exclusively on currency options might seem unsatisfactory. Our model extends the work
of Broll and Wahl (1997) in a way that provides a rationale for the joint use of currency
futures and options. This is done by restricting the firm’s export flexibility.
Under restricted export flexibility, the firm has to maintain certain minimum levels
of domestic sales and exports such that the degree of flexibility enjoyed by the firm
varies inversely with the tightness of these minimum levels. The reason for assuming
the existence of such minimum levels of domestic sales and exports is the observation
that firms typically have explicit or implicit obligations to remain present in a market
even under (temporarily) unfavorable conditions. These obligations may either be due to
already signed contracts with customers or be simply due to the necessity to maintain
a minimum level of activity in a market in order to remain visible to future customers.3
This minimum level of activity is the result of a longer-term consideration in which market
exit and entry costs determine whether a firm is currently in the market with at least the
minimum level of activity or whether the firm is not in the market at all. However, it is
not the purpose of this paper to analyze this longer-term market entry decision. Instead,
it is taken as given that market entry and exit costs are such that it is currently optimal
for the firm to be present in the domestic and the export markets for longer-term reasons
even if this market presence is not necessarily favorable in the period of time considered
in this paper.
Given restricted export flexibility, the firm’s optimal sales allocation rule is state con-
tingent: It exports more than the minimum level to the foreign market when the realized
exchange rate is sufficiently favorable such that the foreign price (measured in units of the
domestic currency) exceeds the domestic price; otherwise, it maintains the minimum level
of exports and sells the rest in the domestic market. Alternatively put, exports are like a
real option with a strike price equal to the domestic price. The sales allocation between
the domestic and foreign markets provides the firm an implicit real hedge against adverse
3Bagwell and Staiger (1989) and Bagwell (1991) show that export subsidies facilitate the entry of
high-quality firms under asymmetric information. Shy (2000) goes one step further and argues that the
decision to export is chosen to signal product quality, despite the fact that exporting is dominated by
non-exporting under symmetric information.