Analysis on the Hedging Effectiveness of KIKO Currency Options

This article explores the hedging effectiveness of KIKO options by using the mean-variance analysis of Markowitz and by comparing three hedge measures such as Sharpe hedging effectiveness measure proposed by Howard and D’Antonio (1987), Fishburn (1977)’s measure, and Ederington (1979)’s. which calculates the degree to which the rate of return per unit of risk increases and total volatilty and down-side risk of hedged portfolio diminishes respectively. This paper differs from the previous researches in that this research first assumes that the firms hold the same value of dollar amount as that of short calls at each of settlement dates, and secondly this article performs multiple period of analysis instead of single period. This paper finds first that the hedging effectiveness of KIKO options is not better than that of currency forward contract in making a reduction of the total volatility and down-side risks of hedged portfolio. Secondly the hedge effectiveness is the highest at the first settlement date but it plunges when the time passes by, which is mainly due to the fact that the value of in-the-money put decreases, but that of out-of-the-money call increases as the time to maturity increases. Thirdly, it is found that another KIKO option with the equal premium shows even better hedging performance than the original KIKO in three aspects of hedging effectiveness. In conclusion, the KIKO turns out to be a lemon.