the hedging performance of ecu futures contracts

The Hedging Performance of ECU Futures Contracts

Anthony Saunders Stanley Sienkiewicz

his paper analyzes the hedging performance of the newly created ECU T futures market as a hedging tool for both the ECU and its constituent currencies. While we find that the ECU futures market provides an effective own- and cross-hedge, its relative lack of success appears to be a puzzle until one considers an alternative hedging strategy. Specifically, this article shows that a strategy based upon a portfolio consisting of pound and mark futures closely replicates the hedging effectiveness of ECU futures contracts. There- fore, it appears that many holders of ECU denominated cash positions and/or other European currencies, such as banks, are aware of this alternative strategy and may be reluctant to use the new (less liquid) market.

I. INTRODUCTION

Since its inception in 1979, the European Currency Unit (ECU) has grown to become a currency of major importance in both foreign trade and capital account transactions (see Lomax (1987)). There are two major reasons for this. First, as a composite Euro-currency, the ECU is not subject to the same direct control many European countries place on transactions in their own currencies (e.g., France and Italy). Second, it has reduced foreign exchange risk among European currencies, i.e., the ECU appreciates less than the strongest and depreciates less than the weakest vis-d-vis “outside” currencies such as the dollar and the yen. In other words, the ECU as a currency portfolio allows important opportunities for foreign exchange risk reduction among holders of European currency portfolios.

Nevertheless, while the ECU does provide some risk diversification/risk reduction benefits for European currency holders, a residual risk of currency fluctuations, particularly against non-EEC currencies such as the dollar and

The views expressed here are solely those of the authors and do not necessarily represent the views of the

The authors would like to thank two anonymous referees of this journal for helpful comments on an

Professor Saunders would like to acknowledge a summer support grant from FINEX and the Salomon

Federal Reserve Bank of Philadelphia, the Federal Reserve System, or of FINEX.

earlier draft.

Brothers Center for the study of Financial Institutions, GBA-NYU.

Anthony Saunders is a Professor of Finance at New York University and an advisor to the Federal Reserve Bank of Philadelphia. Stanley Sienkiewicz is a Research Support Analyst at the Federal Reserve Bank of Philadelphia.

The Journal of Futures Markets, Vol. 8, No. 3, 335-352 (1988) 0 1988 by John Wiley & Sons, Inc. CCC 0270- 73 14/88/030335- 18%04.00

yen, still remains. On January 7, 1986 the Financial Instrument Exchange (FINEX), a division of the New York Cotton Exchange (NYCE), introduced a futures contract on the ECU (equal to 100,000 ECUs) quoted in U.S. cents. This was followed soon after, January 15, 1987, by the IMM (a division at the CME) listing its own ECU futures contract. So far the FINEX contract has been trading for more than a year with limited success, measured in terms of contract volume. For example, between 1/7/86 and 3/20/87 the largest contract volume was 2,389 (on 12/4/86). While the CME contract has been a relative failure with volume falling to an average of only 4 contracts a day by April 1986 (see Hirschfeld (1987)).

In this article reasons for the relative lack of success of the ECU futures contract are examined. In particular, has the relatively low trading volume been due to poor hedging effectiveness of the ECU contract or, alternatively, has the existence of relatively deep futures markets in individual ECU currencies such as the British pound and the German mark allowed sufficiently effi- cient cross-hedging so as to render the ECU futures contract largely redun- dant?' Section I1 provides a brief overview of the ECU and its role in international finance. Section I11 presents a proposed methodology and data. Section IV examines the hedging effectiveness of the ECU contract. In Section V the cross-hedging effectiveness of existing currency futures contracts is examined. Section VI is a summary and conclusion.

II. OVERVIEW OF THE ECU AND ITS ROLE IN INTERNATIONAL FINANCE

The ECU is a composite currency defined as a weighted sum of (a fixed amount of) currency units of the first ten member countries of the European Economic Community (EEC).* On 3/20/87 the percentage (ECU) weights for the ten member currencies, in order of importance, were as follows: German mark (34.6%), French franc (19.0%), British pound (12.4%), Dutch guilder

'Although it is not the objective of this paper to examine directly why the FINEX ECU contract has been relatively more successful over the CME/IMM ECU contract, there are a number of contract characteristics that may have made the FINEX contract more attractive to potential participants. The first is that contract size on FINEX is smaller, 100,000 ECU vs. 125,000 ECU and the second is that FINEX trades a little longer (10 minutes) than the IMM. However, Hirschfeld (1987) argues that:

"The more significant difference between IMM and FINEX ECU contracts is their provisions for delivery when a contract expires. Both stop trading effectively on the third Monday of the contract month. How- ever, the IMM has ECU being delivered on Wednesday, whereas the FINEX has them delivered on Thursday. The IMM employs the same delivery procedure, involving Continental Illinois Bank and Trust, as it does for its existing currency futures contracts. FINEX uses one of the MESA (European clearing banks) to effect delivery. Although the IMM's ECU delivery system is closer to that for existing currencies, it is not quite consistent with established cash ECU delivery procedures. The FINEX system also provides greater flexibility to longs and shorts to meet their delivery obligations and greater assur- ance that delivery will be effected in accordance with FINEX regulations."

