Does multinationality matter? Implications of operational hedging for the exchange risk exposure

An important issue in global corporate risk management is whether the multinationality of a firm matters in terms of its effect on exchange risk exposure. In this paper, we examine the exchange risk exposure of US firms during 1983–2006, comparing multinational and non-multinational firms and focusing on the role of operational hedging. Since MNCs and non-multinationals differ in size and other characteristics, we construct matched samples of MNCs and non-multinationals based on the propensity score method. We find that the multinationality in fact matters for a firm’s exchange exposure but not in the way usually presumed – the exchange risk exposures are actually smaller and less significant for MNCs than non-multinationals. The results are robust with respect to different samples and model specifications. There is evidence that operational hedging decreases a firm’s exchange risk exposure and increases its stock returns. The effective deployment of operational risk management strategies provides one reason why MNCs may have insignificant exchange risk exposure estimates.     

What lies beneath: Foreign exchange rate exposure,hedging and cash flows

This paper presents results from an in-depth analysis of the foreign exchange rate exposure of a large nonfinancial firm based on proprietary internal data including cash flows, derivatives and foreign currency debt, as well as external capital market data. While the operations of the multinational firm have significant exposure to foreign exchange rate risk due to foreign currency-based activities and international competition, corporate hedging mitigates this gross exposure. The analysis illustrates that the insignificance of foreign exchange rate exposures of comprehensive performance measures such as total cash flow can be explained by hedging at the firm level. Thus, the residual net exposure is economically and statistically small, even if the operating cash flows of the firm are significantly exposed to exchange rate risk. The results of the paper suggest that managers of nonfinancial firms with operations exposed to foreign exchange rate risk take savvy actions to reduce exposure to a level too low to allow its detection empirically.     

Foreign exchange exposure and multinationality

We examine the relation between firms’ foreign exchange exposure and the extent of their multinationality as a proxy for operational hedging. Using a sample of 953 US firms over the period 1999–2006, we show that there is a nonlinear relation between operational and financial hedging, confirming anecdotal evidence that many highly multinational firms do not hedge with derivatives. We find that operational hedging and financial hedging are significantly inversely related to firms’ foreign exchange exposure, providing evidence that the two hedging techniques are complementary for all but the most highly operationally hedged firms. By comparing our findings for 1999–2006 with 1999–2009, we show that this complementarity breaks down when exchange rate volatility is high – as the effectiveness of financial hedging diminishes. An important message for firms is that operational hedges work, and they potentially provide better protection than financial hedging during times of stress.     

The choice of hedging techniques and the characteristics of UK industrial firms

This study presents the empirical results for the relationship between the use of hedging techniques and the characteristics of UK multinational enterprises (MNEs). All the firms in the sample hedge foreign exchange (FX) exposure. The results indicate that UK firms focus on a very narrow set of hedging techniques. They make much greater use of derivatives than internal hedging techniques. The degree of utilisation of both internal and external techniques depends on the type of exposure that is hedged. Furthermore, the characteristics of the firms appear to explain the choice of hedging technique but the use of certain hedging techniques appears to be associated with increases in the variability of some accounting measures. This adverse impact of hedging has not been emphasised in the finance literature. The results imply that firms need to ensure that the appropriate techniques are used to hedge exposures.     

The determinants of Norwegian exporters’ foreign exchange risk management

Abstract

This paper examines foreign exchange (FX) hedging by Norwegian exporting firms to provide empirical evidence on the determinants of the hedging decision. The paper contributes to prior studies by, first, focusing on exporters to ensure that the companies in the sample have FX exposure, thereby allowing a more rigorous test of the theoretical determinants of hedging, and, secondly, in contrast to most previous studies that have focused on FX external hedging instruments, the use of both internal and external instruments is examined. Univariate, multivariate and multinominal analyses all provide evidence consistent with the firm value maximization hypotheses of underinvestment and risk aversion. Also, the following characteristics of firms—size, extent of internationalization and liquidity—are found to be related to the decision to hedge FX risk. However, the evidence on the links between the firm characteristics and the decision to hedge is not consistent across internal and external FX hedgers, and also varies for individual hedging instruments. Therefore it is argued that the empirical evidence on the theoretical determinants cannot be generalized to cover the full range of FX hedging strategies (which includes internal hedging instruments). Unlike empirical studies for other countries the evidence for Norwegian firms does not support the hypothesis that the avoidance of financial distress and the need to resort to external capital markets is a significant determinant of the hedging decision. Whilst the evidence suggests that country-specific factors may play a role in determining the use of FX hedging, it does not imply that the different policies adopted are necessarily inconsistent with the firm value maximization hypothesis.     

