Optimal Currency Hedging Under Loss Aversion

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Abstract
This paper characterizes optimal currency hedging in several models of downside risk. We consider, in turn, three models of hedging: (i) a firm that chooses its hedging policy in the presence of bankruptcy costs; (ii) an all equity firm that faces a convex tax schedule; and (iii) a firm whose manager is subject to loss aversion. In all these models, and contrary to conventional wisdom, we show that forwards dominate options as hedges of downside risk.