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Optimal Currency Hedging Under Loss Aversion

Rui A. Albuquerque
Boston University - School of Management; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

August 1999

Simon School of Business Working Paper FR 99-09

Abstract:
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.

JEL Classifications: F31, G30

Working Paper Series

Date posted: September 21, 1999 ; Last revised: October 27, 2008

Suggested Citation

Albuquerque, Rui A., Optimal Currency Hedging Under Loss Aversion (August 1999). Simon School of Business Working Paper FR 99-09. Available at SSRN: http://ssrn.com/abstract=179688 or doi:10.2139/ssrn.179688

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