Is cross-hedging an optimal hedging strategy for commodity currencies?

Recent studies have revealed that commodity currencies provide currency risk premiums, attracting carry traders. However, currency risk premiums may disincentive financial and nonfinancial institutions from investing in countries with commodity currencies due to the negative expected returns of hedging with currency futures contracts. We investigate four different hedging strategies for managing exchange rate risk: full, partial, no and crosshedging. The cross-hedging strategy consists of using commodity futures contracts to hedge exchange rate risk. Our main findings based on nine commodity countries is that for many risk aversions cross-hedging is the optimal hedging strategy for exchange rate risk. INTRODUCTION High currency risk premiums provide opportunities for carry traders but threats to the underlying economy. The economy may suffer from decreased levels of investment because foreign equity investors may face a trade-off decision of either low returns due to hedged exposures or high risks due to unhedged exposures. Domestic corporations that wish to tap external debt markets may also face high total funding costs due to hedged foreign currency denominated debt or volatile debt obligations due to unhedged debt. Recent work by Ready et al. (2017) shows that commodity exporters typically have currencies with high risk premiums relative to the currencies of producer countries or countries where commodities do not comprise most exports. The authors develop a theoretical model that stems from the fact that “commodity currency consumption is relatively insulated from (global) productivity shocks: a relative decline in producer-country productivity reduces global output, but since the commodity country can shift local resources into producing the final good domestically, its consumption declines by less than that of the producer country”. “This difference in exposure also leads to a stronger precautionary motive for saving in the producer country so that, all else equal, the producer country has a lower interest rate”. Differences in interest rates do not translate into a depreciation of the currency of the commodity exporter. Rather, they will provide investors who borrow in the currencies of producer countries and invest in the commodity currency with positive average returns. In other words, carry trade where the basket currencies, or currencies with high interest rates, are commodity currencies and the funding currencies, or currencies with low interest rates, are producer currencies will provide a risk premium. The currency will earn a risk premium, as the commodity currency will tend to appreciate in “good” times and depreciate in “bad” times. Empirical work by the authors supports their theoretical findings. In commodity countries, there may be an alternative for financial and nonfinancial corporations that wish to hedge currency risk. Commodity exporters may have currencies that are significantly affected by changes in commodity prices through transmission channels, including the income effect of Dornbusch (1980) and the Balassa-Samuelson effect; see Balassa (1964) and Samuelson (1964). Both transmission channels are widely accepted by academia. In fact, empirical research such as Cashin et al. (2004), Kohlscheen (2010) and Coudert et al. (2015) provides further supporting evidence.