Cross Hedging with Currency Forward Contracts

Abstract

This study examines the behavior of a competitive exporting firm that exports to a foreign country and faces multiple sources of exchange rate uncertainty. Although there are no hedging instruments between the home and foreign currencies, there is a third country that has well‐developed currency forward markets to which the firm has access. The firm's optimal cross‐hedging decision is shown to depend both on the degree of incompleteness of the currency forward markets in the third country, and on the correlation structure of the random spot exchange rates. Furthermore, the firm is shown to be more eager to produce and expand its exports to the foreign country when the missing currency forward contracts between the home and foreign currencies can be synthesized by the existing currency forward contracts. In this case of perfect cross hedging, the separation theorem holds but the full‐hedging theorem may or may not hold. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark

Ambiguity and the Value of Hedging

“…Since the seminal work of Holthausen (1979), there has been a large body of research on the production and hedging decisions of the competitive firm under price uncertaintyà la Sandmo (1971). Two notable results emanate from this literature (Broll, 1992;Broll & Wong, 1999;Broll & Zilcha, 1992;Danthine, 1978;Feder, Just, & Schmitz, 1980;Wong, 2004Wong, , 2012Wong, , 2013. First, the separation theorem states that the firm's optimal output level depends neither on the risk attitude of the firm, nor on the incidence of the underlying price uncertainty should the firm be able to trade its output forward.…”

Cross‐Hedging Ambiguous Exchange Rate Risk

“…The purpose of this paper is to provide theoretical insights into the decision making of an exporting firm that sells its output to two foreign countries, only one of which has futures and options available for its currency. To this end, we depart from the extant literature that is developed within the standard von Neumann–Morgenstern expected utility paradigm (Adam‐Müller, ; Broll & Zilcha, ; Chang & Wong, ; Viaene & Zilcha, ; Wong, , ). Taking into account the possibility that the firm cannot unambiguously assign a probability distribution that uniquely describes the exchange rate risk, we define uncertainty in the sense of Knight () to be made up of two components, risk and ambiguity.…”

Export and Hedging Decisions Under Correlated Revenue and Exchange Rate Risk

“…In this case, Adam‐Müller and Nolte () show that the prudent firm optimally opts for an under‐hedge, which is consistent with our findings. Wong () examines cross‐hedging when there are home, foreign, and third currencies. In the case of imperfect cross‐hedging when futures contracts between the foreign and third currencies are missing, Wong () shows that a full‐hedge is suboptimal even when the random spot exchange rates are independent.…”