Title: Cross-Hedging with Currency Options and Futures
Reference Number: 1034
Publication Date: January 2002
JEL Classifcation: F23, F31, D81

Eric Chang
The University of Hong Kong

Kit Pong Wong
The University of Hong Kong

This paper develops an expected utility model of a multinational firm facing exchange rate risk exposure to a foreign currency cash flow. Currency derivative markets do not exist between the domestic and foreign currencies. There are, however, currency futures and options markets between the domestic currency and a third currency to which the firm has access. Since a triangular parity condition holds among these three currencies, the available, yet incomplete, currency futures and options markets still provide a useful avenue for the firm to indirectly hedge against its foreign exchange risk exposure. This paper offers analytical insights into the optimal cross-hedging strategies of the firm. In particular, the results show the optimality of using options in conjunction with futures in the case of currency mismatching, even though cash flows appear to be linear.

Published in Journal of Financial and Quantitative Analysis 38:3, Sep 2003, pp. 555-574.

Key words: Options, Futures, Multiple currency risks, Prudence

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Last modified: 01/23/2007