Hedging and nonlinear risk exposure

This paper documents some empirical evidence of nonlinear spot-futuresexchange rates relationships and develops an expected utilitymodel of an exporting firm to examine the associated economicimplications. The model shows that the firm should export more(less) and adopt an over (under) hedge in an unbiased currencyfutures market if the spot-futures exchange rates relationshipsis convex (concave) rather than linear. When fairly priced currencyoptions on futures are available, the firm should use them inconjunction with the currency futures so as to achieve betterhedging against its nonlinear exchange rate risk exposure. Thisprovides a rationale for the hedging role of options when theunderlying uncertainty is nonlinear in nature.