Underutilization of Forward Markets or Rational Behavior?

Abstract

THE POSSIBILITY OF EMPLOYING the forward exchange market in order to avoid risk resulting from exchange rate variations is so well known that it might seem surprising that many positions in foreign currency denominated instruments go unhedged. One possible reason for failing to obtain forward cover stems from the transactions costs that are involved.' Another reason is the conscious decision of speculators who keep open positions based on the difference between their expectation of future spot rates and corresponding forward rates.2 In addition, many writers have emphasized that there are alternative ways by which positions in certain currencies might be offset. For example, foreign currency receivables can be offset by denominating borrowing in that same currency. In other words, asset and liability positions can be cancelling within particular individual currencies without resorting to forward markets.3 This paper suggests a further possible reason why many foreign exchange positions are not covered in the forward market. In particular it is shown that in a world where cross-elasticities between foreign currency movements are known, a portfolio that involves positions in k currencies can theoretically be completely hedged against variations in any of these k currency values with only one forward contract. The hedged portfolio will in general involve open positions in every currency and utilize only the single forward contract.4