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.     

Information and volatility links in the foreign exchange market

We apply the trading model of Fleming et al (1998 ). to a number of currency markets. The model posits that two markets can have common volatility structures as a result of receiving common information and from cross‐hedging activity where a position in one currency is used to hedge risk in a position taken in another. Our results imply that the model is effective in identifying common information flows and volatility spillovers in the currency markets and that some of these effects are lost when simply examining raw correlations. A series of specification tests of the 21 bivariate systems that are examined provides support for the trading model in the foreign exchange context.     

Trading volume and exchange rate volatility: Evidence for the sequential arrival of information hypothesis

The relationship between trading volume and volatility in foreign exchange markets continues to be of much interest, especially given the higher than expected volatility of returns. Allowing for nonlinearities, this paper tests competing hypotheses on the possible relationship between volatility and trading volume using data for three major currency futures contracts denominated in US dollars, namely the British pound, the Canadian dollar and the Japanese yen. We find that trading volumes and return volatility are negatively correlated, implying a lack of support for the mixture of distributions hypothesis (MDH). Using linear and nonlinear Granger causality tests, we document significant lead-lag relations between trading volumes and return volatility consistent with the sequential arrival of information (SAI) hypothesis. These findings are robust and not sample-dependent or due to heterogeneity of beliefs as proxied by open interest. Furthermore, our results are insensitive to the modeling approach used to recover volatility measures. Overall, our findings support the contention that short- to medium-term currency relationships may be dominated by trading dynamics and not by fundamentals.     

Monetary policy, ‘dollarization,’ and parallel market exchange rates: The case of the Dominican Republic

Excessive money creation may give rise to inflation tax revenues and to a depreciation of the domestic currency. this in turn leads to a shift away from the domestic currency into a foreign currency (e.g., the US dollar, hence the term ‘dollarization’). From the domestic monetary authority's point of view, ‘dollarization’ is an unwelcomed phenomenomn, thus the monetary authorities will attempt to arrest the ‘dollarization’ phenomenon while maintaining the excessive money growth. This paper develops and tests a model which analyzes the effects of monetary policy on dollarization and the ‘parallel’ market exchange rates.     

The role of foreign currency debt in financial crises: 1880–1913 versus 1972–1997

We show that exposure to foreign currency debt does not necessarily increase the risk of having a financial crisis. Some countries do not suffer from financial fragility despite original sin. Before 1913 British offshoots and Scandinavia afflicted with it avoided financial meltdowns. Today many advanced countries have original sin, but few have had crises. In both periods, aggregate balance sheet mismatches are associated with a greater likelihood of a crisis. The evidence suggests that foreign currency debt is dangerous when mis-managed. This is part of the difference between developed countries and emerging markets both of which borrow in foreign currency.     

The Importance of Corporate Foreign Debt in Managing Exchange Rate Exposures in Non‐Financial Companies

This empirical study of the exchange rate exposure management of Danish non‐financial firms listed on the Copenhagen Stock Exchange shows that debt denominated in foreign currency (‘foreign debt’) is a very important alternative to the use of currency derivatives. The results show that the relative importance of foreign debt is positively related to (1) the extent of foreign subsidiaries, (2) the relative value of assets in place, and (3) the debt ratio. The pivotal role of time horizon is emphasised. These findings are important to firms in other countries with open economies.     

Currency substitution, capital mobility and money demand

This paper re-examines the currency substitution (CS) issue by specifying a general portfolio balance (PB) model where domestic residents' demand for foreign money is distinguished from their demands for foreign non-monetary assets. The latter possibility, which reflects international capital mobility as opposed to CS per se, is already a key feature in the open-economy macro literature. The inclusion of foreign money leaves the usual asset demand functions unchanged (in the PB model that ignores CS), at least as far as the appropriate rate-of-return arguments and their signs are concerned. Although this suggests that CS is of limited importance in macro modelling, it implication for the estimation of money demand functions is pursued. An initial attempt is made to empirically isolate the separate efects of high capital mobility and currency substitution for Canada, Germany, the United Kingdom, and the United States. The results, while not conclusive due to high multicollinearity problems, bring into question the empirical as well as the theoretical relevance of currency substitution.     

货币错配与经济金融稳定:亚太经验比较分析

中国的汇率制度改革使得在盯住汇率制度下积聚的巨大货币错配风险逐渐暴露出来.货币错配是否会影响经济金融稳定,本文通过对亚洲金融危机、日本经济衰退以及本世纪以来亚洲新兴市场国家的累积的新风险进行梳理、比较与分析,得出净外币负债型货币错配与净外币资产型货币错配在一定的条件下都会影响经济金融稳定.     

