Currency Hedging: Managing Cash Flow Exposure

Foreign currency derivative markets are among the largest in the world, yet their role in emerging markets is relatively understudied. We study firms' currency risk exposure and their hedging choices by employing a unique dataset covering the universe of FX derivatives transactions in Chile since 2005, together with firm-level information on sales, international trade, trade credits and foreign currency debt. We uncover four novel facts: (i) natural hedging of currency risk is limited, (ii) financial hedging is more likely to be used by larger firms and for larger amounts, (iii) firms in international trade are more likely to use FX derivatives to hedge their gross --not net-- cash currency risk, and (iv) firms are more likely to pay higher premiums for longer maturity contracts. We then show that financial intermediaries can affect the forward exchange rate market through a liquidity channel, by leveraging a regulatory negative supply shock that reduced firms' use of FX derivatives and increased the forward premiums.