Dynamic analysis of an open economy and foreign exchange risk management using path-dependent options

The continuing trend towards greater globalization and interdependency of the world economies offers opportunities for long-run efficiency gains for all economies but poses short-run risks for firms operating in international arenas. Recession, inflation, interest rates and exchange rates in a foreign nation impact multinational firms with business interests in that nation, and ultimately affect the domestic economies of such firms. For example, foreign interest rate shocks or exchange rate volatility increases both increase the uncertainty and risk associated with multinational operations. This study examines the impact of foreign economic shocks on domestic economic variables and evaluates the use of options as financial hedging instruments against foreign currency exchange risk. The study is divided into two parts: (1) a dynamic model of an open economy is developed and used to simulate the impact of foreign economic shocks on domestic economic variables; and (2) two types of path dependent options (Average rate and Lookback options) are compared to standard European options as instruments for hedging against foreign exchange risk under various interest rate and exchange rate volatility scenarios.