Academic journal article Atlantic Economic Journal

Volatility Behavior of Exchange Rate Future Contracts

Academic journal article Atlantic Economic Journal

Volatility Behavior of Exchange Rate Future Contracts

Article excerpt

REZA SAIDI [*]

The increasing globalization of economies and the concurrent increase in the risk of currency exposure has stimulated the development of new instruments to allow both investors and traders to hedge their currency risk. The expansion of these derivatives, however, has raised some concerns. This paper studies the determinants of the dynamics of exchange rate future contracts as a means to identify the sources of such concerns. By using a mean-exponential generalized autoregressive conditional heteroskedasticity (M-EGARCH) model for five different future contract lengths and six developed economies, it is found that an MEGARCH(1,1) effectively describes the exchange rate futures' daily dynamic. Sign, size, and persistence effects on the volatility of future contracts are all significant, thus providing important information to both policy makers and market participants. (JEL F31)

Introduction

The globalization of financial markets in past years has increased the internationalization of portfolios and the interconnection of money markets across currencies. The corresponding increases in the risk of currency exposure have led the market to develop new instruments to hedge currency risk. Innovations such as exchange-traded options, future contracts, over-the-counter options, and currency swaps have been added to existing instruments such as forward exchange rate contracts. Though they are retail in nature, they are frequently used by dealers in over-the-counter markets to balance positions when credit lines with other financial institutions are filled or when wholesale counterparts are hard to find. While literature has been successful in determining the efficiency of the future market, few studies have looked at its influence on exchange rate sustainability, and no study is available on the determinants of exchange rate future dynamics.

The understanding of the dynamic behavior of exchange rate futures, such as globalization of portfolio and trade growth, is important to investors and traders as well as policy makers because of the effect that futures' contracts can have on exchange rate policy. International portfolio management obviously depends on the expected exchange rate movements, expectations that are captured in future contracts. Currency risk, understood as the exposure that an agent suffers due to possible fluctuations in the foreign currencies value, not only affects the allocation of investment and capital movement but also the exchange rate policy in place. A key element in determining this currency risk is the credibility of market participants on the strength of a given currency, that is, the conformity of the participant's expectations with exchange rate policy makers' announcements over time. If there is a lack of credibility in the market, the participants' risk of currency exposure, captured by the variance of the exchan ge rate future, will increase. An indication of whether credibility affects the variance and, thus, the risk and sustainability of the exchange rate over time is the sensitivity of markets' participants to innovations and the persistence of these innovations in the exchange rate futures. Such information can be captured in a mean-exponential generalized autoregressive conditional heteroskedasticity (M-EGARCH) model.

Exchange rate futures tend to accentuate exchange rates' value trends, and hedging operations can lead to large price changes. Consider these matters within the context of exchange rate management, especially regarding exchange rate crises such as those suffered by several countries of the European Union (EU) and the Association of South East Asian Nations (ASEAN). The sustainability of a given exchange rate also requires an understanding of exchange rate futures' dynamics by policy makers because dynamic hedging can overwhelm the credit lines available to the central bank for intervention. In addition, the specification of the volatility for daily future contracts is of interest because it indicates the effects of marginal interventions as well as those of external shocks on derivatives. …

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