The valuation-relevance of the foreign translation adjustment: The effect of barriers to entry

We examine the economic effects of barriers to entry on the association between foreign currency translation adjustments and the stock returns of multinational firms operating in the manufacturing and service industries. Firms that are innovation leaders, that is, firms that are research and development (R&D) intensive and firms with high foreign asset intensity (i.e., asset-intensive firms), are our proxies for firms operating in environments with barriers to entry (i.e., environments in which competition is less intense). We hypothesize and find that foreign currency translation adjustments are positively associated with abnormal stock returns for firms operating in environments with barriers to entry in both manufacturing and service industries. This finding highlights the importance of assessing the valuation-relevance of foreign currency translation adjustments by considering the economic contexts of foreign currency movements. Overall, the evidence shows that the accounting rules governing foreign currency translations generally produce results consistent with the economic effects of foreign exchange rate changes.     

Bank Funding,Securitization, and Loan Terms: Evidence from Foreign Currency Lending

We examine how bank funding structure and securitization activities affect the currency denomination of business loans. We analyze a unique data set that includes information on the requested and granted loan currency for 99,490 loans granted to 57,464 firms by a Bulgarian bank. Our findings document that foreign currency lending is at least partially driven by bank eagerness to match the currency structure of assets with that of liabilities. Our results also show that loan currency, as well as loan amount and maturity, are adjusted to make loans eligible for securitization.     

Expectations Hypothesis of the Term Structure of Implied Volatility: Evidence from Foreign Currency and Stock Index Options

Using a stochastic volatility option pricing model, we showthat the implied volatilities of at-the-money options are notnecessarily unbiased and that the fixed interval time-seriescan produce misleading results. Our results do not support theexpectations hypothesis: long-term volatilities rise relativeto short-term volatilities, but the increases are not matchedas predicted by the expectations hypothesis. In addition, anincrease in the current long-term volatility relative to thecurrent short-term volatility is followed by a subsequent decline.The results are similar for both foreign currency and the S&P500 stock index options.     

Borrowing in foreign currency: Austrian households as carry traders

Household borrowing in a foreign currency is a widespread phenomenon in Austria. Thirteen percent of Austrian households report their housing loan to be denominated in foreign currency, mostly Swiss franc. Yet, despite its importance, peculiar character, and acute policy concerns, we know little about the attitudes and characteristics of the households involved in this type of carry trade. We analyze a uniquely detailed financial wealth survey of 2556 Austrian households to sketch a comprehensive profile of the attitudes and characteristics of the households involved. We employ both univariate tests and multivariate multinomial logit models. The survey data suggest that risk seeking, affluent, and married households are more likely to take a housing loan in a foreign currency. Financially literate or high-income households are more likely to take a housing loan in general. These findings partially assuage policy concerns about household default risk on foreign-currency housing loans or household retirement security.     

Households’ foreign currency borrowing in Central and Eastern Europe

Foreign currency loans represent an important feature of recent financial developments in CEECs. This might pose a serious challenge for macroeconomic stability. Against this background, we study the determinants of foreign currency loans of households, using data on the behavior of households in nine CEECs. Our results reveal that foreign currency loans are driven by households’ lack of trust in the stability of the local currency and in domestic financial institutions. Moreover, special factors including remittances and expectations of euro adoption play an important role in selected regions. The financial crisis reduced foreign currency borrowing, but there is some indication this effect might be only temporary.     

Dual foreign currency markets and the role of expectations: Evidence from the Pacific Basin countries

This paper analyzes the role of expectations about the government policy in the official foreign currency market in determining the black market premium. We use data for the recent float from six emerging markets of the Pacific Basin where active black markets for foreign currency exist, namely, Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand. To test the impact of anticipated and unanticipated shocks to the official exchange rate on the black market premium, we employ the two-step procedure of Hoffman et al. [Hoffman, D.L., Low, S.A., Schlagenhauf, D.E., 1984. Tests of rationality, neutrality and market efficiency: a Monte Carlo analysis of alternative test statistics. J. Monet. Econ. 14, 339–363] which provides corrected F-statistics and allows us to draw valid inference in the presence of generated regressors. The main finding of our analysis is that anticipated and unanticipated shocks to the official exchange rate have an impact on the black market premium in all six Pacific Basin countries. These results suggest that portfolio balance models provide the suitable theoretical framework for analyzing the behaviour of the black market premium in the markets for foreign currency in the Pacific Basin countries. Furthermore, this implies that economic agents in these countries are sensitive to expected returns in foreign exchange.     