That is, since the cash market is predominantly in Europe (See Section 11) delivery through one of the European market makers may be deemed more desirable to participants.

*At present there are twelve members of the EEC: Belgium, Denmark, France, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, West Germany, and the United Kingdom. Portugal and Spain are not part of the ECU.

3361 SAUNDERS AND SIENKIEWICZ

(10.9%), Italian lira (9.5%), Belgian franc (8.6%), Danish kroner (2.8%), Irish pound (1.19’0), Greek drachma (O.870), and Luxembourg franc (0.3%). As can be seen, a major weight is given to the German mark, whose importance is reinforced by the fact that all but two of these currencies-the British pound and the Greek drachma-have their currencies pegged to each other under the European Monetary System (EMS). This pegging restricts fluctuations for EMS member currencies to no more than 2V470 either side of a refer- ence rate, although the lira has been allowed a wider fluctuation range (6%) and realignments have averaged approximately one a year since 1979.

Currently the ECU plays both an official and private role in international finance. Specifically, the ECU is the official accounting unit of the EEC and is also used in transactions of the European Investment Bank. However, its role has not been confined to purely official use. In particular, the Bank for Inter- national Settlements (BIS) reports that the share of ECU denominated assets in total nondollar Euro-currency banking assets rose from less than 2% at the end of 1982 to over 9% by the first quarter of 1986. This makes it the fifth most important Euro-currency market behind the dollar, mark, Swiss franc and yen. In addition, the daily turnover in spot and forward currency contracts in ECUs are estimated to exceed $13 billion a day (see Lomax (1987) and Glick (1987)), with a considerable demand for its use arising from commercial firms who use the ECU in trade contracts, export credits and invoicing.

A major reason underlying the growth of the ECU banking market has been extensive borrowing by nonbank residents in Italy and France, while funds (deposits) have traditionally been of either Belgian, Luxembourg, or Dutch origin. This European dominance of the cash market is accentuated by the ECU clearing system. In the absence of an ECU central bank, a system of “Mutual ECU Settlement Accounts” or MESA is used. This clearing system is centered on seven European (MESA) clearing banks3 with whom the 600 or more offices of central and commercial banks trading in ECU’s are likely to have an account. Moreover, clearing settlement times and working days are all specified according to European specifications.

Finally, the ECU is now the third most used currency of denomination in the international bond markets, ahead of both the British pound and Japanese yen. In 1985 there were 127 ECU denominated issues in the Euro-bond market worth $7 billion.

So far U.S. customers’ use of ECU’s has been quite small although there is a small interbank market in ECU’s in New York and ECU denominated “Yankee” bonds are also traded. One reason for this might be that, for risk averse U.S. investors, the SDR (Special Drawing Rights) plays a better multi- currency spot exchange rate hedge than the ECU (see, Logan (1987)) while the opposite holds true for European investors. Indeed, support for this conten- tion comes from Masera (1987) who shows that for U.S. dollar investors the Markowitz determined risk minimizing currency portfolio-when short sales

’MESA is an informal organization of seven banks (Kredietbank, Brussels; Lloyds Bank, London; Kre- dietbank, Luxembourg; Credit Lyonnais, Paris; Banque Bruxelles Lambert, Brussels; Istituto Bancario San Paolo di Torino, Turin; and Societe Generale de Banque, Brussels). The responsibility of these banks is to Serve as a “Central bank” for cash ECU transactions by matching ECU supply’s and demand’s. They do this by bundling and/or unbundling ECU component currencies (see Hirschfeld (1987) p. 102).

ECU FUTURES /337

are excluded-comprises only SDRs with a zero weight for ECU’s. By con- trast for European investors such as the British, the German and the French the ECU enters with weights of 77%, 2470, and 98% respectively compared to 23%, 0’70, and 0% for the SDR.

Hence, the European nature of the cash market, even though it is quite di- verse (including many nonbank participants), may limit the attractiveness of using a U.S. based ECU futures market when imperfect substitutes already exist in the form of existing deep (European) currency futures markets (albeit in the U.S.) and European based ECU forward markets. This bias is only likely to be ameliorated if the ECU futures contract provides an extremely good direct hedge and dominates potential cross-hedging strategies. This hedging effectiveness of ECU futures is examined in Sections 111-V below.

