29 Pages Posted: 21 Sep 1999 Last revised: 29 Dec 2014
Date Written: September 11, 2006
This paper characterizes optimal currency hedging in several models of downside risk. We consider, in turn, three models of hedging: (i) a firm that chooses its hedging policy in the presence of bankruptcy costs; (ii) an all equity firm that faces a convex tax schedule; and (iii) a firm whose manager is subject to loss aversion. In all these models, and contrary to conventional wisdom, we show that forwards dominate options as hedges of downside risk.
Keywords: Currency hedging, forwards, options, bankruptcy costs, taxes, loss aversion, downside risk
JEL Classification: F31, G30
Suggested Citation: Suggested Citation