Foreign Exchange Risk Exposure on Toyota Motors
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The globalization phenomenon allows companies to internationally expand their sales and production activities. A consequence of this phenomenon, however, is the existence of foreign exchange rate exposure which can impact the company's profitability, net cash flow and market values. In the past years, several academic researches have been developed in order to explain and analyze how foreign exchange risk exposure fluctuations affect a multinational company or a purely domestic company value, and how this risk is influenced by the company's risk management strategy. Consequently, this dissertation aims to find some knowledge on these subjects for a specific company, Toyota Motor Corporation.
By applying the capital market approach and analyzing three different periods, it is possible to conclude that Toyota Motor Corporation, in a crisis situation, was able to protect itself against some of the primary exchange rates fluctuations it is exposed to. Thus, the predictability of higher fluctuations allows the company to apply effective risk management strategies.
Considering a ten year period, bilateral exchange rate fluctuations are more significant to the company stock returns than for other periods. However, being an exporting company, its coefficient for exposure is not consistent with the competitive advantage an exporter holds when its company home currency depreciates. It is consistent, however, when the broad currency index is considered. Additionally, the impact of foreign exchange risk fluctuations is small for company stock returns. This can thus indicate that exchange rate fluctuations don't have a significant impact on company stock price returns.
The globalization phenomenon has allowed the integration of national economies into the international economy, giving them easier access to information, goods and services through trade and foreign direct investment around the world. This process has been encouraging an increasing number of companies to start operating on a global scale, expanding their networks worldwide. In recent years, the number of multinational companies has grown in order to respond to the competitiveness experienced in the domestic market and explore new markets to produce or sell new products and services. Multinational companies, or purely domestic companies with a broad network, are exposed to several risks. An important risk that has a significant impact on the management of a company is the foreign exchange risk, due to the fact that it may affect the company's cash flows, value and performance. Nevertheless, besides the foreign exchange risk, many other risks affect companies, such as the interest rate risk. Several financial and operating instruments and techniques are being used and developed by multinational companies to handle these risks. However, in order to manage these risks, companies must know exactly what their risks are and how to measure them.
With regard to foreign exchange rate exposure, several studies conducted in recent years have presented various risk management approaches in order to understand to what extent its fluctuations affect the company's value and performance. However, there is little consensus among the different studies, which indicates that exchange rates are complex and can affect and be affected by different factors. The most traditional approaches are the cash flow approach and the capital market approach. In this study, the capital market approach is used to assess, through quantitative methods, to what extent foreign exchange rate fluctuations affect the company's value. It is important to note that several studies using quantitative methods found no statistical significance when trying to understand the impacts of foreign exchange fluctuations on the company's value. Thus, an explanation given for this fact was that the company was able to protect itself against foreign exchange rate fluctuations by means of hedging instruments and techniques.
The main purpose of this study is to analyze the foreign exchange risk exposure of a multinational company using the capital market approach, and also to what extent the various assumptions underlying this approach produce different results. The choice of the multinational company was based on the following requirements: it had to be a public company operating in a competitive industry and could not be the subject of any other study in the same area. Accordingly, the Toyota Motor Corporation was chosen. Its main plants are located in Japan; it operates in the Automotive Industry and was the world's largest manufacturer in 2009. Furthermore, 61.4% of total sales to external costumers are overseas, which indicates that the company is likely to face considerable impacts from foreign exchange risk exposure.
In order to achieve the main purpose of this study, Toyota's foreign operations are analyzed in a first phase to understand to what extent the company is internationalized. Moreover, this initial analysis also envisages the foreign exchange rate fluctuations against the company's stock price returns and their direct impact on its report accounts, as well as the hedging instruments used to handle the foreign exchange risk.
