Wednesday, May 21, 2008

Does the currency regime shape unhedged currency exposure?

NIPFP Working Paper 50,

Ila Patnaik, Ajay Shah
May, 2008

This paper examines how unhedged currency exposure of firms varies with changes in currency flexibility. A sequence of four time-periods with alternating high and low currency volatility in India provides a natural experiment in which changes in currency exposure of a panel of firms is measured, and the moral hazard versus incomplete markets hypotheses tested. We find that firms carried higher currency exposure in periods when the currency was less flexible. We also find homogeneity of views, where firms set themselves up to benefit from a rupee appreciation, in the later two periods. Our results support the moral hazard hypothesis that low currency flexibility encourages firms to hold unhedged exposure in response to implicit government guarantees.

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