Exchange rate economic exposure and hedging:the significance of currency options

Abstract

This thesis focuses on the theoretical examination of the exchange rate economic (operating) exposure within the context of the theory of the firm, and proposes some hedging solutions using currency options. The examination of economic exposure is based on such parameters as firms' objectives, industry structure and production cost efficiency. In particular, it examines an hypothetical exporting firm with costs in domestic currency, which faces competition from foreign firms in overseas markets and has a market share expansion objective. Within this framework, the hypothesis is established that economic exposure, portrayed in a diagram connecting export prices and real exchange rates, is asymmetric (i.e. the negative effects depreciation are higher than the positive effects of a currency depreciation). In this case, export business can be seen as a real option, given by exporting firms to overseas customer. Different scenarios about the asymmetry hypothesis can be derived for different assumptions about the determinants of economic exposure. Having established the asymmetry hypothesis, the hedging against this exposure is analysed. The hypothesis is established, that a currency call option should be used in hedging against asymmetric economic exposure. Further, some advanced currency options stategies are discussed, and their use in hedging several scenarios of exposure is indicated, establishing the hypothesis that, the optimal options strategy is a function of the determinants of exposure. Some extensions on the theoretical analysis are examined. These include the hedging of multicurrency exposure using options, and the exposure of a purely domestic firm facing import competition. The empirical work addresses two issues: the empirical validity of the asymmetry hypothesis and the examination of the hedging effectiveness of currency options.