Spreading currency forwards: why and how?

In this paper we have adopted a continuous time framework in which a hedger has a currency risk-sensitive non-traded cash position. The hedger has the opportunity to hedge against risk by using two currency forward contracts that differ only in their maturities. The hedger is able to reach a perfect hedge of his non-traded position by using only two currency forward contra cts with different maturities even though four sources of uncertainty drive the international economy. This perfect hedge is reached by spreading forw ard contracts, where the hedger is short in the nearby contract and long in the deferred contract. This strategy is easy to implement since no paramet er has to be estimated empirically when the hedger is a price taker. Finall y, the analysis has been extended to currency futures contracts. We show in explicit terms how the marking-to-market of futures positions affects the spreading strategy. (C) 1999 Elsevier Science Ltd. All rights reserved.