III. METHODOLOGY AND DATA

To evaluate the hedging effectiveness of the ECU futures contract the standard Ederington (1979) methodology was used (in first difference form to re- duce problems of autocorrelation see: Grammatikos and Saunders (1983), Black (1986) and Working (1953)). That is, specify an OLS regression model:

AS, = a 4- pAF, i- e ,

where AS, is the change (daily, weekly, biweekly) in the spot currency price, AFt is the change in the futures price, a is an intercept term, with E(a) = 0, and 0, the slope coefficient, is the optimal number of futures contracts to sell (buy) per unit of the spot position to minimize the variance of the spot currency holders wealth, or the so-called hedge ratio. Finally, the estimated R 2 of this regression is a measure of hedging effectiveness of the futures contract vis- d-vis the spot currency position (i.e., a measure of the correlation between the spot and futures prices over time).

Data on ECU futures prices (nearby contract) were provided by the NYCE/ FINEX, while spot prices on the ECU and nine of the ten composite currencies (the Luxembourg franc is at par with the Belgian franc)5 vis-d-vis the U.S. dollar were provided by Data Resources Incorporated (DRI) based on Paris Foreign Exchange prices6 Because of a standard time difference of six hours

4Although these regressions could be run without an intercept, the convention in the literature is to in- clude an intercept with the implicit restriction that E ( a ) = 0. In all our regressions & was found to be insignificantly different from zero at the 5% level.

SLuxembourg is linked to Belgium in a monetary association, in accordance with a Luxembourg decree. (See IMF‘s Annual Report. various issues).

bThe FINEX contract is used instead of the IMM’s because of the longevity and greater contract volume of the former. DRI only provides a spot quote for the ECU on the Paris and London exchanges (i.e. no quotes for New York are provided). Paris mid-afternoon prices (8:20 a.m. New York time) are used instead of London closing prices (11:OO a.m. New York time) due to aforementioned timing problems (see McCormick (1979)). In order to ensure consistency across all spot rates, including the ECU, the same data set (Paris exchange) was used. Moreover, since spot markets are OTC markets and data services such as the DRI rarely provide more than one or two representative prices per day for each spot rate, the Paris data set provides the best match available to the opening rate on the FINEX.

3381 SAUNDERS A N D SIENKIEWICZ

between Paris and New York, the actual prices used in this study were the mid- afternoon spot prices on the Paris exchange (8 a.m. New York time) and the opening futures price on the ECU contract in New York (8:20 a.m. New York time). This procedure minimizes time synchroneity problems between the data sets.'

Table I, reports daily distribution statistics: mean, variance, skewness, kurtosis, and the Kolmogorov D statistic for changes in the relevant foreign exchange prices over the data period of the study 1/7/86-3/20/87. As can be seen, on average, European currencies were appreciating against the U.S. dollar over this time period.

However, while the average daily exchange rate change may be positive, Table I may mask the existence of potential day of the week effects in the foreign exchange market. Indeed, elsewhere McFarland, Pettit, and Sung (1982) have found the presence of a day of the week effect in the foreign exchange market. Such day of the week effects, if significant, are important be-

Table I DAILY DISTRIBUTION STATISTICS

1/1/86-3/20/81

Variableb Mean variance Skewness Kurtosis Kolmogorov D

ECUS ECUF BF/LF DK DU FF GR IR IT UK WG

0.000819 0.0008 16 0.000021 0.000113 0.000409 0.000103 0.000002 0.000721 5.7E-07 0.000530 0.000467

0.000067 0.000063 4.1E-08 1.2E-06 0.0000 13 1.7E-06 3.8E-09 0.0001 48

0.000116 O.ooOo17

3.4E-11

0.217 0.261 0.204 0.245 0.181

-0.093 0.093

-0.802 0.156

-0.201 0.186

3.742 4.100 3.664 3.864 3.802 4.710 6.644 10.028 3.722 3.782 3.806

0.0462 0.0411 0.0460 0.0368 0.0430 0.0421 0.0688" 0.0506 a

0.0393 0.0517 0.0391

aNon-normal at the 5% level. bECUS = ECU spot ECUF = ECU future

BF = Belgian franc DK = Danish kroner DU = Dutchguilder FF = French franc

GR = Greek drachma IR = Irish pound IT = Italian lira LF = Luxembourg franc

UK = British pound WG = West German mark

Dollars per foreign currency unit.

'Whenever the Paris and/or the New York exchanges were closed, that date was dropped from the sample.

