Managing Foreign Exchange Risk in International Trade
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MANAGING FOREIGN EXCHANGE RISK IN INTERNATIONAL TRADE WITH A FOCUS ON EAST MIDLANDS COMPANIES
The purpose of this research is to investigate how international trade companies in the East Midlands manage foreign exchange risk.
This study utilises descriptive statistics in presenting and analysing data from the primary research.
The findings of the research indicate that a majority of the firms used broad business strategies in managing their foreign exchange risk. The main problems the firms had with managing foreign exchange risks centred on customer retention and receiving payments on time. The results also indicate that there were a few firms which took an integrated approach to mitigating foreign exchange risk.
This research is of value to firms involved in international trade and also business development agencies which seek to assist firms which are planning to enter or are already operating in foreign markets.
International trade involves exporting and importing of goods or services across foreign borders and, as soon as a firm engages in import and/or export it is exposed to numerous risks. As a result firms operating outside their home country, have to deal with the economic conditions of the foreign country in which it wishes to operate in. One of the key issues firms involved in import and/ or export are faced with is dealing with foreign currency as this is the only means by which the exchange of goods or services is facilitated. To this end it is import to study and understand the impact which foreign currency has on international trade.
Following the demise of the Bretton Woods agreement (1971) whereby exchange rates were allowed to float freely, managing foreign exchange has become important (Heakel, 2009). Consequently the prices of currencies were determined by market forces that is, demand for and supply of money (Mastry and Salam, 2007). Due to the constant changes in demand and supply which are in turn influenced by other external factors, fluctuations arise (Czinkota et al, 2009). As a result of these fluctuations firms are exposed to foreign exchange risks also known as currency risks. Firms trading in different currencies are exposed to three types of foreign exchange risks; economic, transaction and translational risk (Czinkota et al, 2009). Firms which are involved in international trade are exposed to economic and transaction risks as they both pose potential threats to the firm's cash flow over time (Czinkota et al, 2009). Studies have shown that foreign exchange fluctuations can affect the value of a firm's cash flow over time (Aretz, Bartram and Dufey, 2007, Judge, 2004, Bradley and Moles 2002, Allayannis and Ofek 1998, Chowdhry, 1995, Damant, 2002 and Wong 2001). More so, domestic firms although not dealing with foreign currency are also affected by foreign exchange fluctuations as the price of the commodity they trade in are also affected (Abor, 2005).
Most of the extant literatures have focused on corporate risk management for financial firms and as such financial hedging with derivatives has been the central theme of currency risk management. On the other hand there has been evidence to show alternative methods exist for firms involved in international trade, these methods of managing foreign exchange risks involve strategic and operational risk management.
However most of these studies have been carried out in isolation; financial hedging techniques carried out in isolation of strategic and operational hedging methods and vice versa. Little has been done to provide an integrated perspective, on utilising both techniques of managing foreign exchange risks with regards to international trade firms. This is the area in which the present study intends to explore thereby contributing to the overall literature
Purpose of the Research
Due to the nature of international trade which expose the firm to foreign exchange movements, thus subjecting the firm to currency risks, the purpose of this research is to explore how international trade firms deal with foreign exchange risk. The research focuses how import and export firms in the East Midlands manage their foreign exchange risk. This study also aims to explore the problems involved in managing those risks.
Consequently the research hopes to answer the following questions:
Do import and export firms in the East Midlands actually manage their foreign exchange rate risks?
How import and export companies in the East Midlands manage their foreign exchange risks?
What problems they encounter with managing these risks?
Definition of Key Terms
A hedge can be defined as “making an investment to reduce the risk of adverse price movements in an asset. Investors use this strategy when they are unsure of what the market will do” (Investopedia, 2010).
Derivatives are instruments whose performance is derived from an underlying asset (Arnold, 2002)
The spot rate is defined as the rate of exchange quoted immediately if buying or selling currency (Watson and Head)
This involves the flow of goods and services between nations; it involves import and/ export of goods and services (Harrison et al, 2000)
The subsequent section provides a break down of how rest of the research is set out.
Chapter 2: Literature Review; this chapter provides an overview of the research topic by mapping out the key areas; theories within the risk management and finance literature are identified, explored and analysed. The concept of risk and risk management is explored. A broad classification is made on the types of risks and this is then narrowed down to include foreign exchange risk. The chapter proceeds by exploring the concept of foreign exchange and foreign exchange risks; which include the types of foreign exchange exposures. The common techniques for managing foreign exchange risks are explored. This is followed by a review of relevant literature in the key areas of the research topic.
Chapter 3: Research Methodology; in this chapter the research design and strategy are discussed.
Chapter 4: Research Findings and Analysis; this chapter presents the findings of the research which were obtained from the questionnaire. The findings are presented using tables, graphs and charts, to enable the reader gain a clearer understanding. An analysis of the findings is carried out by cross-tabulating the responses of the respondent in order to observe for any commonalities and/or differences.
Chapter 5: Conclusion and Recommendation; this chapter concludes the research and recommendations are made.
Chapter 2: Literature Review
2.1 Risk Management-
Risk is an intrinsic part of any business, due to unpredictability of the forces which govern business transactions such as political, economic and social conditions; risk is a factor which cannot be completely eliminated (Watson and Head, 2007). Arnold (2002) describes risk as a situation where there is more than just one possible outcome, but a range of potential returns. It can also be defined as the chance that the actual return from an investment will be different than expected (Lamb, 2008). From the above definitions, risk does not necessarily spell doom or does not necessarily have a negative connotation. Markowitz was one of the earliest academics to point this out, by establishing a link between risks and return (risk-return trade-off). Essentially the theory; Modern Portfolio Theory (MPT) involves expected return and the degree of accompanying risk for an investment (Yorke and Droussiotis, 1994). A central theme of this theory is that the greater risk an investor accepts the higher the potential for increased returns (Yorke and Droussiotis, 1994).
