corporate risk management for multinational corporations.pdfVIP

European Finance Review 2: 229–246, 1999. 229 © 1999 Kluwer Academic Publishers. Printed in the Netherlands. Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies BHAGWAN CHOWDHRY1 and JONATHAN T. B. HOWE2 1The Anderson School at UCLA, 110 Westwood Plaza, Los Angeles, CA 90095-1481, USA; Phone: (310)-825-5883; Fax: (310)-206-5455; E-mail: bhagwan@; 2Hotchkis and Wiley, Division of Merrill Lynch Capital Management Group, Los Angeles; Phone: (213)-362-8949; E-mail: jonathan howe@. Abstract. Under what conditions will a multinational corporation alter its operations to manage its risk exposure? We show that multinational firms will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. Operational hedging is less important for managing short-term exposures, since demand uncertainty is lower in the short term. Opera- tional hedging is also less important for commodity-based firms, which face price but not quantity uncertainty. When the fixed costs of establishing a plant are low or the variability of the exchange rate is high, a firm may benefit from establishing plants in both the domestic and foreign location. Capacity allocated to the foreign location relative to the domestic location will increase when the variability of foreign demand increases relative to the variability of domestic demand or when the expected profit margin is larger. For firms with plants in both a domestic and foreign location, the foreign currency cash flow generally will not be independent of the exchange rate and consequently the optimal financial hedging policy cannot be implemented with forward contracts alone. We show that the optimal financial hedging policy can be implemented using foreign currency call and put options and forward contracts. 1. Introduction Multinational corporations oft