Title: Hedging, Liquidity, and the Multinational Firm under Exchange Rate Uncertainty
Reference Number: 1167
Publication Date: February 2007
JEL Classifcation: D81, F23, F31

Kit Pong Wong
The University of Hong Kong

This paper examines the impact of liquidity risk on the behavior of the risk-averse multinational firm (MNF) under exchange rate uncertainty in a two-period dynamic setting. 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. To hedge the exchange rate risk, the MNF trades currency futures contracts that are marked to market at the end of the first period. Liquidity risk is introduced to the MNF by a liquidity constraint that obliges the MNF to prematurely liquidate its futures position whenever the interim loss incurred from this position exceeds a prespecified threshold level. We show that the liquidity constrained 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 liquidity constrained MNF is expanded to include nearby currency futures and option contracts, both of which mature at the end of the first period, we show that the MNF optimally opts for a long nearby futures position, a short distant futures position, and a long option position. This paper thus offers a rationale for the hedging role of futures spreads and currency options for liquidity constrained MNFs.

Key words: Currency hedging, Liquidity contraints, Multinationals

Last modified: 06/12/2007