In a second phase, the capital market approach is used to suggest that foreign exchange risk exposure could be measured as the sensitivity of stock price returns to exchange rate movements. This approach requires the implementation of statistical regressions. For this purpose, market, stock price and foreign exchange rate data were collected from 1999 to 2009. Considering the studies developed by different authors, regressions involve several hypotheses for the exchange rate variables, such as a Nominal Broad Index that is like a basket of currencies and several bilateral exchange rates, in order to understand which variables affect stock price returns. In this second phase, the quantitative method is applied to three different periods in order to compare how the company handles the foreign exchange risk. As this dissertation takes into account the investor's point of view, it can help to understand how investors determine and quantify the exposure of their portfolio to the foreign exchange risk. Moreover, this approach allows comparing the company's exposure to foreign exchange rate fluctuations with that of competitors in order to understand the effectiveness of the hedging activities.
To complement this study, this dissertation is organized under the following sections:
The first section is a thorough review of the literature on this subject. It explains why it is important that companies know how to handle the foreign exchange risk and presents the findings of past research.
In the second section, the traditional categories of foreign exchange risk exposure are described, the effects of hedging the foreign exchange risks are shown and the most used analysis methods are discussed.
The third section provides an overview of Toyota and an analysis of its foreign operations. The main purpose of this section is to support the interpretations that emerge from the regression results and this information is used as the basis for selecting the variables for the regression model.
In the fourth section, relevant analyses are provided about the variables that may be a source of risk for Toyota and which were chosen for the regression model. In addition to this, it presents the hedging programs undertaken, the designated and undesignated financial instruments used and the reasons why the company does not need to have financial instruments to hedge translation and economic exposure.
The fifth section describes the methodology used. The reasoning, as well as the issues of each variable included in the model, is expressed in this section. It also presents the study time periods and data sources. In addition to this, it provides an analysis of the descriptive statistics for the data and different periods used in the model.
The sixth section contains the regression results and provides an analysis and explanation of the findings. It also presents the limitations of the software used for the regressions and a brief analysis of the foreign exchange risk exposure of Honda and Nissan Motor Corporation.
The seventh and last section summarizes the main conclusions of this study and presents some suggestions for further research.
The goal of creating a global business has, in the past years, been the fundamental reason behind the growth of multinational companies. Such an example is the registered growth in Japanese companies' exports. In 2000 and 2009, exports from Japanese companies amounted to 0.8%  and 10.8%1 of the GDP, respectively. An annual growth of 32.9% in foreign activity, for a nine year period, is one of many advantages that companies can obtain by opening themselves in many ways. Other advantages include the opportunity to diversify labor force, to enter new markets and sell more, to reduce transport costs and to benefit from economies of scale. This, however, also creates new problems, challenges and demands.
A multinational company is either a company with operating subsidiaries, branches or affiliates in more than one country, or a purely domestic company engaged in international activities (imports and exports). Some of the new problems and challenges these companies face include an increased exposure to foreign risks, such as exchange rates, interest rates and commodity prices [Miller, 1998]. Moreover, the risks associated to exchange rates appear do to the contact with new currencies  . Exchange rates constitute one of the most important macroeconomic risks, which can potentially impact, positively or negatively, the companies' profitability, cash-flows and market value, due to exchange rate fluctuations. Consequently, in order to handle exchange risk exposure, companies can adopt several hedging tools.
In the past decades, thanks to the increasing number of international trade activities and multinational enterprises, as well as the large currency fluctuations registered, the volume of research that tries to measure and analyze the impact of exchange rate fluctuations in multinational companies and their vulnerability to it has grown. However, produced results/conclusions have a mixed nature due to the complexity of this subject.
The main goal in this section is to understand, through previous researches, what types of companies are most affected by exchange risk exposure, the importance of hedging, several types of foreign exchange risk exposure, types of hedging activities depending on the foreign exchange risk exposure the company is facing and traditional approaches to measure exchange risk exposure.
Exchange Risk Exposure of Multinational Companies vs. Domestic Companies
Thanks to the phenomenon of globalization, as well as the increase in companies' foreign activities, several researches have been developed in order to give some input on what type of companies show a higher exchange risk exposure: multinational or domestic companies.
