Title: Restricted Export Flexibility and Risk Management with Options and Forward Contracts
Reference Number: 1148
Publication Date: August 2005
JEL Classifcation: F31; D21; D81
Author(s):

Axel F.A. Adam-Miller
Lancaster University Management School

Kit Pong Wong
The University of Hong Kong

Abstract:
This paper examines the interaction between operational and financial hedging in the context of a risk averse competitive exporting firm under exchange rate uncertainty. The firm is export-flexible in that it makes its export decision after observing the realized spot exchange rate. However, export-flexibility is limited by certain minimum sales requirements due to long-term considerations. This creates a piecewise linear exchange rate exposure. If the firm is allowed to use customized derivatives contracts, its optimal hedge position can be replicated by selling currency forward contracts and call options. If the firm is restricted to use forward contracts as the sole hedging instrument, optimal output is unambiguously smaller. Introducing currency call options thus stimulates production. An extension analyzes more general types of exchange rate exposure.

Key words: Restricted export flexibility; Risk management; Production

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Last modified: 11/04/2005