Title: Cross-Hedging for the Multinational Firm under Exchange Rate Uncertainty
Reference Number: 1173
Publication Date: July 2007
JEL Classifcation: D81, F23, F31
Author(s):

Kit Pong Wong
The University of Hong Kong

Abstract:
This paper examines the impact of cross-hedging on the behavior of the risk-averse multinational firm (MNF) under multiple sources of exchange rate uncertainty. The MNF has operations domiciled in the home country and in a foreign country, each of which produces a single homogeneous good to be sold in the home and foreign markets. Since there are no currency derivative markets between the domestic and foreign currencies, the MNF has to rely on a currency futures market in a third country to cross-hedge its exchange rate risk exposure. We show that the MNF optimally opts for an under-hedge, sells less (more) and produces more (less) in the foreign (home) country. When the set of hedging instruments made available to the MNF is expanded to include currency option contracts between the domestic and third currencies, we show that the MNF optimally opts for a long option position. This paper thus offers a rationale for the cross-hedging role of currency options for MNFs under multiple sources of exchange rate uncertainty.

Key words: Cross-hedging, Multinationals, Prudence

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Last modified: 07/24/2007