ECU FUTURES /339

cause the optimal hedge, if instituted for example on a Monday, may be very different from the optimal hedge instituted on a Tuesday, etc. Moreover, hedging effectiveness over periods of similar length but starting and ending on different days of the week may differ. Table I1 illustrates a test following Dyl and Maberly (1986) that uses a standard t-ratio8 to test whether the mean daily change in any day of the week in our sample was significantly different from the mean daily change over all days of the week.

From Table 11, it can be seen that over our sample period B definite Friday effect appears to exist. For all currencies the mean daily change on a Friday is negative and is significant at the 5% level in 8 out of the 11 cases. Conse- quently, Section IV also considers hedging effectiveness and optimal hedge ratios over holding periods starting and ending on the same day of the week, e.g., Monday-Monday, Tuesday-Tuesday, etc.

IV. HEDGING EFFECTIVENESS OF THE ECU FUTURES CONTRACT

This section analyzes the hedging effectiveness of the ECU contract vis-d-vis spot ECU as well as for the ten major individual currencies of the ECU (Lux- embourg is equivalent to Belgium) to evaluate the ability of the ECU futures contract to provide a cross-hedge for individual ECU currencies. As has been widely noted in the literature (see, for example, Ederington, 1979) the hedging effectiveness of a futures contract will generally be a positive function of the length of the contract holding (hedging) period. Consequently, Tables 111-V compare hedging effectiveness over a one-day holding period horizon, a one- week holding period horizon and a two-week holding period horizon .9

(a) ECU Spot

The daily data show that for very short-hedges the hedging effectiveness ratio ( R 2 ) of ECU futures is .75, which increases to a range of .86 to .99 with a weekly horizon. The weakest hedging effectiveness is for Friday-to-Friday (.86), while the strongest is for Thursday-to-Thursday (.99). These figures are consistent with the view that the day of the week on which a hedge is instituted has a material effect on the ability of the investor in ECUs to protect himself against foreign exchange rate risk. As expected, hedging effectiveness of ECU futures is stronger for two-week hedging horizons, although, as with weekly hedges, effectiveness varies from a low of (.89) on Fridays to a high of (.99) on Thursdays.

(b) Individual Currencies of the ECU

Analyzing the cross-hedging effectiveness of the ECU is important since inves- torlholders of only two of the individual currencies of the ECU, the British

*t = [(Daily Mean - Sample Mean)]/[(Daily Standard Deviation/&)]. 9Three-week and four-week hedging horizons were also examined. Due to space limitations these results

are not included in the text. However, as expected, the three- and four-week horizons imply slightly higher hedging effectiveness than the two-week horizon for both the ECU futures and the cross-hedging portfolio. An F-test failed to reject the null hypothesis of no difference in the hedging effectiveness of the two (alter- nate) hedging strategies.

340/ SAUNDERS AND SIENKIEWICZ

pound and the German mark, have the potential to use a deep and liquid futures contract market in the “own” currency.1° From Tables 111-V, the ECU appears to provide quite a strong and effective cross-hedge. For the daily holding period all R 2s with the exception of the British pound are greater than .60. For the weekly and two-weekly holding periods the cross-hedging effectiveness is again strong and again exceeds .63 with the exception of the British pound. As with the direct hedge, cross-hedging effectiveness appears to be day of the week specific. Thus, for example, looking at a one-week horizon and currencies with no directly matching futures contract, it is found that the cross-hedge R 2 for the Belgian franc/Luxembourg franc varied between .88 and .97, for the Danish kroner .86 to .97, for the Dutch guilder .86 to .97, for the Greek drachma .69 to .92, for the Irish pound .64 to .82, and for the Italian lira .84 to .96.

These high R2s would seem to suggest that the ECU should be a highly successful futures contract and that the relatively low trading volume in these contracts remains a puzzle. However, as Black (1986) and others have noted, a relevant test as to whether a futures contract will be successful or not is to compare the new contract’s hedging effectiveness with the hedging effectiveness of a strategy based on existing futures contracts-which in this case could be viewed as a strategy based on using a portfolio of British pound futures and German mark futures for which relatively deep markets have existed for over 15 years. Since the German mark is the dominant component of the ECU and is the key currency in the EMS to which the Belgian franc/Luxembourg franc, Danish kroner, Dutch guilder, French franc, Irish pound, and Italian lira are linked; and since the British pound is an important component of the ECU, but remains outside the EMS, a portfolio of pound and mark futures contracts might provide quite an effective cross-hedge for both the ECU and its currency components. This intuition is reinforced by the fact that the daily currency correlation matrix among ECU component currencies shows that, over this sample period, changes in the British pound spot rate had the lowest correlation coefficient with other ECU currencies. Specifically this correlation varied from .53 to .58 while for the mark, the correlation (excluding that with the pound) varied between .82 and .99.

