Hedging with mismatched currencies

Abstract

This article presents a model of a risk‐averse multinational firm facing risk exposure to a foreign currency cash flow. Forward markets do not exist between the firm's own currency and the foreign currency, but do exist for a third currency. Because a triangular parity condition holds among these three currencies, the available forward markets, albeit incomplete, provide a useful avenue for the firm to indirectly hedge against its foreign exchange rate risk exposure. This article offers analytical insights into the optimal cross‐hedging strategies of the firm. In particular, the results show that separate unbiasedness of the forward markets does not necessarily imply a perfect full hedge that eliminates the entire foreign exchange rate risk exposure of the firm. The optimal cross‐hedging strategies depend largely on the firm's marginal utility function and on the correlation of the random spot exchange rates. © 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19:859–875, 1999