Conventional Hedging: An Inadequate Response to Long‐Term Foreign Exchange Exposure

Abstract

Since the demise of the Bretton Woods System of quasi‐fixed exchange rates in the early seventies, unanticipated exchange rate movements are a fundamental feature of the international economic environment. The ever increasing degree of exchange rates volatility has spurred the creation of new financing and hedging instruments and techniques. The proliferation of these financial innovations has confounded many treasurers as to the appropriate instrument or technique to be used in resolving a foreign exchange risk management problem. Notwithstanding the persistent and sophisticated nature of current foreign exchange risk management, there are situations where hedging does not protect the firm from large losses caused by unanticipated changes in exchange rates. We present three situations where hedging fails to protect the firm from risks arising from fluctuating exchange rates: first, where the firm has a continuous inflow of foreign currency; second, where foreign exchange risks are compounded by general and relative price risks; and third, where the perfectly hedged firm faces competition from unhedged rivals.