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Optimal currency hedging

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  • Albuquerque, Rui

Abstract

This paper characterizes optimal currency hedging in several models of downside risk. We consider, in turn, three models of hedging: (i) a firm that chooses its hedging policy in the presence of bankruptcy costs; (ii) an all equity firm that faces a convex tax schedule; and (iii) a firm whose manager is subject to loss aversion. In all these models, and contrary to conventional wisdom, we show that forwards dominate options as hedges of downside risk.

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Bibliographic Info

Article provided by Elsevier in its journal Global Finance Journal.

Volume (Year): 18 (2007)
Issue (Month): 1 ()
Pages: 16-33

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Handle: RePEc:eee:glofin:v:18:y:2007:i:1:p:16-33

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Web page: http://www.elsevier.com/locate/inca/620162

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  1. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  2. Mello, Antonio S & Parsons, John E, 2000. "Hedging and Liquidity," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 13(1), pages 127-53.
  3. Rosanne Altshuler & Alan J. Auerbach, 1987. "The Significance of Tax Law Asymmetries: An Empirical Investigation," NBER Working Papers 2279, National Bureau of Economic Research, Inc.
  4. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
  5. René M. Stulz, 1996. "Rethinking Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 9(3), pages 8-25.
  6. Michael H. Moffett & Douglas J. Skinner, 1995. "Issues In Foreign Exchange Hedge Accounting," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 8(3), pages 82-94.
  7. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 20(04), pages 391-405, December.
  8. Bessembinder, H., 1989. "Forward Contracts And Firm Value: Investment Incentive And Contracting Effects," Papers, Rochester, Business - Managerial Economics Research Center 89-06, Rochester, Business - Managerial Economics Research Center.
  9. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, Springer, vol. 5(4), pages 297-323, October.
  10. Kurt Jesswein & Chuck C. Y. Kwok & William R. Folks, 1995. "What New Currency Risk Products Are Companies Using, And Why?," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 8(3), pages 103-114.
  11. John R. Graham & Clifford W. Smith, 1999. "Tax Incentives to Hedge," Journal of Finance, American Finance Association, American Finance Association, vol. 54(6), pages 2241-2262, December.
  12. DeMarzo, Peter M & Duffie, Darrell, 1995. "Corporate Incentives for Hedging and Hedge Accounting," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 8(3), pages 743-71.
  13. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, American Finance Association, vol. 53(4), pages 1213-1243, 08.
  14. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  15. Andrea S. Kramer & J. Clark Heston, 1993. "An Overview Of Current Tax Impediments To Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 6(3), pages 73-80.
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Cited by:
  1. Andreas Röthig & Willi Semmler & Peter Flaschel, 2006. "Hedging, Speculation, and Investment in Balance-Sheet Triggered Currency Crises," Research Paper Series, Quantitative Finance Research Centre, University of Technology, Sydney 173, Quantitative Finance Research Centre, University of Technology, Sydney.
  2. Topaloglou, Nikolas & Vladimirou, Hercules & Zenios, Stavros A., 2011. "Optimizing international portfolios with options and forwards," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(12), pages 3188-3201.
  3. Bj�rn D�hring, 2008. "Hedging and invoicing strategies to reduce exchange rate exposure - a euro-area perspective," European Economy - Economic Papers, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission 299, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission.
  4. Jeanne, Olivier, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4030, C.E.P.R. Discussion Papers.
  5. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1999. "Hedging and financial fragility in fixed exchange rate regimes," Working Paper Series, Federal Reserve Bank of Chicago WP-99-11, Federal Reserve Bank of Chicago.
  6. Simon Gilchrist & Jae W. Sim, 2007. "Investment during the Korean Financial Crisis: A Structural Econometric Analysis," NBER Working Papers 13315, National Bureau of Economic Research, Inc.

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