Risk Transfer Arrangements as a Hedging Device with Evidence from the Kuwaiti Dinar-British Pound Market

Abstract

An operational hedging technique is proposed to shift some of the foreign exchange risk from the importer to the exporter when the currency of invoicing is the base currency of the exporter. This technique, which may be resorted to when financial hedging is not feasible or expensive, requires an arrangement for the conversion of cash flows at a range of exchange rates calculated as some weighted average of the rates used under a risk sharing arrangement and a currency collar. The problem of negotiating the dimensions of the arrangement when the exporter and importer have different degrees of risk tolerance can be resolved by fine tuning the weights in such a way as to eliminate the sensitivity of the base currency value of the cash flow to the value of the risk sharing threshold parameter. The theory is subsequently illustrated by using monthly observations on the exchange rate between the Kuwaiti dinar and the British pound.