Hedging Exchange Rate Economic Exposure: Real Options Or Currency Options?

Previous literature suggests that economic exposure shouid be managed within the firm’s overall strategy regarding the choice of production iocation. In this paper, it is shown that this strategy is equivalent to exposed firms incorporating real options in their cost function, enabling these firms to eliminate relative cost increases due to domestic currency appreciations. The paper offers two strands of criticism against this approach: First, it shows that the exercise of these real options for hedging economie exposure does not correspond to the real exchange rate changes which create exposure. Second, in short-run periods, relocating production as a means of hedging is a negative Net Present Value ‘investment’. li is proposed that currency cali options should be used instead of real options. Setting the strike rate equal to the PPP exchange rate adjusted by the expected inflation rate differential captures reai exchange rate changes which cause economie exposure. The practical implication of this proposition is that the decision on the production location is free of any economie exposure management considerations and thus, can be determined on the basis of the profit maximisation criterion.