Operational hedging strategies and competitive exposure to exchange rates

Abstract

This paper investigates the impact of operational flexibility on firms׳ economic exposure to currency fluctuations in the presence of global competition. We consider a global firm who sells as a monopolist in the domestic market, and also sells to a foreign market facing competition from a local competitor of certain capacity. We compare the effects of two operational strategies of the global firm, namely, matching currency footprints (“natural hedge”) and the capacity pooling strategy with allocation flexibility. For a two-stage stochastic model, we derive the optimal capacity and selling decisions for the global firm, and from the comparative statics analysis of our model we infer useful managerial insights. (1) We find that operational flexibility enables the global firm to exploit the possible high exchange rate (i.e., devalued home currency) realizations for profit improvement, and thus increases in the long run the firm׳s expected profit. (2) Furthermore, operational flexibility allows for downside risk control as the exchange rate becomes more volatile, since the resource pooling option cleverly exercised minimizes the impact of unfavorable currency realizations. (3) The global firm׳s operational flexibility increases its competitor׳s downside risk, but may also benefit the competitor׳s expected profit since a flexible global firm may decide not to compete when the exchange rate is not favorable. In conclusion, our paper substantiates that “natural hedge” is not effective from a profit maximization perspective. We clearly illustrate the robust profit maximizing performance and reasonable downside risk control of operational hedging approaches, which rely on the clever exercising of operational flexibility options such as resource pooling and allocation, in handling competitive exposure to fluctuating exchange rates.