The results of previous empirical studies suggest that only certain industries and/or companies are exposed to foreign exchange risk  . In the other hand, even a purely domestic company with importing or exporting activities is impacted by fluctuations in exchange rates. This idea is connected with competitive advantage; for instance, the products an exporting company sells abroad can still affect the company's value due to the effect of exchange rate fluctuations in competitors, suppliers and in customers' demands. Muller and Verschoor (2006) concluded in their study that a company's size is also an indicator of its foreign exposure. They found that a company's lower dividend payout ratio results in a stronger short-term liquidity position and, consequently, a smaller hedging motivation and a higher exchange risk exposure.
Other authors however, such as Choi and Jiang (2009), defend that multinationality is important for a company's exchange exposure, but not in the popular notion that was mentioned. Some authors found evidences that foreign exchange risk exposure is actually higher and more significant in absolute magnitude for domestic companies, when compared to multinational companies. The existing explanation for this finding is the fact that multinational enterprises are more capable to effectively and easily use financial hedging and operational hedging in order to reduce their position against foreign exchange risk, and also to increase their stock returns. Additionally, these companies are more aware of foreign exchange risks. Dominguez and Tesar (2006) agree with this finding and they also found that small companies, rather than large and medium-sized companies, show a higher exposure due to the same reasons. As a result, companies that don't engage directly in international business but compete against foreign companies can be affected by exchange rate fluctuations [Dominguez, Tesar, 2006]. Dominguez and Tesar (2006) also found that the industry level may influence exposure. They suggest that exposure increases in highly competitive industries. In more competitive industries, however, an almost perfect pass-through can be expected since they are more aware of their vulnerability and are consequently better motivated to hedge foreign exchange risks, when compared with less competitive industries  .
Regarding purely domestic companies, Pritamani, Some and Singal (2005) found that importing companies are more affected by fluctuations in exchange rates than exporting companies. Therefore, companies with importing activities should have more reasons to hedge exchange risk exposure.
The Importance of Hedging Exchange Risk Exposure
Hedging means taking a position when acquiring a cash-flow, an asset or a contract in order to protect the owner from losses and to eliminate any gain in the position hedged. Several researches indicate that currency risk management is very important to manage earnings and unexpected losses. Consequently, this should be done in order to reduce any impacts on the stockholder's equity and to prevent value declines for the equity holder due to cash flow changes and unfavorable exchange rate fluctuations, respectively. Hedging currency exposure can therefore reduce some of the expected fluctuations in future cash flows and increase their predictability [Smith and Stulz, 1985].
It is believed that foreign exchange rate fluctuations impact 'financial decision-making in production, marketing, planning and strategy' [Moffett and Karlsen, 1994]. It is therefore necessary to make contingent investments or develop long-term strategic plans and management perspectives in order to understand the volatility of foreign exchange. Companies can implement hedging tools based on policies that define when and how to hedge against foreign exchange risks. Hedging tools are not static mechanisms, companies are able to dynamically adjust their behavior in response to foreign exchange risks; for instance, a company can decide to hedge only part of their foreign transactions. To undertake these policies, the company needs to determine its risk tolerance and needs to understand the direction that the currency to which it is exposed is likely to take.
A value maximization corporation that hedges its exposure to exchange risks can reduce the costs connected to financial distresses and taxes, as well as agency problems existing between shareholders and bondholders [Martin and Mauer, 2005]  . A possible reduction of financial distress costs allows investors to require lower risk premiums. Consequently, the company value increases [Smith and Stulz, 1985]. Therefore, as mentioned by Smith and Stulz (1985), 'hedging is part of the overall corporate financing policy'.
Moreover, Dumas and Solnik (1995) concluded that part of the return rate of an asset's price is influenced by the foreign exchange risk premium. Thus, when a company implements risk management activities that decrease its foreign exchange risk exposure, the cost of capital is reduced.
