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Exchange Rate Risk Management Concepts

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Published: Wed, 11 Oct 2017

1.Introduction

Foreign Exchange Risk Management is a lot of enterprises are facing the risk of foreign exchange. Their wealth through the impact of exchange rate changes, and will seek to manage their risk exposure. Foreign exchange risk (also known as foreign exchange risk, exchange rate risk and currency risk) is the existence of financial transactions denominated a financial risk than the monetary base of the company when the currency. Foreign exchange risk also exists, when outside the foreign subsidiaries of an enterprise to keep in the consolidated entity standard currency for bookkeeping currency financial statements.

Foreign exchange exposure has been a hot issue and its relationship with hedging strategy also has been studied in many literatures. The authors argued that there is an operational hedging and financial hedging are inversely related to the firm’s foreign exchange exposure. (Hutson &Laing 2014) However, another author argued that the the foreign exchange rate exposure that is not related with the implication of hedging strategy. (Makar & Huffman, 2008). The objective of this paper is to study the hedging strategy by using Foreign exchange exposure as dependent variable.

This paper reviews the standard measures of exchange rate risk, examines best practices on exchange rate risk management. It concentrates on the major types of risk affecting firms’ foreign currency exposure, and pays more attention to techniques on hedging transaction and balance sheet currency risk. It is argued that prudent management of multinational firms requires currency risk hedging for their foreign transaction, translation and economic operations to avoid potentially adverse currency effects on their profitability and market valuation. (Papaioannou, November 2006)

2. Theoretical and modeling framework

According to the Choi and Jiang (2009), Allayannis, Ihrig and P.Weston (2013) and Hutson and Laing (2014) stated there are one model has been common used in the three journals out of the six journals. The model is known as the two-factor model (2F). The purpose of this model is used to estimate the foreign exchange risk exposure coefficients for the multinational and non-multinational firms. The equation is shown as below:

where is the firm’s excess stock return at time t, is the individual firm intercept,

is the market or exchange risk exposure coefficient, is the excess market return for time period t, is the exchange rate over the same period, and is a random error term.

The exchange rate implied random walk assumption which means the changes of actual exchange rate is same as the changes of unexpected exchange rate.

According to Hutson and Laing (2014) stated that there are few theoretical relations between exposure and multinationality. The graphs of exposure and multinationality are shown below:

Direct exposure is when the operational hedging is reduces direct foreign exchange exposure, as a result, multinationality increases will affect the direct exposure to fall.

Indirect exposure is inverse and linear because all the firms will exposed to the movement of exchange rate and the domestic firms will be the most exposed while the multinationality firms will be the least.

Overall exposure is an inverse U-shape curve which means that the firm which has highest multinationality, it will has a lower exposure while for the intermediate level of multinationality firm will has higher exposure.

3. Empirical testing procedures

Afza and Alman (2011) employed the univariate test in descriptive statistics of users and non-users of FX derivative. In order to test and analyse the mean difference between the users and non-users of foreign exchange derivative to determine firm’s hedging policies. In the study, the researchers explain that the users have higher cost in financial hedging strategy with mean value of 0.4708 as compared to non-user for financial derivative instrument. The researchers found out that univariate test can be used to analyse the relationship between corporate foreign exchange derivative instrument usage and firm’s foreign exchange exposure in Pakistan market.

Moreover, Makar and Huffman (2008) implied univariate test in descriptive statistics of 1–month return horizontal and12 month return horizontal. This is to test and analyse the mean difference between 1-month return horizontal and 12 month return horizontal. Furthermore, Hutson and Liang (2012) employed the size as exposure coefficient in descriptive statistic where one is less than $500 million and another one is more than $500 million of total asset. Based on those researches, the advantage of univariate test is it can analyse the descriptive statistic and use the average value of descriptive statistic to do testing.

On the other hand, there are two journals that used ordinary least-square regression as one of the test in the journals. Makar and Huffman(2008) had used time-series ordinary least square(OLS) and cross-sectional OLS to carry out the test. Time-series OLS had used percentage change in market index and percentage change in exchange rate as their independent variables. This test is use to investigate the relationship between monthly return and independent variables. Besides that, cross-sectional OLS used financial hedges, percentage of foreign sales and non-financial hedge as independent variables. This is use to test the relationship between foreign exchange exposure and those independent variables.

On the other hand, Allayannis, Ihrig and P.Weston(2013) used OLS regressions to estimate the relationship between exchange rate exposure and financial hedges Another two variables that used OLS are foreign sales ratio and exchange-rate exposure. By using the OLS regressions, the correlation between the variables can be test accurately either it is highly correlated or not correlated. Different variables can be included into the model to test the correlation.

4. Empirical Evidences

There are three journals have the same similarities that they use operational hedges as a financial derivative to hedge the foreign exchange exposure.

Choi and Jiang (2009) found that the operational can reduce the firm’s exchange risk exposure and increase the firm’s market return in the case that financial hedging and multinationality are under control. Another journal that supports this result showed that firm’s operational hedges are not always lead to high value. The use of operational hedges as the financial derivatives should be in conjunction with the foreign currency derivatives in order to enhance the firm’s value. It was stated that the firm that rely on operational hedges alone will not increase the shareholder value (Allayannis, Ihrig and P.Weston, 2013).