V. CROSS-HEDGING EFFECTIVENESS OF A PORTFOLIO OF BRITISH POUND AND GERMAN MARK FUTURES RELATIVE TO ECU FUTURES

Table VI reports the daily cross-hedging results with a portfolio of pound and mark futures contracts and Table VII the weekly holding period results (two- week horizon results are not presented here for reasons of space). While the daily direct and cross-hedge R 2s with ECU are slightly above those for a portfolio of pound and mark futures-which often entails holding a short position in marks and a long position in pounds-for weekly hedging horizons there is

‘OWhile a futures contract does exist for the French franc, the market is very thin and in recent years trading has been negligible.

ECU FUTURES /341

Tab

le II

TEST

FO

R DAY O

F TH

E W

EEK

EFF

ECT

Mon

'h

e

Wed

Th

U Fr

i Sm

pl

N =

56

N =

61

N=60

N =

57

N=290

N =

56

ECUS

2 U t

ECUF

2 t

BF/

LF

2 U t

DK

x t U -

U

-

DU

x U t

0.002197

0.010356

1 .00

0.001498

0.009861

0.52

O.ooOo58

0.000248

1.11

0.000309

0.00 1340

1.09

0.000989

0.004643

0.93

0.001009

0.008529

0.17

0.001039

0 .OO832 1

0.21

0.m20

0.000211

0.000100

0.001160

-0.03

-0.08

0.000394

0.003895

-0.03

0.001182

0.006832

0.41

0.001145

0.007339

0.35

O.ooOo28

0.000176

0.70

0.000171

0.000955

0.47

0.000565

0.003207

0.37

0.001370

0.006899

0.60

0.000926

0.006430

0.13

O.ooOo37

0.000171

-2.30"

0.000174

0.000957

0.04

0.000748

0.003117

0.81

- 0.001659

0.007903

-2.37"

-0.000545

0.00768 1

- 1.3

4

-3.7E-05

0.000190

-2.30"

-0.000187

0.001053

-2.15"

-0.000640

0.003567

-2.22"

0.000819

0.008238

0.000816

0.007979

o.ooo021

0.000202

0.000113

0.001106

0.000409

0.003738

FF

GR

IR

IT

UK

WG

-

X

U t X

U - t X

U t -

-

X

U t X

U t -

-

X

U t

0.00

0275

0.

0017

52

0.73

9.3E

-06

0.00

0067

0.

82

0.00

2367

0.

01 77

68

0.69

1.7E

-06

7.4E

-06

1.14

0.00

0108

0.

0123

14

-0.2

6

0.00

1194

0.

0053

24

1.02

0.00

01 19

0.

0012

68

0.09

-2.1

E-0

6 0.

0000

72

-0.4

4

0.00

1 205

0.

0117

23

0.32

6.3E

-07

6.O

E-06

0.

08

0.00

2587

0.

0117

57

1.37

0.00

0464

0.

0043

56

-0.0

1

0.00

0 143

0.

001 1

24

0.28

1.8E

-06

0.00

0049

-0

.03

0.00

1138

0.

0099

06

0.33

6.8E

-07

5.O

E-06

0.

17

0.00

1632

0.

0095

17

0.90

0.00

0576

0.

0035

71

0.24

0.00

02 10

0.

0011

05

0.72

0.00

0009

0.

0000

49

1.07

0.00

1043

0.

0089

89

0.27

8.3E

-07

5.O

E-06

0.

40

- 0.0

0018

6 0.

0088

03

-0.6

1

0.00

0847

0.

0035

40

0.80

-0.0

0022

8 0.

0011

95

-2.0

9"

- 6.

1E-0

6 0.

0000

68

-0.9

0

-0.0

0217

1 0.

0107

69

-2.0

3"

-9.7

E-0

7 5.

6E-0

6 -2

.08"

-0.0

0171

1 0.

0109

01

-1.5

5

-0.0

0073

3 0.

0040

3 1

-2.2

5"

0.00

0103

0.

0013

10

0.00

0002

O

.ooO

o62

0.00

0721

0.

0121

98

5.7E

-07

5.9E

-06

0.00

0530

0.

0107

75

0.00

0467

0 .

