UK Multinationals' Effective Use of Financial Currency‐Hedge Techniques: Estimating and Explaining Foreign Exchange Exposure Using Bilateral Exchange Rates

Using a unique dataset of recently available accounting disclosures, this study examines the relationship between UK multinationals' stock returns and changes in the principal exchange rate to which each firm is most exposed. We find more firms with significant foreign exchange exposure estimates using this firm‐specific principal currency data, compared with those exposure estimates using the broad exchange rate index data prevalent in prior studies. The cross‐sectional variations in such principal‐currency exposure estimates are explained in relation to the financial currency‐hedge techniques that each firm specifically identifies as being used to manage its currency risk. In particular, we provide evidence that firms effectively use foreign currency derivatives and foreign‐denominated debt to reduce the currency risk associated with the bilateral exchange rate to which they are most exposed. This study is important to both the academic and the practitioner communities because it represents the first use of publicly available UK disclosures to improve the estimation and explanation of foreign exchange exposure.     

Hedging Foreign Project Risk

We study the firm's hedging problem when there is uncertainty about whether its bid on a foreign project will be accepted. Most treatments of this problem suggest that foreign currency options are the preferred hedging instrument. However, we show that when the uncertainty pertaining to the realization of the foreign cash flow is unrelated to the exchange rate, which typically will be the case, futures dominate options as hedge vehicles.
Conversely, options hedging will be appropriate when the viability of the foreign project depends also on an exchange-rate contingency, as would be the case when the bidding firm can withdraw its bid if the foreign currency depreciates sufficiently.
In many cases, both futures and options will form part of the best hedge position. The general principle in forming the hedge is that futures will best offset exchange-rate exposure the existence of which is not exchange-rate contingent. Options will best hedge any costs or revenues that might occur in a foreign currency depending on the outcome of an exchange-rate contingency.     

A Firm-Specific Analysis of the Exchange-Rate Exposure of Dutch Firms

We examine the relationship between exchange‐rate changes and stock returns for a sample of Dutch firms over 1994–1998. We find that over 50 per cent of the firms are significantly exposed to exchange‐rate risk. Furthermore, all firms with significant exchange‐rate exposure benefit from a depreciation of the Dutch guilder relative to a trade‐weighted currency index. This result confirms that firms in open economies, such as the Netherlands, exhibit significant exchange‐rate exposure. We collect unique information on the most relevant individual currencies for each firm with respect to their influence on firm value. Our results indicate that the use of a trade‐weighted currency index and the use of individual exchange rates are complements. We also measure the determinants of exchange‐rate exposure. As expected, we find that firm size and the foreign sales ratio are significantly and positively related to exchange‐rate exposure. In contrast with our hypothesis, off‐balance hedging using derivatives has no significant effects. Finally, in line with theory, we find that exposure is significantly reduced through on‐balance sheet hedging, i.e., through foreign loans and by producing in factories abroad.     

The Introduction of the Euro and Derivative Use in French Firms

In January 1999 several European countries adopted a common currency, the “euro”. This important economic event provided an opportunity to examine the determinants of risk management in an environment where exposure to foreign exchange (FX) risk was considerably reduced. For a sample of French firms we found the decline in the use of FX derivatives was greater for firms with substantial sales within the euro zone and less for firms in industries that still had significant imports from outside the euro zone. The focus on derivatives adds to existing research, as it is a more explicit indicator of a reduction in the resources devoted to hedging. The reduction in hedging was not in direct proportion to the reduction in FX exposure, implying that euro risk was hedged more intensely than French franc risk in the sample of French firms over the chosen years.     

The Use of Forward Contracts for Hedging Currency Risk

This paper derives an optimal rule for hedging currency risk in a general utility framework. Ex ante hedging performance of the forward markets is examined using the optimal hedge ratio derived from the utility model and an optimal rule derived from another model (excess return per unit risk) suggested in the hedging literature. Results of this study indicate a naive (one-to-one) hedge performs similarly to the optimal hedge ratios under either model. An implication of this study is that financial managers of multinational firms should simply follow a one-to-one rule when hedging foreign exchange risk in the forward markets.     

