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Keywords:

  • currency options;
  • export flexibility;
  • production
  • D21;
  • D81;
  • F31

Abstract

This paper examines the production and hedging decisions of a globally competitive firm under exchange rate uncertainty. The firm is risk averse and possesses export flexibility in that it can distribute its output to either the domestic market or a foreign market after observing the realized spot exchange rate. To hedge against its exchange rate risk exposure, the firm can trade fairly priced currency call options of an arbitrary strike price. We show that both the separation and the full-hedging results hold if the strike price of the currency call options is set equal to the ratio of the domestic and foreign selling prices. Otherwise, neither result holds. Specifically, we show that the optimal level of output is always less than that of an otherwise identical firm that is risk neutral. Furthermore, an under-hedge (over-hedge) is optimal whenever the strike price of the currency call options is below (above) the ratio of the domestic and foreign selling prices.