OO

4229

aSig

nific

ant a

t 5%

leve

l. t =

[(D

aily

Mea

n - S

ampl

e M

ean)

]/[D

aily

a/&]

Table III ENTIRE SAMPLE DAILY HOLDING PERIOD

1/77/86-3/20/87

BECUF RZ DW

ECUS 0.89389 0.7496 2.30" BF/LF 0.02177 0.7296 2.26" DK 0.1 1 798 0.7205 2.26" DU 0.40204 0.7372 2.28" FF 0.13577 0.6956 2.19" GR 0.00560 0.6085 2.24" IR 1.19648 0.6002 2.06" IT 0.00063 0.7253 2.25a UK 0.73923 0.3099 2.02" WG 0.45676 0.7417 2.27" aCorrected for serial correlation.

Table N ONE-WEEK HOLDING PERIOD: MONDAYS

BECUF RZ

ECUS BF/LF DK DU FF GR IR IT UK WG

1.01534 0.02464 0.13441 0.45522 0.1643 15 0.006763 1.30739 0.00072 0.80875 0.52056

0.9755 0.9632 0.9563 0.9600 0.9258 0.9236 0.8157 0.9414 0.4005 0.9590

DW

2.52" 2.29" 2.20" 2.18" 2.08" 2.00" 2.10 2.18 1.86 2.21"

ONE-WEEK HOLDING PERIOD: TUESDAYS

BECUF RZ DW


1.02261 0.02522 0.13640 0.46556 0.16074 0.00653 1.38008 0.000722 0.77713 0.52871

0.9732 0.9439 0.9464 0,9505 0.8903 0.91 12 0.7435 0,9240 0.3566 0.9599

2.16a 2.13a 1.92" 2.03" 2.19 2.05 2.13 1.97" 1.95 1.99"


Table IV-Continued

ONE-WEEK HOLDING PERIOD: WEDNESDAYS

ECUS 0.91218 0.9032 2.29" BF/LF 0.022857 0.8770 2.19" DK 0.12154 0.8575 2.14" DU 0.42106 0.8843 2.18" FF 0.12843 0.8038 2.44 GR 0.00590 0.8520 2.18 IR 1.11497 0.6373 2.09 IT 0.000618 0.8582 2.01" UK 0.688 15 0.3175 1.89 WG 0.47753 0.8798 2.17"

ONE-WEEK HOLDING PERIOD: THURSDAYS

BECUF R2 DW


0.99490 0.024960 0.13368 0.44990 0.14755 0.00620 1.24803 0.00068 0.81814 0.51192

0.9886 0.9664 0.9711 0.9731 0.9414 0.9199 0.7672 0.9633 0.4018 0.9754

2.08" 2.04" 2.07" 2.32 2.02 1.97 1.99 2.31 1.92 2.39

ONE-WEEK HOLDING PERIOD: FRIDAYS

BECUF R2


0.91656 0.02315 0.12580 0.420063 0.132130 0.00597 1.22302 0.000627 0.67866 0.479994

0.8628 0.8666 0.8628 0.8573 0.7879 0.6915 0.7083 0.8362 0.4499 0.8636

DW

2.18" 2.13" 2.16" 2.12" 2.06" 2.24" 1 .90" 2.12" 1.92" 2.13"

"Corrected for serial correlation.

ECU FUTURES /345

Table V TWO-WEEK HOLDING PERIOD: MONDAYS

BECUF RZ DW


1.01582 0.02474 0.13448 0.45792 0.16671 0.00682 1.34925 0.00072 0.86884 0.52241

0.9817 0.9719 0.9638 0.9677 0.9399 0.9468 0.8586 0.9494 0.5456 0.9671

2.28 1.87 1.71 1.65 1.89" 1.85" 1.76" 1.78" 1 .48" 1.70

TWO-WEEK HOLDING PERIOD: TUESDAYS

BECUF R2 DW

ECU S BF/LF DK DU FF GR IR IT UK WG

1.01844 0.025066 0.13635 0.461731 0.16181 0.00658 1.38847 0.00072 0.78341 0.52619

0.9809 0.9609 0.9652 0.9672 0.9225 0.9406 0.8153 0.9498 0.5979 0.9743

1.66 1.85" 1.75" 1.82" 1.60" 1.71" 1.67" 1.68" 1.51" 1.77"

TWO-WEEK HOLDING PERIOD: WEDNESDAYS


0.92773 0.02360 0.12463 0.43283 0.13276 0,00606 1,19061 0.00062 0.71847 0.49032

0.9441 0.9201 0.9142 0.9304 0.8829 0.9221 0.7752 0.9190 0.6500 0.9270

1.93 1.75 1.64 1.72 1.81" 1.70" 1.68" 1.77" 1.71" 1.69


Table V-Continued

TWO-WEEK HOLDING PERIOD: THURSDAYS

~ECUF R2 DW


0.994056 0.02486 0.133693 0.44822 0.14472 0.00638 1.28020 0.00067 0.86636 0.51131