International tenders and futures hedging

This paper examines the optimal bidding and hedging decisions of a risk‐averse firm that takes part in an international tender. The firm faces multiple sources of uncertainty: exchange rate risk, risk of an unsuccessful tender, and business risk. The firm is allowed to trade unbiased currency futures contracts to imperfectly hedge its contingent foreign exchange risk exposure. We show that the firm shorts less (more) of the unbiased futures contracts when its marginal utility function is convex (concave) as compared with the case that the marginal utility function is linear. We further show that the curvature of the marginal utility function plays a decisive role in determining the impact of currency futures hedging on the firm's bidding behavior. Sufficient conditions that ensure the firm bids more or less aggressively than in the case without hedging opportunities are derived. Copyright © 2006 John Wiley & Sons, Ltd.     

Is Bitcoin a better hedging and safe-haven investment than traditional assets against currencies? Evidence from the time-frequency domain approach

Many studies have discussed hedges and safe havens against stocks, but few studies focus on the hedging/safe-haven performance of assets against the currency market over different time horizons. This paper studies the connectedness, hedging and safe-haven properties of Bitcoin/gold/crude oil/commodities against six currencies across multiple investment horizons, placing a particular focus on the performance of these assets during the recent COVID-19 outbreak. Our findings suggest that the overall dependence between assets and the currency market is the strongest in the short term, and Bitcoin is the least dependent across all investment horizons. The dynamic relationships between the four assets and the currency market vary with timescales. Bitcoin offers better hedging capability in the long term and commodities emerge as the most favorable option for the optimal portfolio of currency over all time horizons. Further analysis shows that assets are better at helping investments reduce risk in the initial stages of the pandemic, and gold is an effective and robust safe haven for currencies.     

Translation Exposure Hedging Post SFAS No. 52

Translation exposure hedging is frequently said to have begun after firms adopted SFAS No. 8 and assumed to have ceased–or at least decreased–after adoption of SFAS No. 52 due to different treatments of translation gains (losses). Based on proprietary data, this study presents evidence from a small sample of firms which would be predicted to cease hedging translation exposure, but of which the majority did not.
The study focuses on eighteen firms which exclude at least 50% and up to 100% of the translation gains (losses) from the income statement after adopting SFAS No. 52. Of those eighteen firms, only seven ceased hedging. The other eleven firms not only continued hedging translation exposure, but hedged translation exposure of only those subsidiaries whose translation gains (losses) are now excluded from the income statement.
Characteristics which might explain the different decision are investigated: proportion of assets which are nonmonetary; the proportion of net assets located abroad; the geographic dispersion of subsidiaries; and the estimated effect on the balance sheet and income statement of changing from the temporal method to the current rate method of translation.
Univariate test results indicate that the geographic dispersion of die foreign subsidiaries as well as the proportion of net assets located abroad differ significantly between firms which ceased hedging and those which continued hedging after adopting the standard. Weak evidence of differential effects of the change to the current rate method on individual firm income statements and of different composition of assets between the two groups also was found. Multivariate analysis, using a linear probability model as well as a randomization procedure, provided weak results corroborating the significance of the proportion of net foreign assets to consolidated assets in differentiating between firms which ceased hedging and those which continued.     

The Foreign Exchange Exposure Management Practices of Finnish Industrial Firms

This study employs questionnaire survey and financial accounting data to extend earlier empirical work on the foreign exchange (FX) exposure management practices of Finnish industrial firms. The paper concentrates on: (i) the form that FX corporate hedging policy takes; (ii) the control of FX procedures and trading; and, (iii) our respondents' perceptions about their ability to predict FX rate changes for hedging decisions. Our results indicate that the extent to which firms hedge FX exposure depends on the type of exposure and the form that FX hedging policy takes. Also, a significant number of the firms pursue FX hedging strategies on the expectation of attaining trading profits and this strategy appears to be accommodated within their FX policies. This feature is not explicitly demonstrated in previous studies. Finnish firms hedge a much higher proportion of both transaction and translation exposures compared to economic exposure. We partly attribute this emphasis to the requirements of the Finnish Accounting Act, which came into effect in 1993. The organisational, historical and financial settings of the firms also have significant impacts on exposure management practices. The overall implication of those results is that firms respond to changes in the financial, economic and regulatory environments in which they operate.     

