Financial Hedging to Neutralize or Operational Flexibility to Exploit Exchange Rate Fluctuations

Abstract

Operational flexibility is a key source of advantage for firms with multinational operations. However, its relation to instruments of international risk management is still unclear, particularly vis-a- vis financial hedging instruments that aim at neutralizing exchange rate fluctuations. In this study, we disentangle and contrast the benefits that firms with multinational operations can earn from financial hedging compared to operational flexibility. We show that financial hedging protects firms with poorly diversified portfolios of multinational operations from exchange rate fluctuations, whereas operational flexibility provides firms with well diversified portfolios of multinational operations with the opportunity to exploit exchange rate fluctuations, conditional on their ability to recognize and exercise international switching options. Results from regression analysis on a sample of S&P1500 U.S. MNCs support the hypotheses.