OPTIMAL HEDGE RATIOS IN THE PRESENCE OF COMMON JUMPS

This study derives optimal hedge ratios with infrequent extreme news events modeled as common jumps in foreign currency spot and futures rates. A dynamic hedging strategy based on a bivariate GARCH model augmented with a common jump component is proposed to manage currency risk. We find significant common jump components in the British pound spot and futures rates. The out-of-sample hedging exercises show that optimal hedge ratios which incorporate information from common jump dynamics substantially reduce daily and weekly portfolio risk.