Integrated Hedging Strategies for Exchange Rate and Commodity Price Risks

We study a firm's hedging strategy when facing both exchange rate and commodity price risks. The firm procures a commodity in the domestic market and sells its product to a foreign market. It has the flexibility to determine its production after the exchange rate and commodity price realizations and may use financial hedging to mitigate the two risks. We find that in a monopoly setting, the firm's hedging strategy is influenced by the correlation between the two risks and their variances. When the correlation between the exchange rate and the commodity price is non-positive, the firm always hedges neither risk, since the non-positive correlation between the two risks provides a natural hedge. When the correlation is positive, the firm chooses to hedge only the less volatile risk if their volatilities differ significantly; otherwise, the firm prefers hedging neither risk. As the correlation between the two risks increases, the firm tends to rely more on financial hedging. When the correlation is sufficiently high, hedging neither risk is no longer optimal, and the firm always chooses sole-hedging strategy. We then extend our model to the duopoly setting, where two firms compete in quantities in the same foreign market and engage in a sequential hedging game. We find that competition drives firms to adopt complementary hedging strategies. For non-positive correlation, one firm hedges both risks while the other firm hedges neither risk. For positive correlation, one firm hedges the exchange rate risk while the other hedges the commodity price risk in equilibrium in most cases. In the latter case, the leader prioritizes hedging foreign exchange exposure to mitigate a strategic vulnerability that its competitor could exploit during adverse currency movements. Our results offer insights on the differentiated hedging strategies of firms in the same industry and the preponderance of global firms in hedging exchange rates.