While MPT purports a positive correlation between risk and return, the fact that an investment can have a range of possible outcomes is an uncertainty which can be very costly. As a result risk management is also a part and parcel of business. Risk management can be defined as “the performance of activities designed to minimize the negative impact (cost) of uncertainty (risk) regarding possible losses” (Abor, p.307, 2005). The objectives of risk management are to minimize potential losses, reduce volatility of cash flow thereby protecting earnings (Abor, 2005). While the objective for risk management is to protect companies against financial loss thereby protecting the value of the firm, traditional finance theory such as that proposed by Modigliani and Miller suggests that the market value of a firm is determined by it earning power (Arnold, 2002). The basic assumption of Modigliani and Miller theorem is that in an efficient market; with the absence of taxation, bankruptcy costs and information asymmetry, the value of the firm is unaffected by its capital structure (Arnold, 2002). However empirical research (list authors) has shown the existence of capital market imperfections, such as taxes, agency problems and financial distress exists thus justifying risk management (Chowdhry, 1995). Furthermore, MPT also suggests that the risk and volatility of an investment portfolio can be reduced, and the gains can be enhanced, all by diversifying the portfolio among several non-correlated assets (Pearce Financial, 2008). That is, investors can maximise their expected return for a given level of risk by diversifying their investments across a range of assets ((McClure, 2006).
MPT involves risk management through diversification of investments. In a simplified expression, MPT is based on the idea of not ‘putting all of ones eggs into one basket'.
2.2 Types of Risk
There are two broad classification of risks; Unsystematic and Systematic (Rossi and Laham, 208)
Systematic risks refers to risks which affect the entire market due to events such as; exchange rate movements, changes in the price of commodities, war, recession and interest rates, however
Unsystematic risks are risks which are specific to individual companies (reference).
These distinctions were made by Sharpe (1960) in addition to Markowitz Modern Portfolio theory (MPT), the rationale behind it was that despite risk management practise through diversification, there were still underlying factors which affected the return potential of an investment portfolio. Chesnay & Jondeau (2001) clearly point out that the correlation of assets which Markowitz talks about depends on other underlying factors and that the relationships are dynamic. They further found that major events such as general adverse movements in markets can significantly change the correlations between assets (Chesnay & Jondeau, 2001). Empirical studies show that in financial crisis, assets tends to act the same, that is they are more likely to more become positively correlated, moving down at the same time (Ardelean, Brandt and Malik, 2009). Essentially, severe market crises will have a spill over effect and cause investments in several different asset classes or markets to succumb to sudden liquidation (Vocke and Wilde, 2000, Pearce Financial, 2008).
However findings from Xing and Howe (2003) are contradictory, their findings show that the failure of previous studies to find a positive risk-return relationship may be as a result of model misspecification. Essentially they found that there was no agreement on the risk-return relationship amongst previous studies which had used data from one market (Xing and Howe, 2003). Thus they argued that the world market should be taken into consideration in assessing risk return-relationship in a partially integrated market (Xing and Howe, 2003). But then it only stands to reason that if markets are integrated partially or wholly, a catastrophic economic cycle such as financial crises would have an adverse effect on the world market. Thus clearly it does not matter how much one diversifies unsystematic risk, the underlying systematic risk is a problematic factor which has to be dealt with.
2.3 Foreign Exchange rate as a Systematic Risk
Foreign Exchange rate can be defined as the “price of one currency expressed in terms of another” (Arnold, p.973, 2002). For example, if the exchange rate exchange rate between the European Euro and the Pound is €1.3 = £ 1.00, this means that £1 is equivalent to €1.3. Foreign Exchange (Forex) is traded on the foreign exchange market, the purpose of which is to facilitate trade and the exchange of currencies between countries (Czinkota et al, 2009). The Forex market is an informal market which does not have a central trading place (Czinkota et al, 2009). Trade is carried out it is a 24 hour market as it involves financial institutions from around the globe, as trade moves from one financial centre to another (Arnold, 2002). Thus as one market closes in one region or continent another opens in a different place (Arnold, 2002). The major trading centres are in Tokyo, Singapore, London and New York (Waston and Head, 2007). The buyers and sellers of foreign currencies included exporters/importers; tourists; fund managers; governments; central banks; speculators and commercial banks (Arnold, 2002). However large commercial banks account for a larger percentage of Forex trading in the currency markets, as they deal currencies on behalf of customers (Arnold, 2002). They also undertake transactions of their own in an attempt to make a profit by speculating on future movements of exchange rates (Arnold, 2002).
Foreign Exchange Risk
After the demise of the Bretton woods conference (1973) exchange rates were allowed to float freely; exchange rates were no longer fixed and currencies were allowed to float freely in value to each other (Czinkota et al, 2009). However freely floating exchange rate poses problems for investors and firms alike who deal with different currencies as the uncertainty of exchange rate movements can have a positive or negative impact on an investment (Czinkota et al, 2009). Foreign exchange risk also known as currency risk is the “risk that an entity will be required to pay more (or less) than expected as a result of fluctuations in the exchange rate between its currency and the foreign currency in which payment must be made” (Abor, p.3, 2005).
Thus considering the potential variability of Forex and the impact it can have on international investments and international business, irrespective of the business sector, it is clear that Foreign exchange risks can be classed as systematic risks. Forex risk is an un-diversifiable risk as it affects the entire market.
Having established the relationship between Forex and systematic risk and understanding that it cannot be diversified the question which presents itself is, what can be done about it? Theory states that the only way out is to hedge this risk (Bartram, 2007), the decision to hedge will be examined in Section 2.7
2.4 Types of Foreign Exchange Exposure
There are three types of foreign exchange risks or exposures; Economic exposure, Transaction exposure and Translational exposure (Maurer and Valiani, 2002).
