unconditional variance of exchange rate return series is subject to occasional structural breaks that may induce spurious phenomenon of high persistence and long memory of volatility processes. In this paper, we investigate the effects of such breaks on estimated risk-minimizing hedge strategies (ratios) and their performance in currency markets. Using bivariate GARCH and fractionally integrated GARCH models, we estimate the hedge ratios for six foreign currencies in the full sample with and without controlling for breaks and each subsample of different unconditional variance regimes identified by a modified version of the Inclan and Tiao (1994) algorithm. Our findings suggest that daily currency risk can be better hedged with currency futures when controlling for unconditional variance breaks in the bivariate GARCH model