AN ARGUMENT AGAINST HEDGING BY MATCHING THE CURRENCIES OF COSTS AND REVENUES

Trevor S. Harris, Nahum D. Melumad and Toshi Shibano

Journal of Applied Corporate Finance, 1996, vol. 9, issue 3, 90-98

Abstract: One way for multinationals to manage their exposures to foreign currency fluctuations is by matching the currencies of costs and revenues, a practice sometimes referred to as “natural hedging.” Proponents of this risk‐management technique argue that matching currencies decreases profit variability. Using the example of a U.S. firm competing with a French firm for sales in France, the authors analyze the desirability of the U.S. firm's matching currencies of costs and revenues by sourcing in France rather than in the U.S. They find that in such settings with limited competition, while matching reduces profit variability, it also causes a reduction in expected profitability–a potential drawback that appears to have been overlooked in previous discussions. The authors demonstrate that the U.S. firm, by choosing not to match currencies, retains the strategic flexibility to adjust its prices and quantities in order to exploit the competitive cost differentials caused by exchange rate shifts. The expected profit effects of matching depend on the tradeoff between expected cost savings, if any, of sourcing abroad versus the reductions in expected profits due to the loss of strategic flexibility. They argue that the benefits of strategic flexibility associated with sourcing in the U.S. can yield an increase in expected profits that may outweigh the cost savings and hedging benefits of currency matching.

Date: 1996
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