Can hedging insulate firms from exchange rate risk?
If exchange rate risk were a major impediment to trade, a currency union with one or more of our trading partners could facilitate trade with those partners. However, it is often suggested that exchange rate risk should not impede trade, because firms can manage the effect of exchange rate fluctuations by hedging. In this article, we examine whether hedging really can eliminate exchange rate risk. We find that hedging known short-term exposures is relatively simple, but that longer-term hedging is more expensive and has the potential to create risks as well as alleviate them. It is in the latter area that exchange rate risk is likely to have the greatest implications for trade.