“Export Flexibility and Currency Hedging” by Kit Pong WONG
Kit Pong WONG
University of Hong Kong
This paper develops a two-period model of an exporting firm facing uncertain exchange rate in each period. The firm is export-flexible in that it makes its export decision only after it has observed the first period spot exchange rate which is an informative, yet noisy, signal for the second period spot exchange rate. We show that the separation theorem holds if, and only if, the time-series pattern of the spot exchange rates is linear. Otherwise, the firm uses its optimal output as an additional hedging instrument. We further show that export flexibility introduces convexity into the firm's foreign exchange risk exposure which induces the firm to use non-linear currency options for hedging purposes. This paper thus provides a rationale for the hedging role of currency options in the context of export flexibility.