Transaction exposure is the risk that arises as a result of an existing contractual agreement involving a commitment in foreign currency, this sort of risk is primarily associated with import or exports (Arnold, 2002). For example a firm which exports goods from the UK to the US; will have an agreement (contract) that the US firm buying the goods will pay for the goods at a later date (could be 30, 60 or 90 days), however changes in the exchange rates to either currency (whether an appreciation or depreciation) will either positive or negative consequences for either firms. Transaction risks also come as a result of firms making foreign investments such as opening subsidiary branches (Arnold, 2002). These risks arise in the form of payment costs associated with constructing or establishing new branches (Arnold, 2002). In order to make the necessary payments, the home-based firm would exchange its home currency for foreign currency, thereby giving rise to potential transaction risk (Arnold, 2002)
Translational exposure relates to a firm's earnings; it involves a firm's accounting practises (Waston and Head, 2007). This risk “arises from the legal requirement that all firms consolidate their financial statement (balance sheet and income statement) of all worldwide operations annually” (Czinkota et al, p. 334, 2009). This implies that, as firms translate and consolidate foreign assets, liabilities and profits into domestic currency, there is the possibility of the firm experiencing a loss or gain (Waston and Head, 2007). This is mainly an accounting risk and as such give a real indication of the impact of exchange rate fluctuations on the value of a firm (Watson and Head, 2007).
Economic exposure impacts a firm's long-term cash flow, positively or negatively (Czinkota et al, 2009). This kind of risk not only affects firms involved in international trade but also has an impact on domestic firms as it can also affect the price of commodities sold (Czinkota et al, 2009). Furthermore, this sort of risk also undermines the competitiveness of a firm (Arnold, 2002). It can affect the firm's competitive position directly if the home currency appreciates and foreign competitors are able to offer a much cheaper price, compared to the firm's products which have become expensive as a result of the currency appreciation (Arnold, 2002). Economic risk can also affect a firm's competitive position indirectly even if a firm's home currency does not experience adverse movements (Arnold, 2002). For example Arnold (2002) illustrate that a South African firm selling in Hong Kong with a New Zealand firm as its main competitor can lose competitive edge if the New Zealand dollar weakens against the Hong dollar. Thus the products or commodity on offer by the New Zealand firm would be cheaper than that of the South African firm assuming both currencies (South African Rand and New Zealand Dollar) had a similar exchange rate against Hong Kong Dollar.
Economic and transaction risk are more related to businesses involved in international trade, translational exposure more to do with accounting practises (Waston and Head, 2007). Consequently these are the foreign exchange exposure that will be focused on.
2.5 Foreign Exchange Risk and Natural Hedging
The idea of applying natural hedging strategies as tools to hedge foreign exchange exposure is one that has received a lot of attention in recent times, as the concept focuses on using non-financial methods to mitigate the volatility of future cash flows and possibly add value to the firm (Kim et al, 2006). The various natural hedging strategies are explained below.
This technique relates to multi-nationals which have foreign subsidiaries, it involves reducing funds transferred by netting off the transaction between the parent company and the subsidiary firm (Watson and Head, 2007). For example “if a UK parent owed a subsidiary in Canada and sold C$2.2m of goods to the subsidiary on credit while the Canadian subsidiary is owed C$1.5m by the UK company, instead of transferring a total of C$3.7m the intra-group transfer is the net amount of C$700,00” (Arnold, p. 982, 2002). This implies that rather than both the parent and subsidiary firm managing their exposure separately they opt for a centralised management system to reduce the size of the currency flows. Consequently transaction costs and the cost of purchasing foreign exchange are mitigated (Arnold, 2002).
Leading and Lagging
This technique involves either settling foreign accounts by either postponing payments (lagging) till the end of the credit period allowed or prepayment (leading) at the beginning of the transaction (Watson and Head, 2007). It functions based on the anticipation a firm has that future exchange rates will either appreciate or depreciate (Czinkota, 2009). Thus if a firm anticipated a depreciation in its home currency, it lead its payments conversely if the firm anticipated an appreciation in exchange rate it would lag its payments.
Invoicing in the Domestic Currency
This method involves invoicing foreign customers in the firm's domestic currency rather than in the foreign currency (Arnold, 2002). What this does is that it shifts the burden of risk to the foreign firm (buyer).
Operational and Strategic Methods
There is no one singular acceptable definition of operational hedging as it varies according to the context it is been used. Boyabatli and Toktay (2004) in their work, review and discuss a diverse cross section of views on operational hedging, they delve into the similarities in application methods of operational hedging across different academic fields. They discovered that although there were some differences in meaning in various academic fields; operations management, finance, strategy and international business, there were basic characteristics which were similar across all fields. On this basis operational hedging can be described according to its functionality. Bradley and Moles describe it as the decisions firms take in regards to the “location of their production facilities, sourcing of inputs, the nature and scope of products, strategic financial decisions such as the currency denomination of debt, the firm's choice of markets and market segments” (Bradley and Moles p.29, 2002).
It involves the use of non-financial methods to mitigate the volatility of future cash flows and possibly add value to the firm (Kim et al, 2006). The objective is geared towards reducing long-term economic exposures. Operational hedging can be said to be based on the principle of real options. Real options are “opportunities to delay and adjust investments and operating decisions over time in response to resolution of uncertainty” (Triantis 2000 cited in Boyabatli and Toktay p.6, 2004).
2.6 Hedging with Financial Derivatives
The different types of financial derivatives are: Forwards and Futures, Foreign currency Options and Currency Swaps.
Forward contract: This enables the business to protect itself from adverse movements in exchange rates by locking in an agreed exchange rate until the agreed date of payment (Brealey, Myers and Allen, 2006). The example given by Horcher and Karen (p.95, 2005) illustrate the concept further; “a company requires 100 million Japanese yen in three months to pay for imported products. The current spot exchange rate is 115.00 yen per U.S. dollar, and the forward rate is 114.50. The company books a forward contract to buy yen (sell U.S. dollars) in three months' time at a price of 114.50 and orders its merchandise. In three months' time, the company will use the contract to buy yen at 114.50. At that time, if yen is trading at 117.00 per U.S. dollar, the company will have locked in a price that, with the benefit of hindsight, is worse than current market prices. If three months later yen is at 112.00 per U.S. dollar, the company will have successfully protected itself against a more expensive yen. Regardless of price changes, the company has locked in its yen purchase price at the forward rate of 114.50, enabling it to budget its costs with certainty”.
