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Optimal currency hedging

  • Albuquerque, Rui

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://www.sciencedirect.com/science/article/pii/S1044-0283(07)00014-2
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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
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/620162

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  1. Mello, Antonio S & Parsons, John E, 2000. "Hedging and Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 127-53.
  2. Hayne E. Leland., 1998. "Agency Costs, Risk Management, and Capital Structure," Research Program in Finance Working Papers RPF-278, University of California at Berkeley.
  3. John R. Graham & Clifford W. Smith, 1999. "Tax Incentives to Hedge," Journal of Finance, American Finance Association, vol. 54(6), pages 2241-2262, December.
  4. 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.
  5. Bessembinder, Hendrik, 1991. "Forward Contracts and Firm Value: Investment Incentive and Contracting Effects," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(04), pages 519-532, December.
  6. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  7. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
  8. 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.
  9. 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.
  10. 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.
  11. Rosanne Altshuler & Alan J. Auerbach, 1990. "The Significance of Tax Law Asymmetries: An Empirical Investigation," The Quarterly Journal of Economics, Oxford University Press, vol. 105(1), pages 61-86.
  12. 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.
  13. 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.
  14. 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.
  15. René M. Stulz, 1996. "Rethinking Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(3), pages 8-25.
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