Inflation and interest rate derivatives for FX risk management: Implications for exporting firms under real wealth

• We analyze firms which are simultaneously exposed to price, FX and cost risks.
• We apply inflation and interest rate derivatives in order to improve the hedging performance.
• A cointegrated VAR model and bootstrap methods are used for empirical evaluations.
• Inflation derivatives perform very well for short hedge horizons.
• Interest rate derivatives are useful for the long-term hedges.

Firms that export goods face risks such as product price, cost, and exchange rate risks. Price and cost risks can substantially reduce the FX hedging performance in real wealth. We thus investigate hedging strategies that are intended to improve the performance of the FX hedge in real terms using inflation and interest rate derivatives. The impact of these additional instruments is not clear and has only been briefly analyzed in the hedging literature so far. For this purpose, we derive variance-minimizing hedge positions of an exporting firm. A cointegrated VAR and bootstrap methods are used to evaluate the efficiencies of several hedging strategies. While inflation derivatives work better in the short run, interest rate derivatives perform better over longer hedge horizons.