Sovereign rating changes—Do they provide new information for stock markets?

The purpose of this paper is to examine the impact of sovereign rating changes on international financial markets using a comprehensive database of 42 countries, covering the major regions in the world over the period 1995–2003. In general, we find that rating agencies provide stock and foreign exchange markets with new tradable information. Specifically, rating upgrades (downgrades) significantly increased (decreased) USD denominated stock market returns and decreased (increased) volatility. Whereas the mean response is contributed evenly by the local currency stock returns and exchange rate changes that make up the USD returns, only the foreign exchange volatility was behind the USD denominated return volatility. In addition, we find significant asymmetric effects of rating announcements. The market responses – both return and volatility – are more pronounced in the cases of downgrades, foreign currency debt, emerging market debt, and during crisis periods. This study has important policy implications for international investors’ asset allocation plans and for regulatory bodies such as the Basel Committee who increasingly rely upon Moody's, Standard and Poor's and Fitch's ratings for their regulatory regimes.     

Hedging local currency risk with precious metals

Precious metals are popular instruments for hedging local currency risk. Most precious metals are priced in US dollars, which is a single-currency numéraire. The numéraire of a precious metal can easily be changed, which allows investors to choose their own local currency as the precious metal’s numéraire and subsequently use it to hedge their own local currency risk. In this paper, we decompose the standard hedge ratio into two parts, namely, a precious-metal hedge ratio and a local-currency hedge ratio. We consider three main precious metals, namely, gold, silver and platinum, from the beginning of 1990 to the end of 2019 to hedge local currency risk for individual G10 currencies. Over the full sample, we find that all standard hedge ratios are negative for all combinations of currencies and precious metals. However, the negativity is driven by the precious metal’s numéraire, rather than the precious metal.     

Cash Position, Credit Risk and Hedging

In choosing between forward and spot hedging, cash constrained and/or high credit risk firms are more likely to hedge foreign currency transactions forward than firms of greater quality. This arises because the cost of the levered component of a spot hedge is greater than the cost of the unlevered component and this premium increases with higher credit risk. For given cash and credit characteristics, importers are more (less) likely to hedge forward than exporters if transactions costs in the home security market are less (more) than the corresponding costs in the foreign security market.     

Foreign Currency Translation Reporting and the Exchange-Rate Exposure Effect

This study further explores a structural break in the relation between stock returns of firms with foreign currency positions and lagged exchange rate changes (exchange rate exposure effect) documented in Bartov and Bodnar (1994). We examine whether changes in the financial accounting reporting of foreign currency positions from SFAS No. 52 might have improved investors' ability to characterize firms' economic exchange rate exposures, and thus the impact of exchange rate movements on firm value. Our findings indicate that only firms reporting using the dollar as the functional currency (i.e., those reporting as if they were still under SFAS No. 8) retain a significant relation between the lagged change in the dollar and firm value in the post-SFAS No. 52 period. For firms reporting using the foreign currency as the functional currency (i.e., those who switched to the new translation method) the significant lagged relation disappears. This is consistent with the use of a foreign currency as the functional currency under SFAS No. 52 facilitating valuation of U.S. firms with foreign operations.     

Input Hedging,Output Hedging,and Market Power

We argue that commodity input hedging is different from commodity output hedging. Output hedging can be detrimental to “sector play.” Furthermore, firms with market power that hedge outputs have incentives to over‐produce and distort market prices. In rational markets, such hedging will be expensive and we expect to see a negative relationship between hedging and market power in “output industries” but not in “input industries.” We test these predictions on a sample of S&P500 firms from 2001 to 2005. Our results support both hypotheses. Placebo tests show that the same empirical regularities do not apply to currency hedging. Finally, our empirical framework, which differentiates between hedging inputs and hedging outputs, can also help in reconciling conflicting results in prior studies.     