Futures Contract: A futures contract refers to an “agreement to buy or sell a standard quantity of specified financial instrument or foreign currency at a future date at a price agreed between two parties” (Watson and Head, 2007). Although it bears some similarities to the forward contract in that it also locks in the exchange rate, however one major difference is that a forward contract can be used in a wide range of currencies while the futures contract is applicable to a limited number of currencies (Brealey, Myers and Allen, 2006).
Foreign currency Options: This gives holders the right to purchase or sell foreign currency under an agreement that allows for the right but not the obligation to undertake the transaction at the agreed future date (Brealey, Myers and Allen, 2006). One key advantage of this method of hedging is that it gives holders the opportunity to take advantage of favourable exchange rate movements (Watson and Head, 2007). However a non-refundable fee on the option known as an option premium is required (Watson and Head, 2007).
Currency Swaps: A currency swap is “an agreement between two parties to exchange principal and interest payments in different currencies over a stated time period” (Watson and Hedge, p. 382, 2007). Basically what this implies is that a firm can gain the use of foreign currency but avoid exchange rate risk which may arise from servicing payments (Watson and Head, 2007).
2.7 A review of Literature on hedging
This section critically examines the rationale for hedging foreign exchange risk.
The rationale which has been put forward for hedging risk in the existing literature (Judge, 2004) is that it maximises shareholder value. The idea behind hedging any kind of risk in general is that once a firm takes on the responsibility of actively managing risk, shareholder value is increased, thereby increasing the overall value of the firm (Judge, 2004). However finance theory proposes that shareholders are diversified and thus are not willing to pay a premium to firms for adopting hedging policies (Rossi and Laham, 2008). So in that vein, theory proposes that what is actually being maximized is the manager's private utility (Tekavcic, Sernic and Spricic, 2008).
Essentially finance theory states that shareholders are diversified while managers of firms are not, so in a bid to protect their income and personal asset, which are linked to the firm, they hedge against uncertainty (Baranoff and Brockett, 2008). Within this theory shareholders are willing to take on risk in exchange for greater returns (risk-return trade off) and so they invest in companies which they believe can provide such high returns. Thus managers hedging risks can be said to lead to underinvestment, which then flaws the theory of risk-return trade off (Baranoff and Brockett, 2008). This theory is based on the premise that financial markets are efficient and as such hedging activities of firm would not add value to the firm (Rossi and Laham).
In addition to the complexities of the above theory, when the concept of hedging is put into the context of foreign exchange movements; the Law of one price (LOP)/ purchasing power parity (PPP) suggests that identical goods are not affected by exchange rate variations (Hyrina and Serletis, 2008). The law of one price is the foundation of the theory of PPP which posits that similar goods should have identical prices across countries once expressed in a common currency (Hyrina and Serletis, 2008, Czinkota et al, 2009).
Numerous studies have been carried out to test whether or not the theory holds, however there is no general consensus as to whether or not the theory is valid. Hyrina and Serletis (2009), Glen (1992), Choi, Laibson and Madrian (2006) found that there are some flaws within the theory as the real exchange rate is not stationary. Engel and Rogers (1996) examines the impact distance has on goods sold and whether the presence of national borders separating locations were these goods are sold, also have any impact on the law of one price. Empirical evidence from the research shows distance and border have significant role to play on the differences in price of goods (Engel and Rogers, 1996). More so, that market segmentation also leads to price differentiation (Engel and Rogers, 1996).
This theory just like the first are both based on the principle that the market is efficient and as such inconsistencies such as movements in exchange rate even out in time (Zanna, 2009). Without attempting to disparage the above theories, in regards to the first theory, whether or not hedging is done to propagate the interests of managers, the fact is that, the basis of the theory (Efficient Market) is flawed as there are numerous empirical evidence (Nobile, 2007; Bartram, 2007, Allayannis and Ofek, 2003, Tekavcic et al 2008, Mastry, 2003) to suggest that there are imperfections in the financial market such as high interests rates, inflation, tax and of course foreign exchange movements which can affect a firm. Thus shareholders cannot afford not to be concerned about hedging as these imperfections in the market can affect the cash flow, profit and ultimately the overall value of the firm. Thus in the same vain PPP should not hold.
In regards to PPP it is necessary to indicate that there are other factors which affect the price of goods sold across national borders. Bradley (2005) states that the prices of goods for each firm are influenced by numerous factors such as; Government policies, high inflation rates and corporate income tax and thus such prices of goods cannot be the same across different borders.
So to state clearly the financial market is not efficient due to market imperfections. Thus movements in foreign exchange can affect the cash flow and overall value of the firm. Consequently it is necessary for firms to focus on how to manage this risk.
2.8 Review of literature on financial derivatives and operational Strategies
The extant literatures on hedging exchange rate risks with financial derivatives have focused on corporate risk management. The main thrust of literatures from authors such as Mastry (2003), Bartram et al (2003) and Galum and Roth (1993) have carried out studies which are aimed at finding the optimal financial derivative. However there is no general consensus as to an optimal financial hedging position. The reason for this can related to basic financial theory which suggests that derivative instruments should be chosen based on the degree of exposure of the firm and the payoff that can be gotten from the instrument (Bartram, 2006). Essentially what this implies instruments with linear characteristics such as forwards, futures and swaps should be used for linear exposures, while instruments with nonlinear profiles such as currency options are suitable to hedging nonlinear exposure (Stulz, 2003). Put simply the theory suggests that after firms assess the nature of its exposure, all that needs to be done is choose a derivative which matches that exposure. However, contrary to financial theory Bartram (2006), Ianieri (2009) found that as a result of the flexible nature of options, options can be used to hedge various types of exposures and not just nonlinear exposures.