Exchange Rate Exposure at the Firm and Industry Level

Previous work on the exposure of firms to exchange rate risk has primarily focused on U.S. firms and, surprisingly, found stock returns were not significantly affected by exchange‐rate fluctuations. The equity market premium for exposure to currency risk was also found to be insignificant. In this paper we examine the relation between Japanese stock returns and unanticipated exchange‐rate changes for 1,079 firms traded on the Tokyo stock exchange over the 1975–1995 period. Second, we investigate whether exchange‐rate risk is priced in the Japanese equity market using both unconditional and conditional multifactor asset pricing testing procedures. We find a significant relation between contemporaneous stock returns and unanticipated yen fluctuations. The exposure effect on multinationals and high‐exporting firms, however, is found to be greater in comparison to low‐exporting and domestic firms. Lagged‐exchange rate changes on firm value are found to be statistically insignificant implying that investors are able to assess the impact of exchange‐rate changes on firm value with no significant delay. The industry level analysis corroborates the cross‐sectional findings for Japanese firms in that they are sensitive to contemporaneous unexpected exchange‐rate fluctuations. The co‐movement between stock returns and changes in the foreign value of the yen is found to be positively associated with the degree of the firm's foreign economic involvement and inversely related to its size and debt to asset ratio. Asset pricing tests show that currency risk is priced. We find corroborating evidence in support of the view that currency exposure is time varying. Our results indicate that the foreign exchange‐rate risk premium is a significant component of Japanese stock returns. The combined evidence from the currency exposure and asset pricing analyses, suggests that currency risk is priced and, therefoe, has implications for corporate and portfolio managers.     

Exchange rate and inflation risk premia in the EMU

This paper tests the effects of exchange rate and inflation risk factors on asset pricing in the European Union (EU) stock markets. This investigation was motivated by the results of Vassalou [J. Int. Money Finance, 2000, 19, 433–470] showing that both exchange rate and foreign inflation are generally priced in equity returns, and it studies the opportunity of evaluating the causality between these sources of risk after the elimination of the EU currency risks because of the adoption of the single currency. Our results show that both exchange rate and inflation risks are significantly priced in the pre- and post-euro periods. Moreover, the sizes of exchange rate and inflation risk premiums are economically significant in the pre- and post-euro periods. Futhermore, the UK and excluding-UK inflation risk premiums explain, in part, our evidence concerning a large EUR/GBP exchange rate risk premium and the existence of an economically significant domestic non-diversifiable risk after euro adoption. Hence overlooking inflation risk factors can produce an under/overestimation of the currency premiums and a miscalculation of the degree of integration of stock markets.     

Country and currency diversification of bond investments: do they really make sense for Swiss investors?

The inclusion of hedged or unhedged foreign currency bonds within a strategic asset allocation is a crucial decision which should be analyzed carefully. The goal of this paper is to provide a contribution to this analysis by focusing particularly on the time horizon of the investment. Results are analyzed from the perspective of a Swiss investor. We find that over the last 21 years, investing in bonds denominated in Swiss Francs has been clearly less efficient in terms of risk-adjusted returns than investing in a hedged global bond portfolio. For short-term investors, we find robust evidence against the hypothesis of investing in unhedged foreign currency bonds. The picture changes dramatically, however, when we consider an investment horizon of 6 years and the normal case of balanced portfolios including also equities and domestic bonds. In this case, the optimal strategy for the period we analyzed would have been to hedge only the exposure to US dollar bonds.      

The effect of foreign currency hedging on the probability of financial distress

This paper investigates the effect of foreign currency hedging with derivatives on the probability of financial distress. I use Merton’s (1974) structural default model to compute firms’ distance to default as a proxy for their probability of financial distress. Using an instrumental variables approach to control for endogenous hedging and leverage, I find that the extent of foreign currency hedging is associated with a lower probability of financial distress. Whereas previous research finds that the probability of financial distress is a determinant of a firm’s hedging policy, this paper provides direct evidence supporting the hypothesis that the extent of hedging reduces a firm’s probability of financial distress.     

Identifying the effects of an exchange rate depreciation on country risk: Evidence from a natural experiment

A natural experiment is used to study exchange rate depreciation and perceived sovereign risk. France suspended coinage of silver in 1876 provoking a significant exogenous depreciation of all silver standard countries versus gold standard currencies like the British pound – the currency in which their debt was payable. The evidence suggests an exchange rate depreciation can significantly increase sovereign risk if a country is exposed to foreign currency debt. We implement a difference-in-differences estimator and find that the average silver country's spread on hard currency debt increased over ten percent relative to non-silver countries.     

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.