International trade and hedging under joint price and exchange rate uncertainty

Abstract

This paper examines the behavior of a competitive exporting firm under joint price and exchange rate uncertainty. We show that the firm's optimal production and hedging decisions depend crucially on the degree of forward market incompleteness, and on the correlation structure of the price and exchange rate risk. The separation theorem holds if there are complete forward markets for hedging purposes. Should the forward markets be incomplete, the firm employs operational hedging by adjusting its output so as to better cope with the residual risk that is unhedgeable by simply trading the existing forward contracts. In the case that the price risk cannot be directly managed by financial hedging, we construct a reasonable example in which the firm optimally produces more, not less, than the benchmark output level under perfect hedging. Our results thus offer new insights into the interaction between financial and operational hedging in the context of multiple sources of uncertainty. © 2012 Elsevier Inc. All rights reserved.