Title: Cross-Hedging of Exchange Rate Risks: A Note
Reference Number: 1122
Publication Date: May 2004
JEL Classifcation: D21; D81, F31

Harald L. Batterman
University of Saarland

Udo Broll
Dresden University of Technology

Kit Pong Wong
University of Hong Kong

This note studies the optimal production and hedging decisions of a competitive international firm that exports to two foreign countries. The firm as such faces multiple sources of exchange rate uncertainty. Cross-hedging is plausible in that one of these two foreign countries has a currency forward market. We show that the separation theorem holds in that the firm's production decision depends neither on its risk attitude nor on the underlying uncertainty. We further show that the firm's optimal forward position is an over-hedge, a full-hedge, or an under-hedge, depending on whether the two random exchange rates are strongly positively correlated, uncorrelated, or negatively correlated, respectively.

Key words: Exchange rate risks, cross-hedging, exports, production

Last modified: 04/27/2005