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Optimal Currency Hedging

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  • Rui Albuquerque

    (Simon School of Business, University of Rochester)

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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File URL: http://128.118.178.162/eps/fin/papers/0405/0405010.pdf
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Bibliographic Info

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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Web page: http://128.118.178.162

Related research

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

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References

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  1. 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.
  2. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  3. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
  4. DeMarzo, Peter M & Duffie, Darrell, 1995. "Corporate Incentives for Hedging and Hedge Accounting," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 743-71.
  5. Hayne E. Leland., 1998. "Agency Costs, Risk Management, and Capital Structure," Research Program in Finance Working Papers RPF-278, University of California at Berkeley.
  6. René M. Stulz, 1996. "Rethinking Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(3), pages 8-25.
  7. 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, vol. 8(3), pages 103-114.
  8. 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.
  9. 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.
  10. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  11. 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.
  12. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 391-405, December.
  13. John R. Graham & Clifford W. Smith, 1999. "Tax Incentives to Hedge," Journal of Finance, American Finance Association, vol. 54(6), pages 2241-2262, December.
  14. Bessembinder, H., 1989. "Forward Contracts And Firm Value: Investment Incentive And Contracting Effects," Papers 89-06, Rochester, Business - Managerial Economics Research Center.
  15. Mello, Antonio S & Parsons, John E, 2000. "Hedging and Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 127-53.
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Cited by:
  1. 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.
  2. Röthig, Andreas & Semmler, Willi & Flaschel, Peter, 2006. "Hedging speculation, and investment in balance-sheet triggered currency crises," Darmstadt Discussion Papers in Economics 25377, Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute of Economics (VWL).
  3. Topaloglou, Nikolas & Vladimirou, Hercules & Zenios, Stavros A., 2011. "Optimizing international portfolios with options and forwards," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3188-3201.
  4. Olivier Jeanne, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," IMF Working Papers 03/177, International Monetary Fund.
  5. Bj�rn D�hring, 2008. "Hedging and invoicing strategies to reduce exchange rate exposure - a euro-area perspective," European Economy - Economic Papers 299, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission.
  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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