Efficient market implications for foreign exchange exposure management

Summary Under the hypothesis of efficient foreign exchange markets, the validity of the Purchasing Power Parity theorem may take care of the company’s uncertainty with respect to the mean value of its foreign currency portfolio. The remaining uncertainty, i.e. the variance of the value of the foreign currency portfolio around its mean, can be reduced by hedging. Assuming efficient markets, the expected cost of hedging is equal to the transaction costs incurred. Taking into account the low cost of hedging, one can substantially reduce the foreign exchange risk at a relatively low cost. Hedging should be used more extensively than is common practice.