Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies

Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies Under what conditions will a multinational corporation alter its operations to manage its risk exposure? We show that multinational firms will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. Operational hedging is less important for managing short-term exposures, since demand uncertainty is lower in the short term. Operational hedging is also less important for commodity-based firms, which face price but not quantity uncertainty. When the fixed costs of establishing a plant are low or the variability of the exchange rate is high, a firm may benefit from establishing plants in both the domestic and foreign location. Capacity allocated to the foreign location relative to the domestic location will increase when the variability of foreign demand increases relative to the variability of domestic demand or when the expected profit margin is larger. For firms with plants in both a domestic and foreign location, the foreign currency cash flow generally will not be independent of the exchange rate and consequently the optimal financial hedging policy cannot be implemented with forward contracts alone. We show that the optimal financial hedging policy can be implemented using foreign currency call and put options and forward contracts. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Finance Oxford University Press

Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies

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Publisher
Oxford University Press
Copyright
© Published by Oxford University Press.
ISSN
1572-3097
eISSN
1573-692X
DOI
10.1023/A:1009778703889
Publisher site
See Article on Publisher Site

Abstract

Under what conditions will a multinational corporation alter its operations to manage its risk exposure? We show that multinational firms will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. Operational hedging is less important for managing short-term exposures, since demand uncertainty is lower in the short term. Operational hedging is also less important for commodity-based firms, which face price but not quantity uncertainty. When the fixed costs of establishing a plant are low or the variability of the exchange rate is high, a firm may benefit from establishing plants in both the domestic and foreign location. Capacity allocated to the foreign location relative to the domestic location will increase when the variability of foreign demand increases relative to the variability of domestic demand or when the expected profit margin is larger. For firms with plants in both a domestic and foreign location, the foreign currency cash flow generally will not be independent of the exchange rate and consequently the optimal financial hedging policy cannot be implemented with forward contracts alone. We show that the optimal financial hedging policy can be implemented using foreign currency call and put options and forward contracts.

Journal

Review of FinanceOxford University Press

Published: Jan 1, 1999

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