Hutson and Laing (2014) found that the operational hedging and financial hedging have an inverse relationship with the firm’s foreign exchange exposure. The most important point that had been stated was that operational hedges work and it actually provide a better protection during stress time.

We find that the similarity in the studies is financial currency derivative effectively managing foreign exchange rate exposure by using bilateral exchange rate. Makar and Huffman (2008) identify currency hedge technique can reduce currency risk associated with change with bilateral exchange rate. Besides, Choi and Jiang (2009) approve multinational corporations manage the exchange risk more effectively than non-multinational corporations due to effectively use the operating hedging strategy that determined by two models in using multilateral and bilateral exchange rate. The similarity in both studies is that the researchers have identified that the foreign currency exchange risk can be managed by using and bilateral exchange rate. Furthermore, Makar and Huffman (2008) have detected bilateral exchange rate is more efficient than broad exchange rate to manage the risk. Hence, it is an advantage to manage the risk and reduce its exposure.

Other than that, we also find that there is another similarity in the studies which is the uses of foreign exchange hedging strategies. The similarity is both of the uses of hedging strategies are benefit to the firms. Dash and N.S. (2008) state that the hedging strategies generated the highest returns and the lowest variability of returns could be recognized. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Makar and Huffman (2008) state that the hedging strategies can effectively reduce the currency risk associated with the change in bilateral exchange rate in UK multinationals. Working (1962) had deliberated hedging, not only as a means to protect against price risks, but also yield returns. Besides that, firms can save the transaction costs through hedging strategies. This is because in long run, gains and losses net off to leave a similar result to that if the firms use hedging strategies.

5.Conclusion Remarks

Foreign exchange risk is a lot of enterprises are facing the risk of foreign exchange. Foreign exchange risk is the existence of financial transactions denominated a financial risk than the monetary base of the company when the currency. Foreign exchange exposure has been a hot issue and its relationship with hedging strategy also has been studied in many literatures.

According to Choi and Jiang (2009), Allayannis, Ihrig and P.Weston (2013) and Huston and Laing (2014) stated that there are one model has been common used in the 3 journals out of 6 journals. That is two-factor model (2F). On the other hand, as Huston and Laing (2014) stated that there are few theoretical relations between exposure and multinationality.

From the empirical testing procedures, as Afza and Alman (2011) employed the Univariate Test in descriptive statistics of users and non-users of FX-Derivative. Besides, Makar and Huffman (2008) had used time-series Ordinary Least Square (OLS) and cross-sectional OLS to carry out the test. Also, Allayannis, Ihrig and P.Weston (2013) used OLS regressions to estimate the relationship between exchange rate exposure and financial hedges.

From the empirical evidences, there are 3 journals have the same similarities that they use operational hedges as a financial derivative to hedge the foreign exchange exposure. Also, we find that the similarity in the studies in financial currency derivative effectively managing foreign exchange rate exposure by using Bilateral Exchange Rate. Last but not least, we also find that another similarity in the studies which is the uses of foreign exchange hedging strategies. The similarity is both of the uses of hedging strategies are benefit to the firms.

Author(Year)

Data

Methodology

Finding

Allayannis, Ihrig & P.Weston (2001)

  • Variables:
  1. Number of countries.
  2. Number of broad regions.
  3. Geographic dispersion of subsidiaries across countries.
  4. Geographic dispersion of its subsidiaries across regions.
  • Time Period: 1996-1998
  • Sources:
  1. Balance sheet and income statement information is from COMPUSTAT.
  2. Return data are collected from the Center for Research in Security Prices (CRSP).
  • Two-factor model
  • Ordinary Least Square (OLS) Regression
  • The coefficient on the foreign-sales ratio is significantly and negatively related.
  • With financial hedges, operational hedges are significantly positively related to firm’s value.
  • The results show that operational supporting is not a viable substitute for financial risk management.

Author(Year)

Data

Methodology

Finding

Hutson & Laing (2014)

  • Sample from 953 US firms.
  • Time period: 1999-2009
  • Sources: New York Stock Exchange (NYSE), American Stock Exchange (AMEX), NASDAQ
  • Dependent variable:
  1. Exchange exposure coefficient
  • Independent variables:
  1. Measures of hedging
  2. Size
  3. Industry
  4. Foreign sales
  5. Leverage
  6. Liquidity
  7. Proxies for growth options
  • There is theoretical relation between exposure and multinationaliy
  • Jorion’s two-factor model
  • Cross-sectional regressions
  • Univariate testing
  • Logit model
  • Robustness tests: the 1999-2009 period
  • Further robustness test
  • The relation between operational hedging and financial hedging are non-linear, instead they are in a robust linear relation.
  • Operational hedging and financial hedging are inversely related to the firm’s foreign exchange exposure.
  • Operational hedging works more effectively and gives a better protection than financial hedging during stress time.

