Effect of Exchange Rate Uncertainty in Presence of Future Markets

I consider a multinational firm(MNF) which produces and sells in domestic and foreign markets with monopolistic power in both markets. I assume that there exists a risk from the volatility of foreign exchange. The volatility of the exchange rates affects the firm's behavior in various ways, depending upon the situation in which the firm engages. When a currency futures market is introduced, agents have more opportunity to avoid risk from the volatility of the exchange rate since the firm can hedge against exchange rate risk on its exports in foreign exchange futures markets. This opportunity may lead the firm to produce more at home and export more, holding other things constant, because one of the major reasons for an exporting firm to produce abroad is to avoid risk from the exchange rate variability. The purpose of the study is to analyze the production and hedging decisions of the firm under exchange rate uncertainty. I examine how exchange rate uncertainty affects the firm's output and hedging decisions. The availability of foreign exchange futures markets encourages the risk averse firm to produce more in the domestic plant except when futures markets are perceived as normal backwardation. In addition, the optimal futures position is short for linear demands and unbiased futures markets, and full hedging only with futures contract cannot be attained in this nonlinear profit model.