Restricted Export Flexibility and Risk Management with Options and Futures

Restricted Export Flexibility and

Risk Management with Options and Futures

This paper examines the production, export and risk management decisions of a
risk-averse competitive firm under exchange rate risk. The firm is export flexible
in allocating its output to either the domestic market or a foreign market after
observing the exchange rate. Export flexibility is restricted by certain minimum
sales requirements that are due to long-term considerations. Currency options are
sufficient to derive a separation result under restricted export flexibility. Under
fairly priced currency futures and options, full hedging with both instruments is
optimal. Introducing fairly-priced currency options stimulates production provided
that the currency futures market is unbiased.

JEL classification: F31; D21; D81

Keywords: restricted export flexibility; risk management; currency futures; currency
options

1 Introduction

Foreign exchange rate fluctuations became a major source of risk for international firms
since the Bretton Woods Agreement collapsed in 1973. Consequently, these firms have
been using various hedging strategies to cope with the adverse effects of exchange rate
risk on their profits.¹ On the one hand, international firms can adopt a real hedge by
following a flexible sales or input/output policy which allows them to alter their operations
according to realized exchange rates. On the other hand, these firms can rely on a financial
hedging strategy which is typically based on currency derivatives such as currency futures
and options. In any case, there is a close link between the hedging activities in the
markets for goods and services and the financial hedging measures. This paper analyzes
the interaction between the firm’s real and financial risk management decisions in the

¹In a survey conducted by Rawls and Smithson (1990), foreign exchange risk management is indicated
by financial managers to be among their primary objectives.

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