Despite these findings, merely identifying the nature of exposure and matching it with a derivative is not enough. There are other factors which influence the decision on what derivatives to use besides the nature of exposure. For instance while an option is flexible and can be adapted to suit various types of exposures, it is also be a highly complex technical method to use. The problem with currency options is that they require highly skilled individuals who can understand and use it effectively. Ianieri (2009) states that even brokers who should know how to use this method have had bad experiences with it.
In an alternative view, Masry and Salam (2007) in an attempt to understand the rationale for using financial derivatives found that the size of the firm impacts on a firm's decision to use financial derivatives. A study conducted by Judge (2004) shows that there is a positive relationship between the size of the firm and the foreign currency hedging decision. The general idea is that large firms have numerous resources available to them; in terms of personnel and information, and as such they are more likely to hedge using financial derivatives (Judge, 2004). So in essence the transaction costs which accompany the use of derivatives would discourage small firms from opting to hedge with financial derivatives.
On the other hand Kim and Sung (2005), De Jong et al (2006) and Choi and Prasad (1995) found that the common use of financial derivatives could be related to the trade intensity of firms. Doidge et al (2002) found that firm's foreign activities are significantly related to exchange rate exposure, thus large firms are more sensitive to currency movements than small firms as the level of their trade activities are more. In a similar study Masry and Salam (2007) empirically analyze whether firm size and level of international operations has any impact on a firm's exposure thus affecting its decision to hedge. He found that large firms generally have more international activities, so they are more exposed to exchange rate risk; consequently they have more incentive to hedge (2007). Thus coupled with the resources which are at the disposal of these large firms they can quite easily hedge using financial derivatives.
The essence of exploring the above ideas is to stress the point that, apart from matching the linear or non-linear profile in order to ascertain what financial derivative to use, there are other factors which influence how companies hedge foreign exchange risk using derivatives.
Hagelin and Pramborg (2004), examine the relationship between foreign exchange risk and hedging with financial derivatives. The aim of the study was to find out if hedging with financial derivatives was effective, as it can be an expensive endeavour. They find that financial hedges are effective in mitigating foreign exchange risk (Hagelin and Pramborg, 2004). However the use of derivatives involves making forecasts about exchange rates. The aim is to study the behaviour of exchange rates so as to, anticipate how exchange rates are going to move (Okunev, 2008). The process involves comparing a currency's value in relation to other currencies (Janabi, 2007). Copeland and Joshi (1996) states that it is difficult to forecast future exchange rate as economic conditions are constantly changing, making it difficult to be certain how exchange rates are going to move. Alternatively Chowdhry (1999) finds that foreign currency can be hedged perfectly using financial derivatives so far the foreign currency value of future cash flow certain. But then the question here is how can anyone be certain about foreign currency value of future cash flow if there are imperfections with the financial market, the answer is that they cant. At most what forecast provide is a calculated guess.
Essentially firms whose main area of expertise is not in the financial market would be a bit reluctant to wage a substantial amount of funds for hedging short-term risks. Authors such as Boyabatli and Toktay (2004), Bradley and Moles (2002) have suggested that due to the unpredictability of financial markets and costly financial hedging techniques, it is more profitable for firms to invest in managing long-term exposure; economic risk.
Thus Boyabatli and Toktay (2004), Bradley and Moles (2002) have suggested that with the use of operational hedging which economic (long-term) term exposure can be hedged. The purpose of applying these strategies is that it attempts to reduce the volatility of cash flow by aligning costs and sales revenues so that they are exposed to a similar level of exchange rate risk.
The general idea of operational hedging is based on the concept of real options; implying that a firm can with delay investment decisions as a means to mitigate exchange rate movements (Boyabatli and Toktay, 2004). Chowdry and Howe (1999) provide a theoretical perspective suggesting that by companies spreading their operations in different locations their costs and revenues are aligned and as such both are subject to the same degree of exposure. Consequently by aligning cost with sales revenue a firm is protected against the impacts of exchange rate movements. Operational hedges function through geographical diversification as well as exercising operational flexibility (real options).
There are disagreements within the field as to whether or not operational strategies actually hedge economic exposure. Allayannis, Ihrig and Weston (2001) find that the use of geographic dispersion as a means to hedge exchange-rate risk does not reduce exchange rate risk. Furthermore, Hamel (2003) suggests that operational strategies are value enhancing strategies. Contrary to the findings of these researches, Bradley and Moles (2002) argue the limited ability of financial derivatives to manage long-term exposure necessitates the use of operational strategies however. Their research examined the extent to which large publicly listed UK firms utilize strategic methods of managing exchange rate exposures (2002). A survey of 579 non-financial UK firms was carried out and a 68% response rate was achieved. Findings from their research indicate that a significant number or respondents in their survey use operational and strategic techniques.
In conclusion there are arguments to support the use of financial derivatives on one hand and operational strategies on the other. Thus the present study aims to provide an integrated approach to on these two perspectives.
The research methodology is a key aspect of any research as it takes the reader as well as the researcher through the process of how the research was carried out. In order to tackle the research methodology (which is geared towards answering the research aims and objectives) this research adopts Saunders (2003) research onion and uses it as a guide. The research process adopted has been modelled after Saunders' research process onion as it depicts the different layers involved in answering the research question. It is important because it shows that there are underlying issues guiding the choice of data collection methods (Saunders, 2003). This model is used as a basis to explain the research process because as Saunders (2003) points out before arriving at the central point; data collection techniques, there are important layers of the onion that need to be peeled away. Thus the research onion takes into account the key stages involved in research process.
1 below shows the stages in the research onion. The first phase involves the research philosophy adopted by the researcher; the next layer is the research approach which emerges from the research philosophy, the third layer is the research strategy followed by the time horizon applied to the research and finally the data collection methods (Saunders, 2003).