Some authors sustain that exposure management may not reduce total risk. Copeland and Joshi (1996) argued that anticipating hedging strategies is difficult given that so many other economic factors change when foreign exchange rates fluctuate. This is confirmed by Moffett and Karlsen (1994), who argue that the uncertain nature of future cash-flows hinders the implementation of long-term strategic plans and better investment decisions.
It is also argued that risks connected to an inefficient hedging activity can increase exposure [Hagelin and Pramborg, 2004]. Additionally, currency risk management usually consumes some of the company's resources, consequently lowering its expected cash-flow [Eitman, Stonehil and Moffett, 2010]. Therefore, companies need to know whether their hedging strategies are successful or not, and if they are relevant to shareholders [Hagelin and Pramborg, 2004].
Findings regarding the Vulnerability of Multinational Companies to Foreign Exchange Risk Exposure
Hedging tools that handle exposure to foreign exchange risks are not simple and they don't hold only a few complexities, since the company's exchange risk exposure correlates with its 'size, multinational status, foreign sales, international assets and competitiveness and trade at the industry' [Dominguez, Tesar, 2006].
Adler and Dumas (1984) suggested that a company's foreign exchange risk exposure can be measured by the stock prices' sensitivity to unexpected foreign exchange rate fluctuations. On the other hand, it could also be measured as the company's cash flows sensitivity to foreign exchange rate fluctuations. Considering that the main goal of this dissertation is to analyze economic exposure, it is important to note that several authors have developed researches that try to measure and analyze unexpected impacts of exchange rate fluctuations on companies' performances, portfolios and Industries. Nevertheless, these researches have produced mixed empirical results.
Jorion (1990) found that only 15 of 287 US multinational companies were statistically significant concerning the impacts of exchange rate fluctuations in companies' stock returns. Additionally, the author detected that higher company foreign operations reflected higher exposure to exchange risks. Nevertheless, Bartov and Bodnar (1994) found that 208 of the companies with foreign operations that composed their sample were not statistically significant to the effect of US exchange rate fluctuations on companies' stock price returns.
Additionally, other researchers have reached mixed conclusions using different methodologies, samples and alternatives for the main variables. The inconsistency in these results, therefore, doesn't allow a sustainable conclusion on this subject. Recent studies, however, found evidences that exchange rate fluctuations do have an impact in companies' performances. Such an example is the research developed by Dominguez and Teaser (2006), who found exposure to be statistically significant due to the effect of exchange rate movements on stock returns at Industry and country level.
Some explanations have been pointed out by several authors for these mixed results. The registered contradiction can be explained by limitations concerning data, variables and methodologies used. Different researches develop different alternatives in order to determine foreign exchange risk factors and company values, which include different samples, the use of companies with less opened economies (USA) or more opened economies and different periods; all of these affect research. Bartram (2008) also explains that the use of stock returns to measure company value reflects the hedging position of companies, and the analysis is thus considering a lower level of risk exposure. Crabb (2002) also suggests that these mixed results can reflect different financial hedging strategies on data or simply reflect noisy data. Additionally, Bartram and Bodnar (2007) found that operational hedging activities help companies reduce their exposure and, consequently, have no statistical significance over the impact of foreign exchange rate fluctuations on companies' returns. Therefore, as suggested by Crabb (2002), a statistically non significant exposure to exchange rates can result from an efficient hedging strategy set in place by the company.
Types of Foreign Exchange Risk Exposure
The hedging decision depends essentially on the level of risk exposure, its magnitude and the magnitude of hedging that companies deem necessary. Companies should essentially hedge activities that put them in a position with a high level of uncertainty, i.e., risk exposure in the strategy field (competitive, input supply, market demand and technological risk) and fields of interest to finance and international business scholars (foreign exchange risk), [Miller, 1998].
Before initiating the hedging process, the company has to decide what exchange risk exposure to hedge and how. There are three traditional foreign exchange rate exposure categories  that impact companies and that have a specific managing method: the transaction exposure, the operating exposure and the translation exposure. Generally, these exchange risk exposures can be hedged through the use of derivatives and financial instruments, such as commodities, futures and forward contracts, options and swaps [Miller, 1998].
