Dynamic hedging with non-martingale futures prices and time-varying volatilities

Conventional hedging theory fails to take into account a number of stylized facts about exchange rate dynamics, most importantly the time-varying nature of volatility and the cointegration between spot and futures prices. In an effort to address this, recent studies have re-examined the hedging problem using both error correction models and GARCH error structures. These studies, however, rely on the questionable assumption of martingale futures prices. This implies that a strategy of holding futures contracts should never produce a non-zero expected profit, since the expectation of any subsequent futures price will always equal today's futures price. This paper derives a hedging model which does not impose this assumption, and uses out-of-sample testing to assess its performance relative to both the timevarying martingale model and other static models. Comparisons reveal that the martingale assumption is non-trivial, and that the hedge ratios derived under this assumption will differ greatly from those derived without it. Moreover, those derived without the martingale assumption can produce a higher expected utility for the hedger under certain circumstances.Business, Sauder School ofGraduat