Optimal Currency Hedging Under Loss Aversion
Rui A. Albuquerque
Boston University - School of Management; Católica-Lisbon School of Business and Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
Simon School of Business Working Paper FR 99-09
This paper characterizes optimal currency hedging for a loss averse firm. Loss aversion gives rise to an incentive to hedge downside risk. Contrary to conventional wisdom we show that forwards dominate options in the presence of a concern over downside risk. The dynamic hedge ratio displays zones of inaction and behaves non-monotonically with the exchange rate.
We discuss how to reinterpret loss aversion in the context of two value-maximizing models of hedging: (i) an all equity firm that faces a convex tax schedule; and (ii) a firm that chooses its hedging policy in the presence of bankruptcy costs.
Number of Pages in PDF File: 44
JEL Classification: F31, G30working papers series
Date posted: September 21, 1999
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