The main goal of this dissertation is to measure and to analyze how unexpected foreign exchange rate fluctuations affect a multinational company. Notwithstanding it is also important to understand how the other two types of exposure impact companies and the types of hedging mechanisms available to handle exposure, in order to reach a deeper analysis and optimal conclusions.
Economic exposure, also known as operating exposure, is an unexpected change in exchange rates that affects the present value of the company by changing future operating cash flows, arising from inter-company and intra-company activities [Eitman, Stonehil and Moffett, 2010]. The unexpected exchange rate fluctuations affect the expected future operating cash-flows changing the volume, price and/or costs of future sales [Moffett and Karlsen, 1994].
Economic exposure approaches the impact of long-term currency exposure and analyzes the health of a company's business in the long run. The changes registered in the expected future cash flows depend of the change in the position the company holds in international competition  . Managing economic exposure involves all aspects of a company.
Before establishing hedging policies, a company needs to measure its economic exposure. In order to do that a company should invest some resources in assessing its exposure, i.e., identifying the set of environmental contingencies affecting and relevant to the creation of shareholder value [Miller, 1998]. This identification allows the assessment of alternative environmental scenarios and consequent adoption of improved strategic decisions by the company. This is the reason why identifying and measuring economic exposure can be complex and difficult, bearing in mind that environmental contingencies vary across industries and across companies within those industries. Moreover, some authors mention economic exposure as being subjective, since it is based in estimates of future cash flows.
The main goal of economic exposure management is to anticipate and influence unexpected and unpredictable effects in exchange rates. This can be accomplished if a company diversifies and changes its international operating and/or financing policies. This diversity allows the company to react in an active or passive way.
The company can diversify operations through sales, location of production facilities and raw material sources or inputs [Eitman, Stonehil and Moffett, 2010]. A company can expand its sales through subsidiaries distributed across different countries, bringing its products or services to new markets and taking advantage of economies of scale, being also capable of diversifying its exposure to foreign exchange risks. Flexible management policies allowing a faster sourcing of raw materials and components can easily mitigate this exposure if this adaptation considers the impact of exchange rate fluctuations in the company costs and revenues. Additionally, R&D can also mitigate this exposure, allowing the cutting back of costs and enhancing productivity as well as product differentiation.
Choi (1989)  pointed out that international investment is one of the major instruments in managing economic exposure. In the same line, Miller and Reuer (1998) developed a study that showed this exposure is considerably reduced with a higher and direct foreign investment by the company (foreign market entry mode). Additionally, Smith and Stulz (1985) found that mergers achieve results that are similar to hedging results. Consequently, a company may wish to diversify the location of its production facilities internationally in order to mitigate the effect of exchange rate movements. This mitigation is possible because the company measures its cash flows in different currencies. Thus, exchange rate fluctuations in all currencies the company is exposed to can be naturally offset as can, consequently, the gains or losses while the company still reacts competitively.
Diversification in financing is achieved by raising funds in more than one capital market and in more than one currency  . This method allows the company to reduce future cash-flow variability, to increase capital availability and to reduce costs, as well several risks, such as political risks.
Allayannis et. al. (2001) observed that companies with geographical dispersion are more likely to use financial hedging strategies to lower their foreign exchange risk exposure. Accordingly, the use of exclusively operational hedging does not increase the company's value. However, if companies combine operational and financial hedging they will improve their value and, consequently, reduce exposure to foreign exchange risks.
Companies can also adopt proactive policies (including operating and financing policies) to offset anticipated foreign exchange risk exposures. These policies allow a partial management of this exposure. The most generally employed are  : matching currency cash flows, risk-sharing agreements, back-to-back loans, currency swaps, leads and lags and reinvoicing centers. [Eitman, Stonehil and Moffett (2010)].
