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Optimal Currency Hedging

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Author Info
Rui Albuquerque (Simon School of Business, University of Rochester)

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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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Paper provided by EconWPA in its series Finance with number 0405010.

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Date of creation: 06 May 2004
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Handle: RePEc:wpa:wuwpfi:0405010

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Related research
Keywords: Currency hedging; forwards; options; bankruptcy costs; taxes; loss aversion; downside risk;

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
G30 - Financial Economics - - Corporate Finance and Governance - - - General

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References listed on IDEAS
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  1. Hayne E. Leland., 1998. "Agency Costs, Risk Management, and Capital Structure," Research Program in Finance Working Papers RPF-278, University of California at Berkeley. [Downloadable!]
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  2. Michael H. Moffett & Douglas J. Skinner, 1995. "Issues In Foreign Exchange Hedge Accounting," Journal of Applied Corporate Finance, Morgan Stanley, vol. 8(3), pages 82-94. [Downloadable!] (restricted)
  3. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  4. Bessembinder, H., 1989. "Forward Contracts And Firm Value: Investment Incentive And Contracting Effects," Papers 89-06, Rochester, Business - Managerial Economics Research Center.
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  5. Altshuler, Rosanne & Auerbach, Alan J, 1990. "The Significance of Tax Law Asymmetries: An Empirical Investigation," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 61-86, February. [Downloadable!] (restricted)
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  6. Andrea S. Kramer & J. Clark Heston, 1993. "An Overview Of Current Tax Impediments To Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 73-80. [Downloadable!] (restricted)
  7. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March. [Downloadable!] (restricted)
  8. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February. [Downloadable!] (restricted)
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  9. Charles Engel, 1996. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. DeMarzo, Peter M & Duffie, Darrell, 1995. "Corporate Incentives for Hedging and Hedge Accounting," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 8(3), pages 743-71. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. 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. [Downloadable!] (restricted)
  2. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1999. "Hedging and financial fragility in fixed exchange rate regimes," Working Paper Series WP-99-11, Federal Reserve Bank of Chicago. [Downloadable!]
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  3. Andreas Röthig & Willi Semmler & Peter Flaschel, 2006. "Hedging, Speculation, and Investment in Balance-Sheet Triggered Currency Crises," Research Paper Series 173, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
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  4. Jeanne, Olivier, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," CEPR Discussion Papers 4030, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
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