0.9920 0.9752 0.9794 0.9826 0.9591 0.9465 0.8337 0.9796 0.6101 0.9850

1.81" 1.75" 1.85" 1.75" 1.66" 1.84" 1.64" 1.91 a

1.61" 1.18"

TWO-WEEK HOLDING PERIOD: FRDAYS

BECUF R2 DW


0.94021 0.02392 0.12827 0.43722 0.13590 0.0061 8 1.23168 0.000641 0.69470 0.49703

0.8947 0.8986 0.8981 0.8932 0.8423 0.7575 0.7102 0.8731 0.5608 0.8957

1.71 1.62 1.70 1.60 1.75" 1.80 1.52" 1.80" 1.49" 1.60

"Corrected for serial correlation.

Table VI ENTIRE SAMPLE (DAILY) PORTFOLIO OF POUND AND

MARK FUTURES CONTRACTS

ECUS 0.03688 1.6819 0.6908 2.09" BF/LF -0.00097 0.04419 0.6885 2.09" DK - 0.00367 0.23708 0.6783 2.08" DU - 0.01 733 0.81317 0.6897 2.10" GR -0.00034 0.01115 0.4751 2.54" IR 0.06748 2.21396 0.5440 2.02" IT -0.00003 0.00 128 0.6827 2.10" "Corrected for serial correlation.

ECU FUTURES /347

Table VII

FUTURE PORTFOLIO POUND AND MARK ONE-WEEK HOLDING PERIOD: MONDAYS

BDM

ECUS 0.09299 BF/LF 0.00065 DK 0.00543 DU 0.00412 GR 0.00031 IR 0.15907 IT - 0.000001

1.8686 0.04768 0.25827 0.89442

2.3365 0.00144

o .a1294

0.9835 0.9818 0.9742 0.9833 0.9445 0.8094 0.9648

DW

2.03" 2.14" 2.07" 2.09" 2.06 2.00 1.77

-

ONE-WEEK HOLDING PERIOD: TUESDAYS FUTURE PORTFOLIO POUND AND MARK

B€ BDM RZ DW

ECUS 0.07086 1.85779 0.9745 2.08" BF/LF -0.oooo2 0.04879 0.9730 2.06" DK - 0.001 17 0.26256 0.9621 2.34 DU -0.00469 0.91011 0.9802 2.12" GR 0.00034 0.01160 0.8955 2.14" IR 0.06958 2.50329 0.7553 1.94 IT -0.00002 0.00140 0.9399 2.22

ONE-WEEK HOLDING PERIOD: WEDNESDAYS FUTURE PORTFOLIO POUND AND MARK

ECUS 0.09603 1.58574 0.8955 2.20" BF/LF 0.00060 0.04277 0.8866 2.22" DK 0.00524 0.2241 6 0.8587 2.10" DU 0.00786 0.80031 0.8985 2.27" GR 0.00042 0.01032 0.8359 2.04 IR 0.21185 1.7481 0.6238 2.05 IT 0.0oO001 0.00116 0.8581 1-95"

ONE-WEEK HOLDING PERIOD: THURSDAYS FUTURE PORTFOLIO POUND AND MARK

ECUS 0.10546 1.7327 0.9850 1.96" BF/LF 0.00068 0.04684 0.9717 2.19" DK 0.00540 0.24728 0.9734 2.05" DU 0.01144 0.85165 0.9825 2.21" GR o.Ooo40 0.01128 0.9173 1.75 IR 0.20946 2.0947 0.7829 1.79 IT 0.000007 0.00128 0.9571 2.00

348/ SAUNDERS AND SIENKIEWICZ

Table VII-Continued

ONE-WEEK HOLDING PERIOD: FRIDAYS FUTURE PORTFOLIO POUND AND MARK

B f DM RZ DW

ECUS 0.06740 1.7273 0.8645

DK 0.002 10 0.24760 0.8734 DU -0.00133 0.84906 0.8722 GR 0.00047 0.01106 0.6783 IR 0.15052 2.1363 0.6853 IT - 0.00002 0.00127 0.8364

aCorrected for serial correlation.

BF/LF 0.00045 0.04570 0 . ~ 2 3 2.22" 2.24" 2.26" 2.23" 2.24" 1.81 2.14" -

little discernible difference between the two strategies. Indeed using an F-test suggested by Black (1986):

Residual Risk of Pound and Mark Futures Portfolio - (1 - R 2)port F = - Residual Risk of ECU Futures (1 - R2)ecu *

Table VIII shows that in no case is it possible to reject the null hypothesis Ho : (1 - R 2)port = (1 - R 2)ecu or similarly Hi: R gort = R f,, . Since there is very little statistical difference in hedging effectiveness, holders of a cash position in European currencies and ECUs may well prefer to use the deeper and more liquid futures markets in pounds and marks rather than turning to a new futures market such as ECUs.

