Oil and currency volatilities: Co‐movements and hedging opportunities

The current literature concentrates its attention to the interactions between oil and exchange rates, focusing only on the first moments. Extending this line of research, we investigate the time‐varying correlation between the volatilities of two oil benchmarks (Brent and WTI) and six currencies of the major oil‐importers and oil‐exporters, for the period from February 1, 1999 to May 30, 2016, using a Diag‐BEKK model. The optimal portfolio weights and hedge ratios for portfolios comprised of the aforementioned volatilities, are also examined. The analysis reveals that oil and currency volatilities exhibit positive correlations during major global or region‐specific economic events (such as the Global Financial Crisis of 2007–2009 and the EU debt crisis period). By contrast, country‐specific events yield heterogeneous time‐varying correlations between oil and the different currencies in our sample. Both the optimal portfolio weights and optimal hedge ratios estimations demonstrate a time‐varying behaviour, suggesting that continuous portfolio rebalancing is necessary for diversification purposes. The findings also show that risk reduction based on the optimal portfolio weight strategy is primarily beneficial for oil volatility investors, whereas currency volatility investors achieve better hedging using the optimal hedge ratio strategy.