The Research Philosophy
The research philosophy refers to the way in which we think about the development of knowledge; because this thought process affects the way we go about doing research (Saunders, 2003). There are three main schools under which the research philosophy can be classified namely: Positivism, Interpretivism and Realism (Saunders et al, 2003).
Positivism “adheres to the notion of objective reality” (Sarantakos and Sotirios p.34, 2005), it also stresses the value of accuracy, precision and measurement (Sarantakos and Sotirios p.34, 2005). This philosophy emphasises “quantification in the collection and analysis of data” (Bryman and Bell, 2007).
Interpretivism which is often associated with the term ‘Constructionism' suggests that there are no absolute truths (Saunders et al, 2003). Unlike the positivist, interpretivism is hinged on the idea that reality is subjective rather than objective; here the human being and how they make sense of the world they live in are central element to this theory (Saunders et al, 2003). Consequently interpretivism emphasizes quality; it “values the reflective assessment of the reconstructed impressions of the world” (Sarantakos and Sotirios, p.45, 2005).
Realism is based on the “belief that a reality exists that is independent of human thoughts and beliefs” (Saunders et al, p.84 2003). Thus implying that there are some realities that exists which affect people without them being aware of it. The emphasis is on how these realities influence people's interpretations and behaviour (Saunders et al, 2003). Realism is similar to both the positivist and intrepretivist school, whilst realist firmly believe that the world exists independent from people and their perception (positivist view), it can also be made an object of human perception (interpretivist view) (Sarantakos and Sotirios, 2005).
The research philosophy adopted in this research is positivism; this philosophy is suitable as the present study seeks to find out how trade firms manage their exchange risk. Similar to the positivist school of thought this research will be accomplished by taking a set of pre-existing theories and testing them, in order to make quantifiable observations (Saunders et al, 2003).
The research approach flows from the research philosophy. There are two main research approaches are deductive and inductive. The main research approach adopted in this research is the deductive approach as this research utilizes quantitative data.
The research strategy is a very vital part of the research process as it involves deciding how the research questions will be answered (Blumberg et al 2005). Research Strategy can be categorised into Quantitative and Qualitative. The research hopes to collect quantitative data, thus the research strategy adopted is a survey.
This method is the most commonly used in business management research (Saunders et al 2003). Reason being, “they allow the collection of a large number of data from a sizeable population in a highly economical way” (Saunders et al p. 92, 2003). Data collected from survey strategy is usually quantitative; furthermore it can be used to address problems of ‘what?' and ‘how?' Thus put into context, this strategy is useful for the present study as it will help provide quantifiable data in relation to how international trade firms manage foreign exchange risk is managed. This strategy can also provide a clear indication of what problems these companies face with managing those risks.
Data Collection Techniques
There are several methods which could be used to gather the necessary data such as; focus groups, interviews and observation of focus groups. Focus group is “a method of interviewing that involves more than one, usually at least four interviewees; essentially it is a group interview” (Bryman and Bell, p.510, 2006). Apart from interviewing focus groups, focus groups can also be observed in order to capture their opinions and beliefs (Bryman and Bell, 2006). Focus groups, interviews and observations can be used as a means of data collection as it can provide qualitative information based on the opinions gathered from the group.
It allows group interaction which would yield a rich variety of information. Despite these positive points, this method of data collection is time consuming as it requires the interviewer to allow enough time for group interaction. There is also the possibility of excess information which would also take time to analyse. Thus due to the time constraint it would not be wise to utilize this method as a means of data collection.
Taking into consideration the constraint involved in the other methods of data collection as explained above, a combination of methods have been sought to accomplish the aims of the research as well as answering the research questions. The data collection methods used was: Secondary data; documentary secondary data, and Questionnaire
Secondary data was sought in order to gather information on the research topic. Furthermore the data used in this research was set in context by studying a range of published and unpublished documentary secondary data; written documents which include: books, unpublished essays, journals and magazine articles related to the research topic.
Data was gathered from a variety of online databases namely Emerald, Business Source Premier, JSTOR and Science Direct, FAME and Nexus. These databases are portals to a range of online academic journals such as Journal of Managerial Finance, International Finance Journals, International Economic Journals, Trade Journals and Journal of Risk Finance. The information from these academic journals was used as a guideline in designing the questionnaires. They are useful resources because they (databases) are a store house for up to date articles. Furthermore they are also credible as the articles on these databases are subject to peer-review. Peer-review is the process whereby proposed academic works from authors are scrutinized in order to facilitate the publication of proposed research in respected journals (Publishing Consortium, 2007). The peer-reviewed articles on these databases lend to the credibility of the journals and have consequently been used as a tool for data collection. Apart from online database, Nottingham Trent University library has a host of books and journals in print form which are related to the research topic.
Unlimited access to these online resources and books were gained through Nottingham Trent University's library resources and collection with the use of a Nottingham Trent University (NTU) I.D number.
Advantages of Secondary Data
The advantages of using secondary data in this study were that it was time and cost effective; as there was unlimited access and money was not spent securing such access. Furthermore the researcher was able to compare the findings of this research within a general context of existing literature.
Challenges of Using Secondary Data
There were several challenges involved in utilizing secondary data among the issues were that there were vast amounts of literature relating to the research topic and there were also data quality issues. However these challenges were over come by using search criteria which focused on key words in the research topic. Issues of quality were addressed by using articles which were cited more than once within the database.
As mentioned in the previous section, secondary data was used as a foundation to constructing the questionnaires. The questionnaire was constructed from studying the work of a range of authors such as Bartram (2006), Bradley and Moles (2002), Boyabatli and Toktay (2004), Allyannis, Ihrig, and Weston (2001), Dixon and Bhandari (1997) and Aretz, Bartram, Dufey (2007). The choice of questionnaires was self-administered; on-line questionnaires
Although there are alternative methods of administering the questionnaires such as handing them out personally and telephone interviews. These methods fall short because of the nature and length of the questions. The questionnaires were intended for people with knowledge on the research topic (finance directors, managers and directors; import and export) and as such could not be passed on to just anyone, thus ruling out handing questionnaires out personally. In terms of telephone interview the length of the questionnaire (21 questions in total) would not encourage potential respondents to want to participate via telephone as they may have busy schedules.
