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situations of both firms, with the financially stronger firm producing more than the
financially weaker firm for two reasons. First, the stronger firm has a lower marginal cost
of production as it faces less external financing costs, and second, the stronger firm also
benefits more from a reduction in the competitor’s profits than the financially weaker firm
+ −
since β > β .
190 This creates an incentive for an even more aggressive behavior on the
part of the stronger firm, and hence, the wealthier firm increases its output beyond the
capacity at which it would choose to produce in the absence of the strategic effect.
However, predatory activity by the stronger firm in the form of larger production quantity
may backfire when both firms hedge partially as opposed to a situation of complete
hedging. If the weaker firm benefits from the exchange rate development in a partialhedging
environment and passes the initially stronger firm, an aggressive product-market
strategy would leave the latter further behind. Therefore, the stronger firm is more cautious
in setting its output when it hedges partially. This more conservative behavior of the
financially stronger firm allows the financially weaker one to act more aggressively in the
product market and increase its output relative to an environment with complete hedging.
As a result, in the equilibrium with complete hedging, the differences in production
quantities and – consequently – debt levels are more pronounced than in the partialhedging
equilibrium. Aggregate production, hence, will be lower and the equilibrium price
will be higher when firms hedge their entire exposure. This confirms that hedging itself
feeds back into the degree of product-market competition and influences the production
levels.
190 See Mello/Ruckes [2004] page 12-13 for the derivation of latter proposition.
185