Wentong Chen (Santa Clara)

Abstract: Foreign exchange risk management is usually viewed as a decision that stabilizes the hedging firm's own cash flows. This paper shows that, with financial frictions and production networks, a firm's hedging also stabilizes its suppliers and customers. In a model of hedging in a production network, firms finance production before collecting revenue at a borrowing rate that falls with their financial position. By shifting resources across exchange-rate states, hedging changes a firm's borrowing costs, prices, and input purchases, and thereby the costs and demand of connected firms. Using new hand-collected data on U.S. firms' foreign exchange derivatives from 10-K filings, linked to their supply-chain relationships, I find that when a firm's customers (suppliers) first begin to hedge, the volatility of its sales (cost of goods sold) falls by 3.1 percentage points relative to matched firms. In a model calibrated to the U.S. input-output network, hedging offsets one-quarter to two-fifths of the volatility amplification generated by the borrowing-cost channel. An industry's own hedge accounts for almost all of the stabilization of its net worth, whereas the hedging of other industries accounts for about half of the stabilization of its output, and hedging affects other industries most when undertaken by central suppliers. Foreign exchange risk management is thus both a private stabilizer of financial positions and a network stabilizer of real activity.