Hedging Transaction Exposure within the Context of a Basket Foreign Exchange Rate Arrangement

In a basket managed foreign exchange rate arrangement, the volatility of the domestic money should exhibit a particular pattern: (1) it is reduced due to the diversification effect by linking the domestic money to a portfolio of currencies and frequent interventions of policymakers, (2) it reflects the variability of each component in the basket. Consequently, if there exists a significant foreign exchange exposure to hedge, this will be a multidimensional exposure. In a basket arrangement, two main relevant questions arise: to hedge or not to hedge? And if hedging is a worthwhile decision, what type of financial instrument should be used to offset the currency risk? Different hedging strategies are proposed and compared to the unhedged strategy. Reconstituted data on basket option hedging as a direct policy implication of the basket foreign exchange arrangement is also included and compared to the overall hedging strategies. Given the nonlinear payoff structure of some hedging strategies we implement a performance comparison based extensively on non parametric distribution free approaches—the difference in the Sharpe Ratios with statistical inference based on the studentized circular block bootstrap method and Stochastic Dominance approach. Daily data on the Tunisian Dinar exchange rate against two major currencies, the EUR and the USD, and on currency call options written by the Central Bank of Tunisia spanning the period from January 1999 to December 2005 is the basis of our empirical evidence. It is shown that the choice of the hedging instrument depends on the currency of denomination and the hedging horizon, and that the basket option is frequently ranked (in 88% of the cases) as the adequate strategy.