Transaction exposure measures gains or losses resulting from unexpected changes in future cash flows already contracted in a currency-denominated transaction [Martin and Mauer, 2005]. The uncertainty stems from the 'impact of exchange rate changes on the consolidated financial reports' [Friberg and Ganslandt, 2007] and the fact that it is not anticipated in any line item of a financial statement [Eitman, Stonehil and Moffett, 2010]. Thus, 'the uncertainty can be the specific quantity of foreign currency or the timing of cash-flow' [Moffet and Karlsen, 1994].
Transaction exposure approaches foreign exchange risk exposure in the short-term. It is therefore easier to identify and to measure, allowing a greater effectiveness of hedging strategies to be expected.
The exposure to foreign exchange transactions can be hedged by contractual, natural, operating and financial hedges. The company, however, needs to determine its own risk tolerance and its expectations concerning the direction the exchange rates will assume. Contractual techniques include hedges in forward  , policies that imply proportional hedging.
A natural hedge is basically an unhedged position where the transaction is left uncovered. Crabb (2004) suggests that this is not a very good hedge because it doesn't control variation over time and, consequently, companies cannot perfectly hedge their exchange rate exposure.
An operating hedge means that the company will simply create an off-setting operating cash-flow (account payables, for instance). This hedge can also be implemented through several techniques, such as invoice currency, leads and lags in payment terms and exposure netting [Eun and Resnick, 2004].
Hedging through invoice currency allows the company to shift its foreign exchange risk exposure, invoicing foreign sales in home currency, or share foreign exchange risk exposure  , pro-rating the invoice currency between foreign and home currencies. Additionally, a company can also diversify its exposure to foreign exchange risks by invoicing sales in a market basket index [Eun and Resnick, 2004].
By hedging with leads and lags companies can accelerate or decelerate the timing of payments (receipts) made (received) in foreign currencies. This hedging strategy is efficient if a currency is expected to appreciate or depreciate against another [Eun and Resnick, 2004].
Finally, the technique of exposure netting suggests that a multinational company should not consider its deals in isolation, focusing rather on hedging the company in a portfolio of currency positions. This means that companies should consider overall payments (receipts) that must be done (received) after taking in account the opposite operations that naturally hedge each other. To use this technique some companies have re-invoicing centers, separate corporate subsidiaries that serve the parent or related unit in one location and all foreign subsidiaries. The reinvoicing center receives the invoice between the subsidiaries, taking legal title of the good that manufacturing plants sells to distribution subsidiaries of the same company, managing all foreign exchange transaction exposure for intracompany sales [Eun and Resnick, 2004]. Additionally, the reinvoicing centers can guarantee the exchange rate for future ordersÂ and also manage intra-subsidiary cash flows [Eitman, Stonehil and Moffett (2010)].
Financial hedging refers to the creation of an off-setting financial cash flow by either borrowing or lending in the currency the company is exposed to. The company can use some type of proactive policies such as back-to-back loans and currency swaps.
A back-to-back loan occurs when two companies in different countries coordinate themselves to borrow each other's currency for a specific period of time. They then return the borrowed currencies at an agreed terminal date.
By hedging via currency swap, the company and a swap dealer agree to exchange an equivalent amount in two different currencies (for instance, a company enters a swap paying yens and receiving dollars) for a specified period of time. The swap dealer assumes the role of a middleman.
A matching currency cash flow proactive policy can act like a financial hedge or an operational hedge. The first alternative to offset a long-anticipated and continuous exposure to a particular currency (i.e., the Japanese Yen) is to acquire debt in that currency (in Yens). Suppose the following exposure: A US Corporation exports goods to a Japanese corporation. The inflow of the Japanese Yen creates a foreign currency exposure. An hedging technique requires that the debt payments in Japanese Yens, which consist of the principal and the interests paid by the US Corporation to the Japanese Bank, act like a financial hedge by requiring a debt service, an outflow of Japanese Yens. As a second alternative, the US Corporation can seek potential raw material or component suppliers in Japan as a substitute for an American or another foreign company. This alternative grants the US Company both an operational cash inflow (the receivables) and an operational cash outflow (the payables) in Japanese Yens. This alternative is called an operational hedging. In a final alternative, the US Corporation can pay its foreign suppliers in Japanese Yens, if the suppliers have a Japanese Yen shortage in their multinational cash-flow network (currency switching).
