Figure 3: Hedged and unhedged profits with futures and options
If there is no export flexibility, the firm’s revenue is linear in the exchange rate. This
is represented by the dashed line and its solid continuation in Figure 3. In this case,
unbiased currency futures are the preferred hedging instrument since they are also linear
in the exchange rate. As shown by Battermann et al. (2000), fairly-priced options will
not be used by an inflexible firm.
On the other hand, a fully flexible firm will entirely rely on fairly priced currency call
options. Broll and Wahl (1997) have shown that full hedging with call options eliminates
exchange rate risk. This is due to the fact that revenue is piecewise linear in the exchange
rate with a zero slope for low exchange rate realizations. It follows that a risk averse and
fully flexible firm will never use unbiased currency futures since this would increase risk
while leaving expected profits unchanged.
Restricted export flexibility allows the firm to implicitly hedge against its exchange
rate risk exposure by the sales allocation between the domestic and foreign markets.
14
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