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.     

Reducing reporting risk: Designating foreign currency forward contracts as cash flow hedges

We present an example that compares the effects on earnings of designating a foreign currency forward contract as either a cash-flow or fair-value hedge of a foreign currency denominated receivable. Entities engaging in exchange transactions not denominated in their functional currency frequently enter into foreign currency forward contracts in order to mitigate their foreign exchange rate risk exposure. The aggregate effect on earnings of the transaction gain or loss on the foreign currency receivable and the gain or loss on the forward contract is known on the date the forward contract is initiated. The effect on each period’s earnings during the term of a forward contract designated as a cash-flow hedge is also known on the date the contract is initiated; whereas the effect on each periods’ earnings from a fair-value hedge cannot be determined until the respective balance sheet dates. Therefore, designating forward contracts as cash-flow hedges may suppress volatility in reported earnings compared to designating forward contracts as fair-value hedges. In addition, the reporting risk (the amount of uncertainty surrounding the pending measure of an item to be reported in the financial statements) is lower when a forward contract is designated as a cash-flow hedge relative to designating it as a fair-value hedge. This suggests foreign currency forward contracts designated as cash-flow hedges are more consistent with the purpose of hedge accounting: to mitigate the effects on earnings of applying different measurement criteria for the hedge and the hedged item.     

International tax arbitrage,currency options and put-call parity conditions

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation where foreign currency exposure can be hedged using forward contracts and a set of currency options. We obtain tax-modified option prices similar to the no-tax ones, but augmented by tax-induced “risk-premium” terms; tax-modified put-call parity conditions are derived that revert to their standard (no-tax) format if the respective marginal agents in the bond and option markets are in identical tax brackets.     

The Impact of the Introduction of the Euro on Foreign Exchange Risk Management in UK Multinational Companies

One of the arguments in favour of the euro is that it will eliminate foreign exchange risk for companies in the euro‐zone. There could also be benefits for companies outside this zone, although their currency risk with the euro remains. This paper considers this, by examining the effect of the euro on the currency risk management of UK multinational companies (MNCs). Using the responses from a questionnaire and interviews we found that the euro, which is being widely used in UK MNCs, is generally favoured due to reductions in exchange uncertainty and costs of managing currency risk. Nonetheless, contrary to what would theoretically be expected, there was no exact relationship in the reduction in hedging activity accompanied by this reduction in risk. The majority of MNCs stated that their hedging activities would remain unchanged. The capacity of MNCs to benefit from reductions in risk and hedging depend on the proportion of non‐UK European trade, the industry sector and the ability to transfer risk down the supply chain. Finally, despite the reductions in currency exposure experienced by the majority of companies the euro will not encourage UK MNCs to expand international trade.     

Optimizing international portfolios with options and forwards

We develop a stochastic programming model to address in a unified manner a number of interrelated decisions in international portfolio management: optimal portfolio diversification and mitigation of market and currency risks. The goal is to control the portfolio’s total risk exposure and attain an effective balance between risk and expected return. By incorporating options and forward contracts in the portfolio optimization model we are able to numerically assess the performance of alternative tactics for mitigating exposure to the primary risks. We find that control of market risk with options has more significant impact on portfolio performance than currency hedging. We demonstrate through extensive empirical tests that incremental benefits, in terms of reducing risk and generating profits, are gained when both the market and currency risks are jointly controlled through appropriate means.     

Tax Timing Options on Futures Contracts and the 1981 Economic Recovery Act

This study utilizes foreign currency futures contracts to evaluate the tax timing options created by the 1981 Economic Recovery Act. Our findings suggest that the act had an impact on contracts with less than six months to maturity and that the marginal trader in those contracts is a long-position holder. Similarly, the results suggest that the option of tax year selection for foreign currency futures in valuable.     

Spot and forward volatility in foreign exchange

This paper investigates the empirical relation between spot and forward implied volatility in foreign exchange. We formulate and test the forward volatility unbiasedness hypothesis, which may be viewed as the volatility analogue to the extensively researched hypothesis of unbiasedness in forward exchange rates. Using a new dataset of spot implied volatility quoted on over-the-counter currency options, we compute the forward implied volatility that corresponds to the delivery price of a forward contract on future spot implied volatility. This contract is known as a forward volatility agreement. We find strong evidence that forward implied volatility is a systematically biased predictor that overestimates movements in future spot implied volatility. This bias in forward volatility generates high economic value to an investor exploiting predictability in the returns to volatility speculation and indicates the presence of predictable volatility term premiums in foreign exchange.     