Translation exposure, also known as accounting-based exposure, results from the translation of foreign subsidiaries financial statements, stated in their foreign currency, into the parent's reporting currency in order to prepare consolidated financial statements. This exposure can potentially increase or decrease the owner's equity and net income, due to exchange rate fluctuations [Moffet and Karlsen, 1994]. The difference between translation exposure and transaction exposure is that the former doesn't have direct cash flows effects.
Like the transaction exposure, translation exposure is easily identified and hedged [Friberg and Ganslandt, 2007]. However, finance literature suggests that companies shouldn't worry about this exposure and, consequently, shouldn't hedge it, since its gains (losses) tend to be irrelevant, to have little direct impact on companies' cash flows, and to be poor estimators of real changes occurring in companies' value. Nevertheless, the work by Nydahl (1999), Hagelin and Pramborg (2004) found a significant reduction in foreign exchange exposure by hedging translation exposure. A possible explanation offered by the authors is that translation exposure approximates the exposed value of future cash flows from operations in foreign subsidiaries. Thus, reducing translation exposure will reduce economic exposure at the same time. Eitman, Stonehil and Moffett (2010) and Eun and Resnick (2004), however, suggest something different and defend that while reducing translation exposure managers usually change the transaction exposure amount, and vice-versa, being sometimes very difficult for a company to offset both at the same time.
There are two existing methods to hedge translation exposure: balance sheet hedge and derivatives hedge.
Balance sheet hedge is used to remove the mismatch determined between assets and liabilities for same currency. This hedging strategy allows the increase or decrease of assets or liabilities both in the parent company and any of its subsidiaries, in order to remove the exposure to exchange rate fluctuations. A loan can acts as a balance sheet hedge.
Derivatives hedge is an action that involves the speculation of foreign exchange rate fluctuations. Such an example is the companies' attempt to hedge in the forward market (the use of forward contracts with maturity of the reporting period to manage accounting numbers). To be successful in this technique, however, a company needs to predict the future exchange rates, and that is a difficult task.
Measurement of Exchange Rate Exposure
The main goal of this section is to explain two of the primary frameworks used in measuring foreign exchange risk: the capital market approach and the cash flow approach. These are important frameworks since they measure foreign exchange risk and allow its diversification. Both address different questions and have different applications.
The capital market approach is applied in order to understand the impact of overall foreign exchange risk exposure on a company's value. This framework approaches exposure from a decision maker's point of view (analysts, investors and portfolio managers), whose primary interest is to maximize value.
The cash flow approach is used when there are concerns about specific conditions in a company. In other words, it is used in a corporate point of view (company executives, employees and bondholders), where the sensitivity of different cash flows provides information for risk management and corporate planning purposes. Additionally, even though it is less direct, this approach can have implications in assessing a company's value  .
Capital Market Approach
Adler and Dumas (1984) and Miller (1998) determined the exchange rate exposure as the elasticity of the company's value with respect to exchange rate fluctuations, which can be obtained by regression, under the assumption that a company's market value is the 'present value of all future cash-flows'  .
Therefore, the following regression quantifies the asset's sensitivity of the company to foreign exchange rate fluctuations, net of hedging effects:
Where is the total return of the company i at time t, is the total exposure elasticity of the company I, is the change percentage in an exchange rate variable, defined as the price of foreign currency in home currency at time t, and represents the white noise error term.
Improvements were made since then. Several researches have included the returns of a market portfolio. This inclusion controls macroeconomic influences and reduces residual variance in regressions [Bodnar and Wong, 2003]. The precision and definition of the exposure are thus improved, essentially thanks to its natural flexibility characteristic and to looking forward in forming its expectations. Another advantage is that future cash flow implications of foreign exchange rate changes would be rapidly imbedded in stock returns due to readily available information and high level market efficiency, incorporated by this methodology [Martin and Mauer, 2005].
