Nahum Melumad

An Argument Against Hedging by Matching the Currencies of Costs and Revenues

Coauthor(s): Trevor Harris.

Abstract:
In this paper, we critically examine the recommended practice of matching currency footprints. We argue that while matching currency footprints reduces profit variability, this practice can also cause reductions in expected profitability, a point that appears to have been overlooked in current literature. The expected profit effects of matching depend on the trade-off between possible expected cost savings of sourcing abroad verses the loss of what we refer to as "strategic flexibility" in responding to competitors' pricing and quantity decisions. When matching reduces expected profits, the firm must weigh the benefits of risk reduction against the costs in the form of reduced flexibility. Thus, the desirability of matching currency footprints depends on a company-specific analysis of its risk aversion, potential cost savings of sourcing abroad, and the value of the strategic flexibility that is given up.

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