Restricted Export Flexibility and Risk Management with Options and Futures

Specifically, for realizations of S below Pd/Pf, the firm optimally allocates less, but still
some, output to the foreign market and more output to the domestic market. This is
illustrated in Figure 3 by bending up the dashed line at Pd/Pf . This implicit real hedge
has two consequences on the firm’s unhedged domestic currency profits. First, unhedged
profits are less volatile. Second, unhedged profits become convex in the exchange rate with
strictly positive slope everywhere. The convexity requires the use of currency options,
similar to the case of a fully flexible firm. Due to the minimum export level, the slope is
positive even at low realizations of S. This requires the use of currency futures in addition
to currency options. This is not the case for a fully flexible firm.

Loosely speaking, adding some export flexibility to the inflexible firm results in adding
currency options to the hedging position which consisted of currency futures only. Alter-
natively, restricting a fully flexible firm to some extent results in adding currency futures
to the hedging position which consisted of currency options. Hence, the restricted export
flexible firm has two appealing characteristics: First, it seems to be more realistic than
totally inflexible or fully flexible firms. Second, it optimally uses a portfolio of currency
futures and currency options which coincides with observable risk management behavior.

4 Optimal production and risk management
with futures

This section analyzes the firm’s optimal production and risk management decisions under
the assumption that currency futures are the only hedging instrument available to the
firm. Since currency options are absent, this section applies to exp ort markets in countries
where currency derivatives markets just begin to develop. Currency futures, because of
their relatively simple structure, are readily available but currency options are not.

The absence of currency call options implies Z = 0 in equation (3). Furthermore,
condition (7) is irrelevant. Let Щ, Q and H denote the firm’s profits and the decisions

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