Theories on derivative hedging

by Yick, Ho-yin

(Uncorrected OCR) Abstract of thesis entitled THEORIES ON DERIVATIVE HEDGING submitted by Yick Ho-yin for the degree of Master of Philosophy at The University of Hong Kong in August 2004 This thesis studies the hedging behavior of a global competitive firm under exchange rate risk. Specifically, it focuses on the analysis of options (including both real and financial options) and cross-hedging technique since both of them are widely used and applied for hedging purpose in the real world. The first part of this thesis examines the hedging behavior and production decisions of a firm with export flexibility, which allows the firm to make export decisions after the resolution of the exchange rate. Thus, the firm can export more (less) products when the realized exchange rate is favorable (unfavorable). This study shows that the firm opts for hedging the risk to attain the maximized expected utility. Moreover, the optimal hedging strategies consist of both futures and options in general. This result offers a rationale to the hedging role of options and implies that the separation theorem and the full-hedging theorem do not necessarily hold. The second part focuses on currency cross-hedging. It studies a multinational firm that has an operation in a foreign country where currency derivative markets do not exist. In this case, direct hedging methods cannot be used. Instead, the firm has to adopt the cross-hedging technique, i.e., hedging against another related currency (a third currency). The study shows that cross-hedging helps the firm to reduce part of the risk exposure. Futures and options are essential components for cross-hedging generally. In addition, the firm? optimal hedging strategy depends on the correlation between the spot exchange rates of related currencies. 3