Hedging with mismatched currencies

✍ Scribed by Broll, Udo; Wong, Kit Pong

• Publisher: John Wiley and Sons
• Year: 1999
• Tongue: English
• Weight: 189 KB
• Volume: 19
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/(sici)1096-9934(199912)19:8<859::aid-fut1>3.0.co;2-a

✦ Synopsis

This article presents a model of a risk-averse multinational firm facing risk exposure to a foreign currency cash flow. Forward markets do not exist between the firm's own currency and the foreign currency, but do exist for a third currency. Because a triangular parity condition holds among these three currencies, the available forward markets, albeit incomplete, provide a useful avenue for the firm to indirectly hedge against its foreign exchange rate risk exposure. This article offers analytical insights into the optimal cross-hedging strategies of the firm. In particular, the results show that separate unbiasedness of the forward markets does not necessarily imply a perfect full hedge that eliminates the entire foreign exchange rate risk exposure of the firm. The optimal cross-hedging strategies depend largely on the firm's marginal utility function and on the correlation of the random spot exchange rates.