Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies

Abstract

We show that multinational corporations will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. The firm is more likely to establish plants in both the domestic as well as the foreign location if the fixed costs of establishing a plant are lower or if the variability in the exchange rate is higher. If the firm establishes plants in both the domestic as well as the foreign location, the foreign currency cash flow will, in general, not be independent of the exchange rate and the optimal financial hedging contract will not be a forward contract. The firm is more likely to establish larger capacity in the foreign location if the variability of the foreign demand relative to the variability of domestic demand is larger or if the expected profitability is larger. If the variability of foreign demand is equal to the variability of domestic demand, the firm will establish a larger capacity in the foreign location as long as the expected profit margin is positive.

JEL Classification: G39