Real Exposure to Foreign Currency Risk

The Adler‐Dumas regression approach to foreign currency exposure measurement and hedging is examined in the presence of an uncertain domestic inflation rate. The assumption made here is that the investor is primarily concerned with the real, and not the nominal, value of the domestic currency value of his foreign currency cash flow. A revised measure of exposure, real exposure, is developed and shown to exhibit a numerical value less than that of the Adler‐Dumas measure. A revised optimal hedging amount which minimizes the variance of the investor's real terminal cash flow is calculated. It is shown to exhibit a numerical value less than that of the Adler‐Dumas optimal hedging amount. Thus a financial manager who ignores the positive correlation between the domestic inflation rate and the exchange rate would tend to overstate his company's exposure and engage in excessive foreign currency hedging. The correct exposure measure and the appropriate amount of foreign currency hedging can be obtained by employing inflation‐adjusted, rather than nominal, cash flows.