Crossing the lines: The conditional relation between exchange rate exposure and stock returns in emerging and developed markets

This paper examines the importance of exchange rate exposure in the return generating process for a large sample of non-financial firms from 37 countries. We argue that the effect of exchange rate exposure on stock returns is conditional and show evidence of a significant return impact to firm-level currency exposures when conditioning on the exchange rate change. We further show that the realized return to exposure is directly related to the size and sign of the exchange rate change, suggesting fluctuations in exchange rates as a source of time-variation in currency return premia. For the entire sample the return impact ranges from 1.2 to 3.3% per unit of currency exposure, and it is larger for firms in emerging markets compared to developed markets. Overall, the results indicate that foreign exchange rate exposure estimates are economically meaningful, despite the fact that individual time-series results are noisy and many exposures are not statistically significant, and that exchange rate exposure plays an important role in generating cross-sectional return variation. Moreover, we show that the relation between exchange rate exposure and stock returns is more consistent with a cash flow effect than a discount rate effect.     

Is operational hedging a substitute for or a complement to financial hedging?

This paper investigates operational hedging by firms and how operational hedging is related to financial hedging by using a sample of 424 firm observations, which consist of 212 operationally hedged firms (firms with foreign sales) and a size- and industry-matched sample of 212 non-operationally hedged firms (firms with export sales). We find that non-operationally hedged firms use more financial hedging, relative to their levels of foreign currency exposure, as measured by the amount of export sales. On the other hand, though operationally hedged firms have more currency exposure, their usage of financial derivatives becomes much smaller than that of exporting firms. These results can explain why some global firms use very limited amount of financial derivatives for hedging purpose despite much higher levels of currency risk exposure. We also show that hedging increases firm value.     

Exchange rate exposure in the Asian emerging markets

This paper investigates the impact of foreign exchange rate change on stock returns in the Asian emerging markets. The asymmetric exchange exposure framework and real exchange rates are used in this paper to capture the different exposures between currency appreciation and depreciation and the high inflation effect in the emerging markets. My empirical results show that there did exist extensive exchange rate exposure in the Asian emerging markets from 1997 to 2010. Moreover, foreign exchange exposure became more significant or greater during the 1997 Asian crisis and the 2008 global crisis periods, despite the frequent central banks’ interventions during these periods. The greater exchange exposure during the crisis periods can be attributable to net exporters or firms with dollar assets, implying that firms can reduce exchange exposures by decreasing their export ratio or dollar assets holding during times of crisis.     

The Asian exposure of U.S. firms: Operational and risk management strategies

This paper examines the Asian currency exposure of U.S. firms with regard to their international operational and risk management strategies. We find that contemporaneous and lagged changes in real exchange rates have significant impacts on firm value for about 30% of the U.S. firms with Asian operations. The effects of a strong dollar are heterogeneous, with both significantly positive and significantly negative coefficients. The exchange exposure coefficients are then estimated as a function of international operational and risk management variables. A strong dollar has an adverse effect on firm value when the firm has a negative initial exposure position, and is related to exports and local sales activities of the firms. However, asset deployment in Asia raises the exposure in absolute terms regardless of initial exposure condition. Variables for hedging incentives explain exposure in both positive and negative exposure cases. Finally, a disaggregate study by country shows significant intra-regional differences, indicating the different ways in which the U.S. firms used their Asian subsidiaries operationally.     

Using survey data to resolve the exchange risk exposure puzzle: Evidence from U.S. multinational firms

This paper examines the effect of unexpected exchange rate movements on U.S. shareholder wealth. Empirical results based on a sample of 634 U.S. multinational firms (1) confirm previously reported evidence that the disaggregation of the worldwide trade-weighted U.S. dollar exchange rate index into seven region-specific trade-weighted indices increases the precision and significance of exposure estimates; (2) show that models assuming that changes in spot exchange rates are unanticipated are frequently misspecified and, thus, unable to correctly detect the impact of currency movements on firm value; (3) reveal that forward and survey expectations enable us to distinguish between the effect of ‘realized’ and ‘unexpected’ currency movements; and (4) reveal that investors making pricing and hedging decisions prefer to use the information contained in short-term forward and survey expectation rates to the information included in long-term forecasts.     