Forward and Futures Prices: Evidence from the Foreign Exchange Markets

Cornell and Reinganum (1981) , hereafter CR, report that price differentials for future contracts and forward contracts are statistically insignificant in foreign exchange markets. Based on this finding, CR conclude that marking-to-market is insignificant in the formulation of currency futures prices. This note identifies two potential concerns with the CR tests. One problem relates to the timing of delivery dates for “matched” contracts. A second problem relates to the time period for the CR study. We show that correcting for these problems does not affect the overall conclusions of the CR study; marking-to-market does not appear to have a significant effect on currency futures prices.     

Valuation of quanto options in a Markovian regime-switching market: A Markov-modulated Gaussian HJM model

We consider the valuation of European quanto call options in an incomplete market where the domestic and foreign forward interest rates are allowed to exhibit regime shifts under the Heath–Jarrow–Morton (HJM) framework, and the foreign price dynamics is exogenously driven by a regime switching jump-diffusion model with Markov-modulated Poisson processes. We derive closed-form solutions for four different types of quanto call options, which include: options struck in a foreign currency, a foreign equity call struck in domestic currency, a foreign equity call option with a guaranteed exchange rate, and an equity-linked foreign exchange-rate call.     

THE HEDGING EFFECTIVENESS OF FOREIGN CURRENCY FUTURES

This study provides an initial analysis of the hedging potential of the foreign currency futures markets. Numerous studies exist on the pricing efficiency and hedging effectiveness of the foreign currency forward markets, but little research exists on the foreign currency futures market. An adequate price history has only recently become available to carry out such an investigation. Minimum risk hedges and hedging effectiveness measures are presented for five currencies: the British pound, German mark, Canadian dollar, Japanese yen and Swiss franc. Analysis indicates the relative desirability of positions in futures contracts to minimize the risk of spot currency exposure. Results also show hedging effectiveness increases with the investment horizon.     

Foreign Currency Derivatives versus Foreign Currency Debt and the Hedging Premium

This paper compares the effect on firm value of different foreign currency (FC) financial hedging strategies identified by type of exposure (short‐ or long‐term) and type of instrument (forwards, options, swaps and foreign currency debt). We find that hedging instruments depend on the type of exposure. Short‐term instruments such as FC forwards and/or options are used to hedge short‐term exposure generated from export activity while FC debt and FC swaps into foreign currency (but not into domestic currency) are used to hedge long‐term exposure arising from assets located in foreign locations. Our results relating to the value effects of foreign currency hedging indicate that foreign currency derivatives use increases firm value but there is no hedging premium associated with foreign currency debt hedging, except when combined with foreign currency derivatives. Taken individually, FC swaps generate more value than short‐term derivatives.     

Forecasting Emerging Market Exchange Rates from Foreign Equity Options

The use of derivatives to infer future exchange rates has long been a subject of interest in the international finance literature. With the recent currency crises in Mexico, Southeast Asia, and Brazil, work on exchange rate expectations in emerging markets is of particular interest. For some emerging markets, foreign equity options are the only liquid exchange‐traded derivatives with currency information embedded in their prices. Given that emerging markets sometimes undergo currency realignment with discrete jumps in their exchange rate, estimation of risk‐neutral probability density functions from foreign equity option data provides valuable evidence concerning market expectations. To illustrate the use of foreign equity options in estimating market beliefs, we consider Telmex options around the 1994 peso devaluation and find evidence that markets anticipated the change in the Mexican government's foreign exchange policy.     

An analysis of asymmetry in foreign currency exposure of the Australian equities market

Using both daily and monthly data, the authors: (a) analyse the extra-market component of foreign exchange exposure of the Australian equities market using the Australian/US exchange rate factor return in an augmented market model; and (b) use a dummy variable specification to model the potential asymmetric effect induced by non-linear hedging strategies, such as using currency options, for the period 1988–1996. Overall, the results are mixed. The following are found: (i) stronger evidence of foreign exchange exposure in the analysis employing daily data; (ii) when using daily data, a stronger lagged response than a contemporaneous response is observed; (iii) some evidence of asymmetry; and (iv) evidence of significant exchange rate exposures of the predicted sign in several industries. Further, the findings using monthly data are less significant than those using daily data.     

