Title: Multinationals and Futures Hedging under Liquidity Constraints
Reference Number: 1121
Publication Date: April 2005
JEL Classifcation: D81; F23; F31

Donald Lien
University of Texas at San Antonio

Kit Pong Wong
University of Hong Kong

This paper examines the behavior of a multinational firm (MNF) under exchange rate uncertainty. The MNF has operations domiciled in the home country and in a foreign country. Each of these two operations produces a single homogeneous good to be sold in the home and foreign markets. To hedge the exchange rate risk, the MNF has access to an intertemporally unbiased currency futures market. All currency futures contracts are marked-to-market and thus require interim cash settlement of gains and losses. We impose a liquidity constraint on the MNF in that the MNF is forced to prematurely liquidate its futures position from which the interim loss exceeds a predetermined threshold level. If the MNF's utility function satisfies decreasing absolute risk aversion, we show that the MNF optimally opts for a short under-hedge. Furthermore, the MNF sells less (more) and produces more (less) in the foreign (home) country in response to the imposition of the liquidity constraint.

Published in Global Finance Journal 16:2 (2005), pp. 210-220.

Key words: Futures; Marking to market; Multinationals; Liquidity constraints

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Last modified: 01/25/2007