Optimal dynamic hedging portfolios and the currency composition of external debt

We present a model which shows that the currency composition of a country's external debt can serve as a hedging instrument against changes in exchange rates and commodity prices. Because our model permits the second moments to change through time, we get a sequence of optimal dynamic hedging portfolios which can be estimated with a multivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model. To illustrate the usefulness of the technique we apply it to Indonesia and it is found, as expected, that Indonesia's optimal debt portfolio consists of a much larger proportion of US dollars and a much smaller proportion of Japanese yen than they have in their current debt portoflio.