Re: derivatives & uncertainty

["Abu Rizvi" <srizvi@xxxxxxxxxxxxx>]

Both Tom Dickens and Doug Henwood remark that custom-tailored forward
contracts can be used to hedge exchange rate risk associated with
investment projects.  No doubt.  It is certainly true that
trade--being more short-term--can be hedged more systematically; and
real investment might also be on a one-off basis.

I was just saying that such long-term hedging is neither
automatic nor is it easy.  In other words, it's probably very costly
and rare, and consequently--I conjecture--not empirically a
significant determinant of investment flows.  How many of these
one-off contracts--for real investment purposes--are there?  Are
forward/futures markets for foreign exchange really complete let
alone liquid?  Do they exist, even on a custom basis, for more than a
handful of currencies?

I'm not sure of work on investment, but by now it is widely accepted
that empirically, even with hedging available, trade flows are
significantly lower with flexible exchange rates than would have been
the case with fixed rates.  In other words, exchange-rate volatility
may be reduced by hedging, but hedging at the very least
imposes a cost with real consequences.  (You could still argue that
without hedging, trade flows would be even lower; but I'm only saying
that hedging takes care of short-term uncertainty with a very real,
volume-reducing cost, and that this cost will likely rise more than
proportionately with the extension of the time horizon.)  The references
on this are Thursby and Thursby, RevEconStat, Aug. 1987, pp. 488-95;
and Cushman, JIntEcon, May 1988, pp. 317-30.

--Abu.