AN EMPIRICAL STUDY ON CROSS HEDGING THE MALAYSIAN RINGGIT USING COMMODITY FUTURES

Abstract

The concerns of hedging foreign exchange risks of minor currencies has become more apparent among traders and investors due to the recent developments in the volume and nature of third world trade and capital flows. New and alternative hedge instruments have been introduced to fill the vacuum and meet the ever increasing demands in this area. This study focuses on the problem and effectiveness of cross hedging the Malaysian Ringgit (a minor currency) using crude palm oil and rubber futures contracts which are the main export commodities of Malaysia. The primary export commodity hypothesis is presented as the basis of cross hedging in this study. A cross hedging model based on the mean variance framework is also presented and several cross hedging strategies are formulated and tested using this model. Hedge ratios and measures of hedging effectiveness for the single commodity hedge strategy and the two commodity (portfolio) hedge strategy are estimated in this study. To ascertain the credibility and accuracy of the results, a comparison with another similar study was also discussed. The comparison showed that for the single commodity hedge strategy, the estimates of the hedge strategy and hedging effectiveness is moderate and comparable. It also points to the non-rejection of the primary export commodity hypothesis. However for the portfolio strategy, the estimates are found to be relatively lower when compared to the other study. We also proposed an explanation for this observation that the commodities used in this study do not constitute a large proportion to world exports and to Malaysia's total export earnings compared to the commodities used in the other study. Finally, a proposed cross hedging model as a direction for future research work is presented. We believe that if this model is implemented better estimates of the hedge ratio and hedging effectiveness could be obtained and hence suggests the use of crude palm oil and rubber futures contracts as possible instruments for cross hedging foreign exchange risks of the Malaysian ringgit.