The potential for collaboration in hedging multiple commodity price and exchange rate risks

Firms always encounter risks in the process of production, distribution and marketing due to the structure of the firms, market conditions, or some unforeseen circumstances such as natural catastrophe. Instruments have been developed to help firms deal with such risks, and futures contracts are one of the most commonly used hedging instruments.This study focuses on the optimal hedging strategies of a firm which sells its products in both the domestic and foreign markets, and hence encounters multiple commodity price and exchange rate risks. There are two options available to the firm: either have the risk managers manage the risks separately (i.e. no collaboration) or manage them jointly (i.e. collaboration is permitted). A theoretical model is developed to determine the optimal hedge ratios for each of the options. The results indicate that when the risk managers are allowed to collaborate in their hedging efforts, they will supplement their hedging efforts by using other types of futures contracts that were not previously available to them. In other words, commodity price and exchange rate risks are no longer hedged solely with commodity and currency futures, respectively. Instead, each of the two risks is hedged with both commodity and currency futures.Optimal ex-ante hedge ratios are estimated in this study for each option (suggested by the model) for a firm which sells corn, soybeans or wheat in the U.S. and in Japan during the period between 1983 to 1992. Our results indicate that collaboration has a bigger impact on the firm's overall hedge positions in currency futures than in commodity futures. However, risk managers do not alter their original hedge positions in commodity and currency futures significantly while managing their price and exchange rate risks, respectively.We evaluated the out-of-sample performances of the optimal hedging strategies and a naive hedging strategy relative to an unhedged position using two criteria: (i) the ability of the hedging strategies in reducing the variability of returns (i.e. the hedging effectiveness), and (ii) the excess return generated from the hedging strategies. We picked the preferred hedging strategy using both selection criteria with a ranking system (which can alter the emphasis placed on each criteria). Our results indicate that optimal hedging with collaboration is most successful for a firm selling soybeans in both the U.S. and Japan markets, and least successful for a firm selling wheat in the same markets.U of I OnlyETDs are only available to UIUC Users without author permissio