Financial Regulation,Exchange Rate Exposure,and Hedging Activities: Evidence from Korean Firms

ABSTRACT

In this article, we attempt to estimate whether firm-specific exchange rate exposures affected by hedging activities can be improved through financial regulation or supervision. To analyze this, we compose three-step estimations by using a sample of KOSPI 200 firms during 1,803 trading days between 2005 and 2012. We first estimate the relationship between exchange rate exposure and hedging activities and see whether financial regulation had any effect on hedging activities. Furthermore, using TSLS analysis, we estimate the effect of hedging activities on exchange rate exposure, which is caused by tightened financial regulation in the form of corporate governance. We report the following findings. First, firms are less likely to be exposed to exchange risk with more hedging activities. Second, corporate governance has a strongly positive effect on the hedging activities. Firms use more hedging tools when they have a strong structure of shareholder’s protection, clear outside ownership, and a better monitoring system; but the relationship becomes weaker in times of crisis.     

The effects of SFAS 133 on foreign currency exposure of US-based multinational corporations

This study examines the change in foreign currency exposure of US-based multinational corporations (MNCs) upon implementation of SFAS 133—Disclosure of Derivative Instruments. We attempt to answer the question of whether this accounting requirement, which seeks to eliminate earnings surprises associated with derivatives, actually impacts earnings volatility and hedging strategies of exporting firms. Our results indicate that firms who were hedged prior to SFAS 133, i.e., those which managed their exposure using operational hedges, derivatives, or both, were able to decrease exposure to exchange rates following SFAS 133. However, those that were hedged prior to SFAS 133 and remained hedged following SFAS 133 did so without significantly changing their imbalances, i.e., without using operational hedges. These firms also experienced an increase in earnings volatility and a decrease in earnings predictability, as predicted by critics of the regulation. However, market value does not change following SFAS 133, implying that investors do not equate accounting regulation changes and EPS volatility with changes in cash flow.     

The time-varying diversifiability of corporate foreign exchange exposure

Estimating comovement measures for a large set of bilateral foreign exchange (FX) rates, I explore the relation between firm-level FX exposure and its time-varying diversifiability. For a sample of U.S. firms, the magnitude of FX exposure appears to increase during periods of low currency risk diversifiability. Additional results suggest that the introduction of the euro exacerbated the effect of diversifiability on developed market currency exposure. Moreover, the low diversifiability of emerging market currencies seems to have a stronger effect on FX exposure than the low diversifiability of developed market currencies.     

The Determinants of Stock Price Exposure: Financial Engineering and the Gold Mining Industry

This paper studies the exposure of North American gold mining firms to changes in the price of gold. The average mining stock moves 2 percent for each 1 percent change in gold prices, but exposures vary considerably over time and across firms. As predicted by valuation models, gold firm exposures are significantly negatively related to the firm's hedging and diversification activities and to gold prices and gold return volatility, and are positively related to firm leverage. Simple discounted cash flow models produce useful exposure predictions but they systematically overestimate exposures, possibly due to their failure to reflect managerial flexibility.     

Foreign Exchange Risk,Hedging, and Tax-Motivated Outbound Income Shifting

Although outbound income shifting to low-tax jurisdictions provides tax savings, it is often accompanied by nontax costs. In this study, I examine whether foreign exchange (FX) risk constrains tax-motivated outbound income shifting by U.S. multinational corporations. My findings indicate that exposure to greater currency volatility is associated with less outbound income shifting, and this effect is stronger for firms with foreign affiliates using foreign functional currencies. I also investigate whether hedging facilitates outbound income shifting. Consistent with hedging lowering costs associated with exchange rate volatility, I find that U.S. firms that use more currency derivatives tend to shift more income to low-tax foreign jurisdictions. Overall, these findings suggest that FX risk is an important cost of outbound income shifting.     

Does Risk Management Add Value? A Survey of the Evidence

The fact that 92% of the world's 500 largest companies recently reported using derivatives suggests that corporate managers believe financial risk management can increase shareholder value. Surveys of finance academics indicate that they too believe that corporate risk management is, on the whole, a valueadding activity. This article provides an overview of almost 30 years of broadbased, stock‐market‐oriented academic studies that address one or more of the following questions:

• ? Are interest rate, exchange rate, and commodity price risks reflected in stock price movements?
• ? Is volatility in corporate earnings and cash flows related in a systematic way to corporate market values?
• ? Is the corporate use of derivatives associated with reduced risk and higher market values?

