Time-Varying Optimal Currency Hedging and the Preference for Skewness
We derive an Optimal Hedge Ratio (OHR) under the mean-variance-skewness framework, where investors are allowed to have heterogeneous preference for skewness. Allowing heterogeneous preference for skewness changes the investors optimal hedging decisions. Using spot and futures exchange rate data, we estimate bivariate GARCH models allowing for skewness and excess kurtosis in the conditional bivariate distribution, and compare the new OHR with the standard mean-variance OHR. We find that (i) Skewness of futures returns influence hedging decisions. Investors with skewness preference seem to be choosing a hedge ratio in order to construct a mean-variance-skewness efficient portfolio, which may appear to be mean-variance inefficient. However, Japanese Yen and Euro investors obtain higher levels of positive skewness in their hedged portfolios without sacrificing mean-variance efficiency; (ii) The preference for skewness and risk-avert level of investors are positively correlated. Investors with higher risk-aversion level construct a hedged portfolio with higher level of positive skewness (lower level of negative skewness) in returns; (iii) The sign of futures returns are negatively correlated with hedging decisions of the mean-variance-skewness investors. When futures returns are positive (negative), investors with skewness preference tend to hedge less (more) than the mean-variance investors. In addition, the using of the bivariate asymmetry distributions improved the goodness-of-fit of the models.