Optimal bidding and hedging in international markets

Abstract

This paper examines the optimal bidding and hedging decisions of a risk-averse contractor for a construction project abroad. We show that currency options play no role as a hedging instrument when the contractor has a quadratic utility function. However, if the contractor is prudent, currency options are used for hedging purposes. Prudence thus generates a hedging demand for currency options when foreign exchange exposure is uncertain. Contrary to the conventional wisdom, we show that currency hedging may have perverse effects on the contractor's bidding behavior. In a canonical example with negative exponential utility functions, we demonstrate that the possibilities for the contractor to bid more aggressively in the absence of currency hedging are not factitious. © 2004 Elsevier Ltd. All rights reserved.