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Cross-Hedging with Currency Options and Futures

Published online by Cambridge University Press:  06 April 2009

Eric C. Chang  and
Kit Pong Wong
Eric C. Chang
Affiliation:
ecchang@business.hku.hk, School of Business
Kit Pong Wong
Affiliation:
kpwong@econ.hku.hk, School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong.
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Abstract

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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 38 , Issue 3 , September 2003 , pp. 555 - 574
Copyright
Copyright © School of Business Administration, University of Washington 2003

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