Managing Foreign Exchange Risk in International Trade
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Published: Wed, 07 Mar 2018
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),
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