Optimal Indirect Hedging and Price Conditions

Abstract

This study examines the indirect hedging strategy and its price ccndition against exchange risk for the export firms which can not directly hedge due to non-existence of appropriate futures market for the export market currency. The export firms would manipulate their mark-up rate as real hedging against exchange risk in the incomplete export market. Real options tend to reduce the uncertainty of an export profit curve in nonlinear manner and thus, substitute for the financial hedging. As a result, the optimal hedging strategy for the firms exporting to the incomplete market is an under hedge combining short futures and long put. The long put is a substitute with short futures and required to cover the nonlinear risk of export profit derived by real options. Indirect hedging would increase the expected profit by reducing risk, while a sufficient and necessary condition for the optimal indirect hedging depends on exchange volatility and a magnitude of put premium relative to an expected excercise loss.</jats:p