At a lunchtime meeting in London on 9 December, Bernard Dumas suggested that while forward contracts and currency options have proved effective means of reducing risk in managing financial portfolios, they cannot cushion companies engaged in international trade against the risks of exchange rate fluctuations. &nbspHedging techniques are essential tools for managing portfolios of financial assets, he argued, but even the most sophisticated hedges are no substitute for stable exchange rates. Exchange rate instability deters international trade, and only central banks can offset this by stabilizing exchange rates. Dumas is Professor of Finance at &nbspHautes Études Commerciales, Jouy-en-Josas and Co-Director of CEPR's Financial Economics programme. His talk was based on research reported in Discussion Paper No. 1083, `Short and Long-term Hedging for the Corporation'.

Foreign exchange hedging tools are appropriate as hedges of financial investments made in foreign currencies because financial assets are liquid and the gains and losses made on both them and the hedging tools depend on changes in the exchange rate. A portfolio manager can usually trade securities at any time, and for each security a price is quoted almost continuously. Thus, it is legitimate to focus on the rate of return achieved over a relatively short holding period, and the natural objective of a hedging programme is to reduce the conditional variance of the rate of return in each period by attaching a hedge to each investment in the form of a forward contract (or currency option). Because the gain or loss on the forward contract depends on the change in the exchange rate over the holding period, the size of the hedge is determined by the extent to which the holding period return on the portfolio is related to the change in the exchange rate.

Dumas notes that hedging the activities of a commercial firm against exchange rate risk differs in two important ways from portfolio hedging. One is that a firm's assets (its future cash flows) are not usually tradable, and while a firm that undertakes an investment project can shut it down, such decisions involve considerable costs. For most firms, the possibility of trading claims to future operational cash flows is much more limited than that of trading financial claims in the capital market. Hence, corporate officers aim instead to stabilize cash flow, net earnings from year to year or the value of the firm. The other difference is that cash flows, net earnings and the firm's value tend to be correlated not only with recent changes in the exchange rate, but also with the current level of the exchange rate. That rate is not simply the relative price of two moneys or financial assets: because the prices of labour, commodities and services are `sticky' in terms of local currencies, exchange rates also act as the price of goods produced abroad relative to the price of goods produced at home. They have important effects on competitiveness, quantities sold and ultimately the firm's cash flow.

Corporate cash flows generally depend on both levels and changes in exchange rates, and are related to past and current exchange rates via a distributed lag relationship. These lags are linked to the firm's production-shipment-inventory-sales-payment cycle. The adjustment of prices to exchange rates is neither complete nor immediate. As a result, Dumas argues, long-run exposure is related to: the average degree of pass-through; the response of demand; and the rate of mark-up. Even if pass-through is 100%, the amount of profit depends on the exchange rate because of the mark-up. The first step in the analysis of a long-run exposure problem is to establish the distributed lag relationship between prices and exchange rates.

The relationship between cash flows and exchange rate levels is a long-run relationship which, Dumas asserts, could form the basis of a new approach to hedging corporate profits. Conventional hedges are constructed using an estimated relationship between the rate of return on an asset and the change in the exchange rate. Dumas' approach is based instead on a hedge constructed from the relationship between the firm's cash flow and the level of the exchange rate. He illustrates this with the example of an import/export firm which endeavours to hedge its trading activity. This involves measuring the statistical relationship between cash flows and exchange rates, exploring how cash flow depends on the level or the changes in the exchange rate. In the case of an import/export firm, this hinges on the degree and speed at which the firm can pass through to the customer changes in import prices.

Dumas illustrates how his new hedging strategy could reduce the volatility of profits for a UK firm which imported goods priced in US dollars. He notes, however, that a firm's optimal hedging strategy might also be influenced by the industry's average currency hedging policies. For instance, if competitors' treasurers hedge their dollar purchases of imported raw materials by buying dollars before receiving shipments, this may result in a lengthening of the lag between shifts in the translated dollar price and the domestic price, which in turn affect the firm's optimal hedging strategy. And even the most carefully designed programme cannot fully hedge a firm's long-run exposure. Dumas emphasizes this point by demonstrating the problem of hedging a cash flow which is related to the level of the exchange rate. One strategy is to take a forward contract n months in advance, but this only shifts the risk over time and does not change the long-run variability. Another is to take a currency option at the purchasing power parity level of the exchange rate producing a fixed cash flow at maturity, but the premium on the option depends on the earlier exchange rate. The firm could also take a hedge when the exchange rate is at parity or is favourable to the firm and not hedge otherwise, but with what maturity? `Perpetual hedging' implemented as value hedging is effective but its practicality is questionable since its horizon extends beyond most corporate hedging programmes. In addition, it stabilizes value but not cash flow or net earnings.