Official FX interventions through derivatives

We use high-frequency data to study the effects of currency swap auctions carried out by the Brazilian Central Bank on the USDBRL exchange rate. We find that official currency swap auctions impact the exchange rate in a significant way, even though they do not directly alter the supply of foreign currency in the market. We show that during our sample period auctions of contracts in which the Central Bank took a short position in USD had larger effects than those in which the Central Bank took a long position. The supply of currency swaps to the market provides an alternative for traders that demand foreign currency for financial (speculative or hedging) rather than transactional reasons, and thus affects the demand for foreign currency and its price. This mechanism is likely to be particularly relevant when forecasters extrapolate exchange rate trends at short-term horizons.     

Hedging,selective hedging,or speculation? Evidence of the use of derivatives by Brazilian firms during the financial crisis

This paper analyse the use of foreign exchange derivatives by non-financial publicly traded Brazilian companies from 2007 to 2009. Using balance-sheet data on firms’ positions in derivatives and their foreign exchange exposure, the paper verifies the existence of three groups of derivative users: hedgers, selective hedgers – companies that significantly changed the volume of derivatives used during this period, but used them in line with their currency exposure – and active speculators – companies that adopted positions that would have been inadvisable had the aim been to hedge their currency exposure. Selective hedgers and speculators have one similarity: both tried to obtain gains through the continuous process of domestic currency appreciation. Confirming the optimal hedging literature, the paper shows that several firm characteristics are able to explain the use of derivatives and hedging by firms but market timing in the derivative markets is explained solely by firms’ foreign exposure, corporate governance and the macroeconomic environment.     

以新思维审视中国外汇储备风险

外汇储备是一国国际经济活动往来形成的特殊的外币债权,中国经常项目、资本和金融项目的特点以及热钱的大规模流入决定了中国当前的外汇储备存在一定的不稳定因素。过多的外汇储备必将产生较大的机会成本风险,并且面临着较大且频繁的汇率风险以及境外金融机构倒闭和资产价格波动的风险,给国内的流动性控制和金融调控带来诸多的困难,增加了贸易摩擦的频率。要审时度势,通过加快国内经济结构调整、鼓励走出去、多元化运作储备资产等形式规避中国外汇储备所面临的风险。     

A simple approach to interest-rate option pricing

A simple introduction to contingent claim valuation of riskyassets in a discrete time, stochastic interest-rate economyis provided. Taking the term structure of interest rates asexogenous, closed-form solutions are derived for European optionswritten on (i) Treasury bills, (ii) interest-rate forward contracts,(iii) interest-rate futures contracts, (iv) Treasury bonds,(v) interest-rate caps, (vi) stock options, (vii) equity forwardcontracts, (viii) equity futures contracts, (ix) Eurodollarliabilities, and (x) foreign exchange contracts.     

Impact of macro-economic surprises on carry trade activity

Can official news and policy announcements affect foreign exchange speculation? A widespread speculative strategy in foreign exchange markets is carry trade. This paper explores the links between macro-economic news and foreign exchange options to identify macro-economic fundamentals most relevant to the pricing of downside risk – measured by risk reversals options contracts – to carry trade activity. Focusing primarily on the Japanese yen carry trade, we identify a significant impact of macro-economic surprises on dollar/yen risk reversals. The effect is sizeable, with news related to bilateral trade balance of particular concern. Moreover, there is a close link between risk reversals and speculative futures positions in Japanese yen. This allows us to quantify a substantial effect of macro-economic news on carry trade activity, with the cost of hedging as the transmission mechanism.     

An Analysis of Intertemporal Pricing for Forward Foreign Exchange Contracts

An asset-pricing model with an unobservable time-varying risk premium is used to price forward foreign exchange contracts. Specifically, the term spectrum of forward foreign exchange contracts is examined in order to focus on country-specific and maturity-specific information. The testable restrictions imposed by the model are consistent with both cross-country and cross-maturity forward contracts except at the short end of the maturity spectrum for cross-country forward exchange rates. This indicates that the intertemporal model is relatively robust in valuing forward contracts of different maturities and for different exchange rates but that it may fail when there are significant short-term country-specific shocks.