An on-line questionnaire was chosen as a tool for gathering data because it is cost effective and it also saves time. It is cost- effective in that it is easier to access a much wider audience. An advantage of this method is that a large number of questionnaires can sent out at once in a matter of seconds. Questionnaires were sent to directors, financial managers, and mid-level managers of import and export companies as they would be in a better position to give meaningful responses. The questionnaires were sent to Import and export companies in the East Midlands listed in the UK Export and Import Agent online directory.
However there were some challenges involved in using online questionnaires which are worth mentioning namely:
* Obtaining Email addresses of potential respondents;
* Uncertainty about whether or not the questionnaire reached the intended respondent;
* Possibility of the questionnaire being ignored or sent to junk mail or the respondent's inbox.
These challenges were tackled in the following ways:
* Companies were contacted via phone in order to obtain the Email address of potential respondents. Furthermore in order to gain the cooperation of potential respondents (to take part in the research), statistical results of the research was offered as an incentive;
* A follow up call was made after a week to ensure that the intended respondent received the questionnaire, the follow up call also served as a reminder to the respondents.
A web-based too known as Survey Monkey (a useful website for designing and distributing, collecting responses as well as analysing the results from questionnaires) was used to design the questionnaires. The questionnaire had an introductory note attached, which explained the purpose of the questionnaire. The questionnaire comprised of both open and closed ended questions.
Open ended questions was included in the questionnaire because the researcher was not able to anticipate the probable answers to the research question thus these types of questions were used as means to encourage respondents to provide more information (Fisher, 2007).
According to Bryman and Bell (p. 259, 2007) the advantages of open ended questions include:
Advantages of Open-ended questions
* Respondents can answer in their own terms. They are not forced to answer in the same terms as those foisted on them by he closed answers;
* They allow unusual responses to be derived. Replies that the survey researcher may not have contemplated (and that would therefore not form the basis for fixed choice alternatives) are possible;
* The questions do not suggest certain types of answers to the respondents;
* They are useful for exploring new areas or ones in which the researcher has limited knowledge.
Disadvantages of Open-ended questions
Bryman and Bell (p. 259, 2007) also provide a list of problems which can be encountered with using open ended questions:
* They require greater effort from respondents
* Answers have to be coded. For each open question it entails reading through answers, deriving themes that can be employed to form the basis for codes, and then going through the answers again so the answers can be coded for entry into a computer spreadsheet.
Closed ended questions are direct questions which require the respondents to choose specific answers by ticking, circling of filling in boxes (Fisher, 2007). Closed ended questions are advantageous in the following ways (Bryman and Bell, p. 260, 2007)
Advantages of closed-ended questions
* Easy to process answers;
* Answers can be compared, making it easier to show the relationship between variables and to make comparisons between respondents or types of respondents;
* Availability of answers may help clarify the meaning of questions to respondents
Disadvantages of closed -ended questions
Closed questions however also come with some disadvantages such as (Bryman and Bell, p.262, 2007):
* Answers given by respondents tend to be restricted to options provided, thus answers lose their spontaneity;
* Difficulty in covering or providing all possible answer options for closed ended questions;
* Possibility that certain term maybe interpreted differently.
The challenges which arose (such as the ones mentioned above) with the use of open ended questions were addressed by also including closed ended questions and vice versa. However some of the other challenges of using closed ended questions were resolved by providing a category of ‘other' in which case respondents were allowed to provide answers separate from the ones provided (Bryman and Bell, 2007).
Due to time constraint a total of 40 questionnaires were sent out with an expected response rate of at least 10 respondents. Authors such as Saunders et al (2003) identify that it is very unlikely that there will be a 100% response rate. The sample size consisted of import and export companies in the East Midlands. The type of sampling technique used was systematic sampling as there was insufficient time and funds to contact all import and export companies in the East Midlands. Systematic sampling was used because the sample size needed does not necessarily have to be large, it could be small (Saunders et al, 2003). Other methods such as simple random sampling, multi-stage sampling would not have been useful for this research as the size of the sample for those methods would be better with a large number of respondents.
Chapter 4: Research Finding and Analysis
This chapter presents and analyses the findings of the research. The structure of the chapter starts with the presentation of findings, which has been done under the following headings: characteristics of the surveyed firms, Foreign Exchange Risk management structure, and problems with managing foreign exchange risks. The section which comes after this will focus on analysing the findings. The analysis will examine how respondents from the survey manage their foreign exchange risk. Graphs, charts and tables are used to illustrate the findings and analysis for better understanding.
Before proceeding to present the findings, it is necessary to re-emphasise the nature of questions which respondents were asked, in order to gain a better understanding of the data that will be presented. The questionnaire comprised both open and closed ended questions. Certain questions required single option answers such as; background information and characteristics of the respondent. While other questions allowed for multiple answers; such as questions which concerned the foreign exchange risk management techniques. The reason for this is that a firm could employ more than one method in mitigating exchange rate risks. Open ended questions were also asked in order that respondents may express their views on certain issues.
The questions asked are similar to the ones asked by Bradley and Moles (2002) and Abor (2005). This research builds on their work and asks very similar questions as both studies focus on two different aspects of managing foreign exchange risk. Thus in order to get a high response rate this research has merged and employed the strategies used by both studies.
Due to the low number of responses received, some questions which were initially asked in the questionnaire have not been presented in the main body of this research, because the responses received were too low to carry out any meaningful analysis on them. However, a full copy of all the response form the questionnaire have been included as part of the appendices.
In all there were a total of 16 responses received from the survey, however after checking for errors only 15 responses were of use.