In this approach, the exchange risk exposure affecting a company results from the exchange rate's volatility effect on the company's value when global markets react excessively to foreign exchange rate movements.
This is considered the traditional approach to estimate exposures:
Where, is the total return on market portfolio, is the company's beta concerning market portfolio and is the company's residual exposure elasticity  .
This residual exposure reflects returns' fluctuations that can be explained by exchange rate movements after market returns are taken in consideration [Dominguez and Tesar, 2006]. Residual exposure seems to overcome the disadvantage of total exposure, meaning it allows the distinction between the effect of exchange rate fluctuations and macroeconomic shocks in the company's value (stock price returns).
The market return variable of the regression implies that different market portfolio constructions have a different impact on exposure estimates, thanks to the size effect in exchange rate exposure. This can represent a problem in this model12.
Additionally, considering that this approach allows an understanding of the risk level an investor faces when market returns are incorporated, the investor can optimize his risk level and his returns and, consequently, diversify his portfolio.
Cash Flow Approach
This approach examines the impact of exchange rate fluctuations on companies by measuring its impact on the company's cash flow. This method is of interest to company managers, who want to understand how foreign exchange risks impact cash flow volatility  .
This cash flow modeling approach, however, is not so flexible because it derives from historic data. This is a past-oriented approach focused on the impact of exchange rate volatility on current cash flows. Therefore, it does not include expectations and it doesn't measure the total impact of exchange rate movements on a company's value. Besides, it is difficult to incorporate complex data in this model, such as competitive reactions and the impact of market parameters and structure. Moreover, since this method doesn't have readily available cash flow data  and doesn't easily access information, it is only efficient in determining exposure for specific situations. This methodology allows the understanding of 'past exposure patterns and permits a decomposition of exposure into short-term and long-term components'. This decomposition allows to understand the nature of existing exposures and, consequently, to know the nature of the exposure, and the company is able to evaluate the effectiveness of its hedging programs and efforts [Martin and Mauer, 2005]. This means that it is possible to know if the risk exposure the company faces stems from financial and/or accounting cash flows. Furthermore, it has the advantage of distinguishing between transaction and the hedging for economic exposure [Muller and Verschoor, 2006]. Some authors, such as Martina and Mauer (2005), assume that this approach is a more accurate measure for translation and transaction exposure given that cash flows derive from accounting figures.
This cash flow methodology is based on the following regression; several researches add variables for other macroeconomic risks (such as interest rate, inflation and company- and Industry-specific variables):
Where represents the cash flow variable.
Capital Market Approach vs. Cash Flow Approach
Considering all mentioned advantages and disadvantages for each approach, some authors assume that the best one depends on the intended point of view. Consequently, if one intends to have a model that includes expectations and the total impact of exchange rate fluctuations on a company's value, Griffin and Stulz (2001) suggest the capital market approach because it potentially allows the understanding of foreign exchange exposure  .
At least two studies tried to identify the best method.
The study developed by Bartram (2007)  shows that the exposures based on the cash flow approach are similar to the exposures based on the capital market approach. They only differ in about 10% of all cases. Additionally, this study indicated that in the long term accounting measures became worse proxies for economic exposure.
Martin and Mauer (2005) achieved two different empirical results. In the first place, the authors found evidences of the capital market approach's strength, because in this sample 25% of the banks  , which means readily-available information may be the most accurate. The authors suggest that greater disclosure can improve statistical significance detection by the capital market. As a conclusion of their study, they support that the main advantage behind the cash flow approach is the ability to reveal the nature of the company's exposure and, consequently, the effectiveness of the company's hedging strategies. The authors therefore believe that, considering the advantages of the cash flow approach, the capital market participants can benefit from the information achieved through this method.
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