Cross‐Hedging of Exchange‐Rate Risk

Abstract

For currencies with highly developed forward markets a well‐known separation theorem holds which implies that international firms fully hedge the exchange rate risk if the forward markets are unbiased. In this paper we present a model of a risk‐averse firm when perfect hedging instruments are not available. Instead the firm can cross‐hedge the exchange‐rate risk by using the forward markets of a third country's currency. We demonstrate that the unbiasedness of all forward markets does not imply full hedge, although the firm has the option to hedge all the risks.

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