Daily Exchange Rate Behaviour and Hedging of Currency Risk

Exchange rates typically exhibit time-varying patterns in both means and variances. The histograms of such series indicate heavy tails. In this paper we construct models which enable a decision-maker to analyze the implications of such time series patterns for currency risk management. Our approach is Bayesian where extensive use is made of Markov chain Monte Carlo methods. The e ects of several model characteristics (unit roots, GARCH, stochastic volatility, heavy tailed disturbance densities) are investigated in relation to the hedging decision strategies. Consequently, we can make a distinction between statistical relevance of model speci cations, and the economic consequences from a risk management point of view. The empirical results suggest that econometric modelling of heavy tails and time-varying means and variances pays o compared to a eÆcient markets model. The di erent ways to measure persistence and changing volatilities appear to strongly in uence the hedging decision the investor faces. JEL classi cation: C11, C15, C44, E47, G15