The Real Costs of Hedging in the Forward Exchange Market: An Empirical Investigation.

This paper estimates the real costs of hedging in the forward exchange market. The hedging costs can only be determined at termination of the hedging period. This analysis presents the derivation of the average hedging costs for seven major currencies that would have been incurred by a U.S. firm over the 1978-1981 time frame. The empirical results lead to vital implications for corporations which hedge. The hedging cost of each currency was derived for all observations so that an average could be obtained. These costs are then transformed to represent an average hedging cost per dollar's worth of a foreign currency hedging. The average hedging costs were then obtained for seven currencies. These figures apply to a U.S. corporation which purchases these currencies forward. Note that the average cost of hedging varies with the currency of concern. In general, a U.S. firm incurs a very low hedging cost from purchasing Sterling forward, while the forward purchases of other currencies are more costly. Even high-cost hedges are worthwhile for firms which are strongly averse to exchange rate risk.