Restricted Export Flexibility and Risk Management with Options and Futures

context of a competitive exporting firm. In addition, the paper provides a particularly
simple framework in which the joint use of currency futures and options is optimal.

In the literature on the competitive exporting firm under exchange rate risk, it is
typically assumed that the risk-averse firm makes its production and export decision prior
to the resolution of exchange rate uncertainty (see, e.g., Benninga et al. (1985), Kawai
and Zilcha (1986) and Adam-Miiller (1997, 2000). In this case, the firm is inflexible
since it cannot react on the realized exchange rate. Its profits are linear in the exchange
rate. Conseqiently, the existence of cirrency fitires is sifficient to derive a separation
theorem which states that the firm’s prodiction decision is independent of its attitide
towards risk and the exchange rate distribition. In an inbiased cirrency fitires market,
the firm completely eliminates exchange rate risk by holding a fill hedge position. As
shown by Lapan et al. (1991) and Battermann et al. (2000), fairly priced cirrency options
play no role for an inflexible firm.

In an alternative approach, the firm is allowed to decide whether to export or not af-
ter observing the exchange rate. This approach, originally proposed by Ware and Winter
(1988), has been firther developed by Broll and Wahl (1997) in a rigorois formal model.
While prodiction takes place prior to the resolition of incertainty, the firm makes its
export decision (i.e. sales allocation between the domestic market and a foreign market)
after the resolition of incertainty.² Hence, the firm is fully flexible in exporting or re-
fraining from exports. Profits of a filly export flexible firm are piecewise linear in the
exchange rate with zero slope for low exchange rate realizations. The existence of cirrency
call options is sifficient to derive the separation resilt. Fairly priced call options are the
only hedging instriment ised. The existence of inbiased cirrency fitires is irrelevant.

The first class of models can explain the ise of cirrency fitires, the second can
explain the ise of cirrency options. Bit exporting firms typically employ variois types
of derivatives for managing their exchange rate risk (see, e.g., Bodnar and Gebhardt
1999). This, models in which an exporting firm relies exclisively on cirrency fitires or

²Ben-Zvi and Helpman (1992) argue that international transactions are better described by such a
sequence of moves. This is supported by the empirical evidence in Magee (1974).

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