Selectively Hedging the Currencies When the PPP Puzzle Meets the Forward Premium Anomaly

This study proposes a selective hedging strategy for managing foreign exchange risk which calls for hedging when a foreign currency is over-valued and the forward contract is trading at a premium but leaves the exposure uncovered otherwise. As empirical researches find that exchange rate deviations from the purchasing power parity (PPP) are self-correcting and exchange rates often move to the opposite directions as implied in forward rate premiums or discounts, the intuitions of the strategy are to avoid predictable depreciations of over-valued currencies and to capture the benefits of forward premiums. Based on daily data of eight free-floating currencies over the period 1986 to 2004, the strategy outperformed the un-hedged strategy in terms of higher realized single-period returns, lower return volatilities and improved risk-adjusted returns. Except for the US perspective, this strategy could realize 0.42 to 2.18 percent more value to long positions of three-month foreign exchange receivables. The strategy’s superior performance is also confirmed by the second order stochastic dominance analysis which finds 44 out of 56 dominance of the proposed strategy over un-hedged strategy. Both exchange rate corrections to PPP and forward premiums contribute to the success of this selective hedging strategy which has practical implication to international investors and corporations