Title: Cross-Hedging with Currency Forward Contracts
Reference Number: 1158
Publication Date: April 2006
JEL Classifcation: D81, F23, F31

Kit Pong Wong
The University of Hong Kong

Abstract: This paper examines the hedging decision of an international firm facing exchange rate risk exposure to a foreign currency cash flow. Financial markets are incomplete in that there are no hedging instruments directly related to the home currency. There is, however, an unbiased currency forward market between the foreign currency and a third currency accessible to the firm. A triangular parity condition holds among the home, foreign, and third currencies, thereby making cross-hedging opportunities available. If the spot exchange rate of the home currency against the third currency and that of the third currency against the foreign currency are positively (negatively) correlated in the sense of regression dependence, we show that the firm's optimal forward position is an under-hedge or an over-hedge, depending on whether the firm's Arrow-Pratt measure of relative risk aversion is everywhere less (greater) or greater (less) than unity, respectively.

Key words: Cross-hedging; Regression dependence; Relative risk aversion

Last modified: 07/08/2006