EXPORT AND HEDGING DECISIONS UNDER CORRELATED REVENUE AND EXCHANGE RATE RISK

Authors

  • Kit Pong Wong

    Corresponding author
    1. University of Hong Kong
    • Correspondence: Kit Pong Wong, School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong. Tel: 852 2859-1044; Fax: 852 2548-1152, Email: kpwong@econ.hku.hk. I would like to thank Axel Adam-Müller, Udo Broll, Gabriel Talmain (Editor-in-Charge), three anonymous referees, and seminar participants at the Shanghai University of Finance and Economics for their helpful comments and suggestions. The usual disclaimer applies.

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ABSTRACT

This paper examines the behaviour of a competitive exporting firm under joint revenue and exchange rate risk. The firm can trade unbiased currency futures contracts for hedging purposes. We show that neither the separation theorem nor the full-hedging theorem holds when the revenue shock prevails. If the correlation between the revenue shock and the random spot exchange rate is non-positive, the firm optimally produces less than the benchmark level when the revenue shock is absent. If, in addition, the firm is prudent, the optimal futures position is an under-hedge. Finally, we derive sufficient conditions under which the firm's optimal output level is higher in the presence than in the absence of the revenue shock. Operational hedging and financial hedging as such interact in a complicated way to better cope with the multiple sources of uncertainty faced by the firm.

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