Offshore Activities and Financial vs Operational Hedging

A key question is why many globally active firms forgo foreign exchange hedging despite its low costs. We propose an explanation based on incomplete hedging markets that further suggests that operational hedging is often a more effective hedge. We use 10-K filings to construct text-based measures of financial hedging and three offshore activities: the sale of output, the purchase of input, and the ownership of assets that produce input. We find that firms do use foreign exchange hedging when it is effective as a hedge against both foreign price risk and demand shocks (quantity risk). Otherwise, firms purchase input from the same nations they sell output to, a highly effective operational hedge. A series of natural experiments based on the introduction of new currency instruments confirms a likely causal relationship.