Author

Data

Methodology

Findings

Makar& Huffman (2008)

  • Time period 1980-2011
  • Sample of 44 UK multinationals companies
  • Independent variable:
  1. Hedge technique
  2. Foreign sales
  3. Principal currencies
  • Dependent variable:
  1. Foreign exchange exposure
  • Sources: UK firm’s operating and financial review section of annual report and DataStream compustat global vantage database
  • Firm specific approach
  • Time series and cross sectional ordinary least square (OLS)
  • Hypothesis test
  • Univariate test
  • By using financial currency hedge technique, it effectively reduces the currency risk associated with the change in bilateral exchange rate in UK multinationals.
  • Based on analysis, it is proven that the hypothesis test is robust to the firm size, the percentage `of foreign sale and non- financial hedge.

Author (Year)

Data

Methodology

Findings

Dash & N.S. (2008)

  • Exchange rate dynamics
  • Currency
  • Forward rate and option premium
  • TP: 1999-2009

(Annually)

  • Source: International Money and Foreign Exchange Markets: An Introduction, John Wiley and Sons.
  • Foreign exchange hedging strategies
  • Simulation
  • Simple non-linear model
  • Paired-samples t-test
  • The hedging strategies generated the highest returns and the lowest variability of returns could be recognized.
  • Change in exchange rate is comparative to the gap between the exchange rate in previous period and long-run equilibrium.
  • Hedging with out-of-the-money currency options contracts was found to result in the highest mean returns, regardless of the movement of exchange rate.

Author(Year)

Data

Methodology

Finding

Choi & Jiang (2009)

  • Multinational and non-multinational firms in U.S (889 firms)
  • January 1983- December 2003 (monthly)
  • Financial and operating hedging data from 2000-2006 (annually)
  • Monthly time series of dividend adjusted stock returns from the University of Chicago CRSP (Center for Research in Security Prices)
  • Value-weighted, dividend-adjusted return on stocks from the NYSE, AMEX AND NASDAQ
  • Information of operating and financial hedging from the corporate financial statement in Compact Disclosure database
  • variables: sales, market value of equity, firm size, book to market value of equity, foreign sales, excess market return, exchange risk factor, excess stock return
  • The Standard two-factor model (2F)
  • The extended Fama-French model (FF)
  • time series cross sectional panel regressions
  • Theory: the net exchange faced by the multinational may be greater or smaller than non-

multinational

  • Two-stage least square(2SLS)
  • The exchange exposure coefficients of multinational corporations are less significant than non-multinational corporations
  • Multinational corporations manage the exchange risk more effectively than non-multinational corporations due to effective use the operating hedging
  • The exchange risk coefficients are significant in the unmatched sample than matched sample
  • Find no evidence that significant exchange exposure for Japanese multinational corporations for 1979-1993
  • Operational hedging shows a positive result

Authors Name (year)

Data

Methodology

Findings

Aabo & Ploeen

(2014)

  • Sample from 198 of German large listed non-financial firms.
  • Time Periods: 2010
  • Sources: Orbis database and the 2010 annual reports of German large listed non-financial firms.
  • Dependent Variable;
  1. Foreign exchange hedging
  • Independent Variable
  1. Assets
  2. Equity Ratio
  3. Current
  4. Ebitda
  5. Diversification
  6. Foreign Debt
  7. Foreign Sale
  8. Foreign Assets
  • Ordinary least squares regression analysis
  • Robustness test
  • No indication that the reduced usage of foreign exchange derivatives among highly inter-national firms as compared to less internationalized firms (=the inverse U-shape) is driven by (1) geographical diversification or (2) matching of cash flows or operational flexibility from the firms’ ownforeign production facilities.
  • Robust to alternative definitions of strong international hedge alternative measures, rather than by specific sectors of the economy to promote .
  • A sample of large non-financial firms inless open economies (e.g. the U.S. and Japan) may not exhibit the same inverse U-shape relationship.

References

Aabo, T., Ploeen, R. (2014). The German humpback: Internationalization and foreign exchange hedging. Journal of Multinational Financial Management, 27, 114-129.

Afza, T., Alam, A. (2011). Corporate derivatives and foreign exchange risk management: A case study of non-financial firms of Pakistan. The Journal of Risk Finance, 12(5), 409-420.

Allayannis, G., Ihrig, J., Weston, J.P. (2001). Exchange-Rate Hedging: Financial versus Operational Strategies.

Choi, J.J., Jiang, C. (2009). Does multinational matter? Implications of operational hedging for the exchange risk exposure. Journal of Banking and Finance, 33, 1973- 1982.

Dash, M., N.S., A.K. (2008). Exchange rate dynamics and Forex hedging strategies.

Hutson, E., Laing, E. (2014). Foreign exchange exposure and multinationality. Journal of Banking and Finance, 43, 97-113.

Makar, S.D., Huffman, S.P. (2008). UK Multinationals’ Effective Use of Financial Currency- Hedge Techniques: Estimating and Explaining Foreign Exchange Exposure Using Bilateral Exchange Rates.

Papaioannou, M. (2006, November). Exchange Rate Risk Measurement and Management:

Issues and Approaches for Firms.

Walmsleyy, J. (1996). International Money and Foreign Exchange Market: An Introduction, John Wiley and Sons.


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