Measuring Efficiency of South American Foreign Exchange Derivatives Market in Minimizing Currency Risk: A Lesson for Bangladesh

Abstract

This paper attempts to reveal whether the foreign exchange (FX)
derivatives market effectively and efficiently reduces the volatility to foreign
exchange rate fluctuations. Cross-country evidence suggests that development of the
FX derivatives market does not boost up spot exchange rate volatility and reduces
aggregate exposure to currency risk. Intraday evidence for Chile shows that activity
in the forward market has not been associated with higher volatility in the exchange
rate following the adoption of a floating exchange rate regime. We also find no
evidence that net positions of large participants in the FX derivatives market help to
predict the exchange rate. These findings support the view that development of the
FX derivatives market is valuable to reduce aggregate currency risk. Although in
Bangladesh, the use of currency derivatives to hedge foreign exchange risk is not
popular among the existing firms engaged in foreign exchange transactions, there
are a few firms such as ACI and General Motors with extensive foreign exchangerate
exposure and economies of scale in hedging activities, which are more likely to
use currency derivatives. This is because, given the potential shifts in the supply of
or demand for currency, firms and individuals who have assets denominated in
foreign currencies can be affected favorably or unfavorably. These firms may want
to alter their currency exposure in order to grab benefit or hedge risk from the
expected movements of exchange rates. This study provides a detailed analysis
along with a background on currency derivatives which are commonly used by some
of large firms existing in Bangladesh in order to capitalize on or hedge against
expected exchange rate exposures measured by these firms. In this paper, we have
also divulged an analytical framework for measuring exchange rate exposures
accelerating the use of currency derivatives in foreign exchange market of
Bangladesh.