Title: Hedging Mismatched Currencies with Options and Futures
Reference Number: 1187
Publication Date: January 2009
JEL Classifcation: F23, F31, D81

Donald Lien
University of Texas at San Antonio

Maurice K.S. Tse
The University of Hong Kong

Kit Pong Wong
The University of Hong Kong

This paper develops an expected utility model of an exporting firm in a developing country where currency derivative markets do not exist. The firm faces exchange rate risk exposure to a foreign currency cash flow. To cross-hedge against this risk exposure, the firm uses currency futures and options between the foreign currency and a third currency. Since a triangular parity condition holds among the three given currencies, this available hedging opportunity, albeit incomplete, is proved to be useful in reducing the firm's exchange rate risk exposure. We show that currency options are redundant under two rather restrictive conditions: (i) logarithmic utility functions and/or (ii) independent spot exchange rates. In a more realistic cross-hedging environment, we show that currency options are optimally used by the firm to incompletely span the missing currency futures between the domestic and foreign currencies. We also estimate the benefits of using currency options for cross-hedging purposes. The improvement in hedging effectiveness can be substantial.

Key words: Options, Futures, Multiple currency risks, Hedging effectiveness

Last modified: 03/19/2009