Indeed, Black (1986) mentions the liquidity (or daily volume of trading) in alternative markets for (cross-hedging) along with the underlying variability in the cash market price as two important determinants of contract success in addition to own- and cross-hedging effectiveness as already discussed above.

With respect to liquidity, the average daily volume of trading in German mark futures and British pound futures were 23,071 and 9,009, respectively, compared to 282 for the FINEX ECU contract over our sample period. This suggests that existing foreign currency futures contracts have a very large "liquidity" advantage over the ECU. The importance of the second (other) fac- tor, cash market volatility, can be seen by examining Table 11. As can be seen, the standard deviation (8) of spot ECU's was considerably larger than that for spot German marks (.008238 vs. .004229) but it was lower than that for the pound (.008238 vs. .010775). This implies that the cash market has sufficient volatility, especially vis-d-vis the mark, to encourage a demand for hedging.

VI. SUMMARY AND CONCLUSION

This paper has shown that the new ECU futures contract provides an effective own- and cross-hedge for ECU constituent currencies. As a result, its relative lack of success appears to be a puzzle until one considers the next best (exist-

ECU FUTURES 1349

Table VIII ONE-WEEK HOLDING PERIOD:

Monday

ECUS 0.9755 0.9835 0.0245 0.0165 0.67 BF/LF 0.9632 0.9818 0.0368 0.0182 0.49 DK 0.9563 0.9742 0.0437 0.0258 0.59 DU 0.9600 0.9833 0.0400 0.0167 0.41 GR 0.9236 0.9445 0.0764 0.0555 0.72 IR 0.8157 0.8094 0.1843 0.1906 1.03 IT 0.9414 0.9648 0.0586 0.0352 0.60

Ricu R X R T (1 - RZ)ECU (1 - R')PORT F

ECUS 0.9732 BF/LF 0.9439 DK 0.9464 DU 0.9505 GR 0.9112 IR 0.7435 IT 0.9240

R h R T

0.9745 0.9730 0.9621 0.9802 0.8955 0.7553 0.9399

0.0268 0.0255 0.95 0.0561 0.0270 0.48 0.0536 0.0379 0.70 0.0495 0.0198 0.40 0.0888 0.1045 1.17 0.2565 0.2447 0.95 0.0760 0.0601 0.79

~~~~~ ~~ ~

Wednesday


Thursday


R i C U gORT (1 - R')ECU (1 - WPORT F

R t U R h t T (1 - R')ECU (1 - R')PORT F


Table MII-Continned

RLU ECUS 0.8628 BF/LF 0.8666 DK 0.8628 DU 0.8573 GR 0.6915 IR 0.7083 IT 0.8362

F

0.8645 0.8723 0.8734 0.8722 0.6783 0.6853 0.8364

0.1372 0.1355 0.1334 0.1277 0.1372 0.1266 0.1427 0.1278 0.3085 0.3217 0.2917 0.3147 0.1638 0.1636

0.98 0.95 0.92 0.89 1.04 1.08 0.99

ing) hedging strategy. Specifically, this paper has shown that a strategy of go- ing short in mark futures and long (or short) in pound futures (often) closely replicates the hedging effectiveness of ECU futures contracts. Consequently, it appears that many investors/holders of ECU denominated cash positions and/or of other European currencies, such as banks, are aware of this alternative strategy and are reluctant to use the new market. Moreover, this reluc- tance is probably reinforced by the greater liquidity of the mark and pound futures contracts (measured in terms of contract volume).

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Evidence,” Monograph Series in Finance and Economics. Dewes (1987): “The Mechanics of the Short-Term Interbank ECU Market,” in

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Hirschfeld, D. 3. (1987): “Development of ECU Futures Markets: An Institutional Perspective” in Levich, R. and A. Sommariva (eds.), The ECU Market, pp.

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ECU FUTURES /351

Logan, K. (1987): “Discussion” in Levich, R. and A. Sommariva (eds.), The ECU Markets, pp. 29-32.

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McFarland, J., Pettit, R., and Sung, S. (1982, June): “The Distribution of Foreign Exchange Price Changes: Trading Day Effects and Risk Measurement,” The Jour- nal of Finance, 37:693-717.

Masera, R. S. (1987): “An Increasing Role for the ECU: A Character in Search of a Script” in Levich, R. and A. Sommariva (eds.), The ECU Market, pp. 33-67.

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the hedging performance of ecu futures contracts

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