Abstract

Optimal Hedging in Foreign Trade

This paper integrates currency options in a simple microeconomic model on foreign trade in an environment of uncertainty. Initially, it appears that options do not offer hedging possibilities additional to those of futures contracts. This means that a risk-averse exporter will generally be indifferent to both instruments. The question whether an open currency commitment is fully hedged or not ultimately depends on his exchange-rate expectations. If the spot rate is over and above the exchange-rate he expects, he will - depending on the degree of his risk-averseness - keep a more or less large part of his commitment open. Both options and futures contracts permit him to reach the “risk profile” he considers to be optimal for his purposes. The same model is subsequently used for recapitulating economic intuition underlying the separation theorem according to which the export industry reaches production decisions independent of the exchange-rate risk as well as of exporters’ expectations and risk averseness. It is shown that the existence of options does not affect the validity of this theorem.