The answer to the first question, at least in the case of financial institutions and interest rate risk, is a definite yes; all studies with this focus find that the stock returns of financial firms are clearly sensitive to interest rate changes. The stock returns of industrial companies exhibit no pronounced interest rate exposure (at least as a group), but industrial firms with significant cross‐border revenues and costs show considerable sensitivity to exchange rates (although such sensitivity actually appears to be reduced by the size and geographical diversity of the largest multinationals). What's more, the corporate use of derivatives to hedge interest rate and currency exposures appears to be associated with lower sensitivity of stock returns to interest rate and FX changes. But does the resulting reduction in price sensitivity affect value—and, if so, how? Consistent with a widely cited theory that risk management increases value by limiting the corporate “underinvestment problem,” a number of studies show a correlation between lower cash flow volatility and higher corporate investment and market values. The article also cites a small but growing group of studies that show a strong positive association between derivatives use and stock price performance (typically measured using price‐to‐book ratios). But perhaps the nearest the research comes to establishing causality are two studies—one of companies that hedge FX exposures and another of airlines' hedging of fuel costs—that show that, in industries where hedging with derivatives is common, companies that hedge outperform companies that don't.     

CORPORATE HEDGING AND SHAREHOLDER VALUE

Although theory suggests that corporate hedging can increase shareholder value in the presence of capital market imperfections, empirical studies show overall mixed support for rationales of hedging with derivatives. Although various empirical challenges and limitations advise some caution with regard to the interpretation of the existing evidence, the results are consistent with derivatives use being just one part of a broader financial strategy that considers the type and level of financial risks, the availability of risk management tools, and the operating environment of the firm. Moreover, corporations rely heavily on pass‐through, operational hedging, and foreign currency debt to manage financial risk.     

Fuel hedging,operational hedging and risk exposure — Evidence from the global airline industry

The aviation industry is characterized by low profit margins and a constant struggle with skyrocketing fuel costs. Financial and operational hedging strategies serve aviation managers as a tool to counteract high and volatile fuel prices. While most research on fuel hedging has concentrated on the U.S. airline market, this paper is the first study to include airlines from Asia and Europe. We analyze 64 airlines over 11 years and find that Asian carriers are more negatively exposed than European airlines but less exposed than North American airlines. In contrast to Treanor, Simkins, Rogers and Carter (2012), this study finds less significant negative exposure coefficients among U.S. carriers. Using a fixed effects model we reject the hypothesis that financial hedging decreases risk exposure. One possibility is that the decreased volatility in jet fuel prices over the past few years has perhaps made airlines less exposed to fuel prices and hence, financial hedging is less effective. Operational hedging, defined by two proxies for fleet diversity, does not reduce exposure significantly, either. In contrast, a one percentage point increase in fleet diversity, calculated with a dispersion index using different aircraft types, increases the risk exposure coefficient by 1.83%. On the other hand, fleet diversity, calculated with different aircraft families, increases exposure by only 0.63%. These results are supported by the global trend of airline managers to reduce fleet diversity. Airlines have reduced their fleet diversity by 7.70% or 10.77% (depending on the proxy) between 2002 and 2012. The greatest reduction can be found among European airlines with 23.12% (28.04%).     

Stock return exposure to exchange rate risk: A perspective from delayed reactions and hedging effects

This paper investigates the absence of prevailing evidence on the significant exposure of US stocks to exchange rate risk by considering a firm's pre-hedging currency exposure, its expected hedging activity and the delayed reaction of its stocks to currency movements. Although we demonstrate the importance of lagged exposure relative to contemporaneous exposure, the inclusion of the lagged effect in the exposure measurement still fails to raise the significance of the exchange rate risk with regard to the pricing for the overall sample of stocks. We further demonstrate that the weak evidence on priced currency risk is at least partly attributable to hedging activity, particularly for large firms. Finally, our results provide partial support for the asymmetric hedging hypothesis, in that asymmetric hedging is found to be responsible for reshaping the relationship between a firm's characteristics and its currency exposure.     

Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies

Under what conditions will a multinational corporation alterits operations to manage its risk exposure? We show that multinationalfirms will engage in operational hedging only when both exchangerate uncertainty and demand uncertainty are present. Operationalhedging is less important for managing short-term exposures,since demand uncertainty is lower in the short term. Operationalhedging is also less important for commodity-based firms, whichface price but not quantity uncertainty. When the fixed costsof establishing a plant are low or the variability of the exchangerate is high, a firm may benefit from establishing plants inboth the domestic and foreign location. Capacity allocated tothe foreign location relative to the domestic location willincrease when the variability of foreign demand increases relativeto the variability of domestic demand or when the expected profitmargin is larger. For firms with plants in both a domestic andforeign location, the foreign currency cash flow generally willnot be independent of the exchange rate and consequently theoptimal financial hedging policy cannot be implemented withforward contracts alone. We show that the optimal financialhedging policy can be implemented using foreign currency calland put options and forward contracts.