Forward Contracts: Pricing, Default Risk and Optimal Use

This paper addresses two related issues: the equilibrium pricing of default risk in foreign exchange forward contracts and the optimal use of such contracts for hedging given that the forward price reflects default risk. A model is developed where the motivation for hedging is to avoid deadweight losses associated with bankruptcy. In this model, not all firms that would hedge if forward contracts were default-free will be willing to hedge. We show which firms should hedge and discuss the relationship between forward hedging and hedging with tutures