Restricted Export Flexibility and Risk Management with Options and Forward Contracts

Abstract

This paper examines the interaction between operational and financial hedg-ing in the context of a risk averse competitive exporting firm under exchange rate uncertainty. The firm is export-flexible in that it makes its export deci-sion after observing the realized spot exchange rate. However, export-flexibility is limited by certain minimum sales requirements due to long-term consider-ations. This creates a piecewise linear exchange rate exposure. If the firm is allowed to use customized derivatives contracts, its optimal hedge position can be replicated by selling currency forward contracts and call options. If the firm is restricted to use forward contracts as the sole hedging instrument, optimal output is unambiguously smaller. Introducing currency call options thus stim-ulates production. An extension analyzes more general types of exchange rate exposure. This paper examines the interaction between operational and financial hedg-ing in the context of a risk averse competitive exporting firm under exchange rate uncertainty. The firm is export-flexible in that it makes its export deci-sion after observing the realized spot exchange rate. However, export-flexibility is limited by certain minimum sales requirements due to long-term consider-ations. This creates a piecewise linear exchange rate exposure. If the firm is allowed to use customized derivatives contracts, its optimal hedge position can be replicated by selling currency forward contracts and call options. If the firm is restricted to use forward contracts as the sole hedging instrument, optimal output is unambiguously smaller. Introducing currency call options thus stim-ulates production. An extension analyzes more general types of exchange rate exposure.