Exchange Rate Hedging in a Simulation/Optimization Framework

Abstract

Part III considers another relevant practical problem involving uncertainty about future exchange rate developments: the problem of finding a possibly optimal combination of linear and nonlinear financial instruments in order to hedge foreign exchange transaction risk over a specified planning period. While much research has been done in order to find answers on why multinational firms in reality hedge their exchange rate exposures, newspapers regularly suggest that more research should be directed towards how hedgers can improve their decision making procedures. Hedges are trades designed with the motivation to reduce or eliminate risk which distinguishes them from pure speculation. Still real-world hedging policies often involve a speculative component in terms of exchange rate expectations which may deviate from those implied by derivative prices. For instance, if a hedger believes that the currency is going to move in an unfavorable direction, he may ask about the appropriate strategy in terms of instrument selection. In contrast, if the currency is expected to move favorably, but the hedger is not entirely sure, should he use a different risk management strategy?