Currency Mismatching

This paper considers a firm domiciled in an emerging market, modeling its decision to denominate its debt in a combination of its domestic currency and a foreign currency, that is, the dollar. The objective is to determine those situations when the firm is motivated to engage in currency mismatching, that is, denominating a higher percentage of its debt in dollars than what is warranted by its dollar‐denominated sales. The following factors are shown to induce greater currency mismatching: speculative capital flows into the emerging market, reduced ability to price discriminate between domestic and foreign customers, increased exchange rate stability, and lower risk‐aversion. Copyright © 2011 John Wiley & Sons, Ltd.     

Institutional quality and corporate financing decisions around the world

We investigate the influence of the recent comprehensive institutional quality dimensions of Karolyi (2015), such as market capacity, operational efficiency, foreign accessibility, corporate transparency, legal protection, and political stability, on financing decisions of firms across 56 countries between 2000 and 2015. We find that stronger institutional quality or lower fundamental risks in a country ease firms' access to long-term debt, and equity financing. We attribute our results to institutional environments influencing financing decisions by shaping the severity of market frictions, such as agency conflicts and information asymmetry, and transaction costs. As a result, we conclude that any improvement in a country's institutional environment will boost firms' access to long-term financing, and thus longer-term investments that promote countries' economic growth will be more feasible. Our findings are robust to potential endogeneity issues.     

Region-wide connectedness of Asian equity and currency markets

This study systemically analyzes the dynamics of interdependence between the Asian equity and currency markets. The novelty of our study is that unlike other studies that explore either co-movements among equity markets or co-movements among currency markets, we pay particular attention to the interdependence between the two in terms of both return and volatility connectedness. We find that the contribution of crossspillovers between the Asian equities and currencies is substantial for the region-wide connectedness of both the returns and volatilities. We also find that the short-term spillovers are far more important for the return spillovers, while the long-term spillovers are far more important for the volatility spillovers, presumably reflecting the long-lasting effects of volatility shocks. All the results consistently underline the pivotal role of cross-interdependence between equity and currency markets, both as channels for integrating Asian financial markets and as sources of financial contagion across these markets. Our findings will provide useful guidance for portfolio risk management to adopt better hedging strategies for foreign exchange risks involved in the international investment of Asian equities.     

Do the differences in legal systems hinder international enterprises’ debt financing?

This study examines the impact of the differences in the legal system concerning obligation claim rights between host and multinational enterprises' (MNEs) home countries on bank credit financing by constructing a legal system distance index including four dimensions. Using 57,526 firm-year panel observations of 7,257 firms from 53 countries operating in China, the results find that legal system distance has a negative impact on foreign firms' debt financing. The influential mechanism is due to the increasing transaction costs. Further test finds that the negative effect declines as the cultural differences increase. The heterogeneity analysis finds that the negative impact of the legal system distance on the debt level is more pronounced for those foreign firms with a large scale, short operating age, not enough collateral, and sales in the domestic market, but shows no significant differences between a sole proprietorship and joint ventures. This study not only expands the literature on “Law and Finance” but also provides an implication for foreign firms' debt financing in the emerging host country.     

The importance of client heterogeneity in predicting make-or-buy decisions

Scholars have begun to merge the transaction cost economics and capabilities perspectives to examine outsourcing decisions. Further integrating these perspectives with intermediation theory, we assert that a firm's decision to use an intermediary when entering a foreign market is largely a function of the intermediary's relative capabilities and relative transaction costs (i.e., relative advantage). We hypothesize that the intermediary's relative advantage is influenced by three significantly intertwined exchange conditions: client heterogeneity, intermediary risk, and firm learning. Using a sample of 929 new foreign market initiatives by a global consulting firm, our results support our theory.     

How Comprehensive is Comprehensive Income? The Value Relevance of Foreign Currency Translation Adjustments

Prior empirical research has been unable to forge an unambiguous link between foreign currency translation adjustments, which are an element of “other items of comprehensive income,” and firm valuation. This study adds to the existing literature by empirically testing the value relevance of foreign currency translation adjustments in an earnings and book value model. Interaction terms, which serve as proxies for the theoretical sources of exchange rate exposure, are included in the estimating equation. The main finding of this study is that foreign currency translation adjustments are significantly value relevant when their parameter estimates are allowed to vary in the cross‐section.