4.1 Presentation of Findings
Characteristics of surveyed firms
The characteristics of the surveyed firms were based on industry classification, size of firm, ownership, the nature of international trade activities, trade intensity and percentage of total sales from import and/or export
Respondents were asked to specify the industries to which they belonged to because, the East Midlands is a vast region and as such, it would be tasking to attempt to identify and classify all industries within the area. Furthermore, providing a list of industries would have limited the responses should potential respondents find that their industry sector has not been captured or included. The rationale for asking the question was intended to gain some background information about the respondents. Industries represented were, automobile, Arts, manufacturing, construction, food, textile, Pharmaceutical industry and fashion industries. Amongst the responses manufacturing was the highest with a total of 6.
The number of employees was used as a yardstick to determine the size of firm, based on data derived from the national business statistics, firms were categorised into small, medium and large organizations. Firms with 0-49 employees were considered small, 50-249 employees were classified as medium sized, while 250 or more employees were considered to be large firms.
The diagram in 1 is a graphical representation of the respondents according to size of the organization. It shows that 40% (6) of respondents are small-sized firms, while medium-sized firms also accounts for 40% (6) and large firms were 20% (3).
The nature of international trade activities was also considered, it refers to the actual trading activities of the survey firms. It concerns what aspect of international trade the firm is involved in; import and/ or export. This characteristic is vital, in view that the focus of this research is on international trade firms. Thus firms were asked whether the business was involved import, export or both.
2 above shows that 53.3% (8) of firms which took part in the survey were import oriented, while export accounted for 13.2% (2) and firms which were involved in import and export accounted for 33.3% (5).
To ensure that firms which participated in this survey were adequately exposed to foreign exchange rate risks, only firms which were actively involved in international trade were chosen. The way this was accomplished was that, firms were asked to indicate how often they either imported or exported. 4 shows that 62.5% (5) of the surveyed firms imported on a monthly basis while 37.5% (3) imported on a weekly basis.
On the other hand 87.5% of the firms export on a monthly basis. Thus the firms in the survey are actively involved in international trade.
Foreign Exchange Risk Management Structure
Firms were asked if foreign exchange risk management decisions were incorporated or considered within departments of the firm. 78.6% (11) of the firms replied no while 21.4% (3) replied yes. They were then asked to specify which department apart from the finance department, foreign exchange decisions were handled. The comments from the respondents were as follows can be seen in Table 1
Table 1 Showing responses of respondents who incorporated foreign exchange risk in other departments apart from finance
Are foreign exchange decisions incorporated into other departments,
apart from the finance department? If yes, please specify
Top of Form
Merchandising and marketing department
Bottom of Form
Top of Form
Finance and operations
Bottom of Form
Top of Form
Production and distribution team, finance department, marketing and sales
Bottom of Form
Table 2 below shows the strategies used by import and export firms to manage foreign exchange risk and the frequency with which they are used.
Table 2 showing the strategies used by respondents to manage foreign exchange risk
Frequency of use
Locating production/operations in the same country as major competitors
Foreign currency debt denomination
Diversifying sales in many different currencies
Locating production in the same countries as sales are made
From the surveyed firms, it was discovered that the strategy most used to manage foreign exchange risk is prepayment. Price adjustment was the second most used strategy amongst the firms, followed by locating production/operations in the same country as major competitors. Although it is worth mentioning, that most of the surveyed firms employed a combination of strategies. Some of the respondents also took the opportunity of commenting on some other strategies which they employed. One of the respondents said that in order to manage foreign exchange risk they “purchase stock in advance” (quoted directly from questionnaire)
In relation to financial derivatives, 28.6% 9 (4 out of 15) said that they used forward contracts but on occasion. 4 shows that apart from forward contracts, no other financial derivative was used by any of the firms in the survey.
Furthermore, the respondents were asked to specify under what circumstance they were used. 3 out of the 4 firms replied. One replied that forward contract was used they were expecting large consignments; another said it was used when they were exporting to certain markets. While the said forwards were used as the need arose.
Problems with managing with managing foreign exchange risk
The problems which respondents identified with managing foreign exchange risk can be found in the table below.
Table 3 Showing responses for the problems with managing foreign exchange
What are some of the problems encountered in managing foreign exchange risk?
Sometimes the firms pay in instalments as a result of not being able to meet payment
Maintaining a competitive edge
No problems encountered
Late payments issues
Retaining customers, volatility of the markets we trade with, which makes it hard to plan
Credit allowance required by some customers
Getting customers to pay on time
Credit account services, difficulty with anticipating changes in exchange rate movements
I do not have problems with foreign exchange
The analysis which follows would explain further the findings from the research
4.2 Analysis of Findings
This section takes a closer look at the main strategies (operational strategies and financial hedging strategies) which were chosen by the firms in this survey. The layout of this section is in two parts; the first looks at the operational hedging strategies while the other part examines the use of financial derivatives, the problems which the firms associated with managing foreign exchange risks will also be analysed.
As indicated earlier (refer to Section 4.1 Table 2 to see s) prepayment is the most used strategy, a total of 8 out of the 15 respondents used this strategy. Certain factors were identified which perhaps, influenced the use of prepayment a means to handling foreign exchange risk. One of the factors observed from the responses was that, a relationship can be drawn between the use of prepayments and the nature of business the firm is involved in.
A direct comparison was made between the firms which used prepayments and the nature of business, the results show that 5 out of the 8 firms which used prepayments were export only firms, 2 were involved in import and export and 1 was an export only firm. Thus a majority of the exporting firms use prepayments as a means of managing foreign exchange risk.
Table 4 showing how Foreign Exchange Risk Managed Using Prepayment
Table 4, shows that in addition to prepayment, two of the responses indicate that price adjustment and price negotiation are also used often. This emphasis of this strategy involves paying for commodities before they are received, however the intension of utilising this method might not be particularly geared towards mitigating exchange rate risk
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