Hedging China trade transactions by SMEs
in the Netherlands: A practical approach
By:
Leander van der Wolf
Supervisor:
Dr. B. Qin
This research paper is submitted in part-fulfilment of the degree
of
MSc
in
International
Business
and
Management:
Specialisation International Financial Management
University of Groningen
1. INTRODUCTION ... 1 2. RESEARCH METHODOLOGY... 3 2. RESEARCH METHODOLOGY... 3 2.1. RESEARCH APPROACH ... 4 2.2. INFORMATION SOURCES ... 5 2.2.1. SECONDARY DATA ... 5 2.2.2. PRIMARY DATA ... 5
3. HEDGING AND THE CHINESE YUAN ... 8
3.1. CURRENCY CONVERSION AND THE CHINESE YUAN ... 8
3.2. HEDGING ... 9
3.3. TYPES OF HEDGING ...14
3.4. LONG-TERM AND SHORT-TERM EXPOSURE AND HEDGING ...18
3.5. DEVELOPMENTS OF THE CHINESE CAPITAL MARKET ...19
3.6. SELECTIVE HEDGING ...20
3.7. HEDGING THE CHINESE YUAN...21
4. DATA ANALYSIS ...23
5. DISCUSSION ...40
6. CONCLUSION ...52
APPENDIX A: QUESTIONNAIRE...55
1. INTRODUCTION
The growing importance of business in China has resulted in a considerable increase in the number of foreign currency transactions between firms in the Netherlands and in China. For most multinational enterprises (MNEs) this has led to the necessity of dealing with particular foreign currency exchange rate risks. Besides political, economic, country, and project-related risks, “changes in the exchange rate, in particular, are relevant to almost any type of foreign direct investment and with the liberalisation of the Chinese Yuan, currency conversion is now a growing concern in China” (Alon and Drtina, 2006). China‟s exchange rate regime (and its reform) has been a major discussion topic amongst many economists and governments.
Since the 1950s the Chinese government has adopted an exchange rate regime where its currency, the Chinese Yuan (CHY), was pegged to another major international (trading) currency (predominantly the U.S. dollar (USD)). In 2005, however, internal and external pressures made China change its exchange rate regime. The reform consisted of: (1) a revaluation of the CHY against the USD of 2,1 percent (i.e. from 8,28 CHY per USD to 8,11 CHY per USD); (2) a very narrow band of ±0,3 percent of the closing rate of the previous working day between which the CHY/USD rate was allowed to fluctuate; (3) monitoring of the CHY against an undisclosed basket of currencies instead of against the USD alone. Although a reform was instigated, the Chinese government hesitated to adopt a more flexible exchange rate straight away. They were worried that altering the rate would disturb expectations, discourage adjustment and growth, and further undermine the stability of the banking system (Eichengreen, 2004). Furthermore, they were concerned that if the exchange rate was floated and the capital markets were opened, the weakness of the domestic financial system could generate large-scale capital flight and sharp currency depreciation in response to bad news (Goldstein, 2003).
enterprises (SMEs) located in the Netherlands and importing from China use particular methods of hedging against unexpected exchange rate changes for their trade transactions with China.
In-depth company analyses have been utilised to understand to what extent SMEs in the Netherlands hedge their foreign currency exposure, and if so, what methods they use to protect themselves against unexpected currency fluctuations. Seven firms located in the Netherlands and importing from China have been asked to complete a questionnaire. The results have been analysed to see how these firms protect themselves and to provide Financial Managers with advice on a number of critical issues.
2. RESEARCH METHODOLOGY
This section describes the research approach used for this project. First, the main research question and additional sub-questions are mentioned and this is followed by a description of the research approach and the types of data that have been collected.
The main research question used for this research is:
Do non-financial small and medium-sized enterprises (SMEs) located in the Netherlands and importing from China hedge themselves against unexpected changes in exchange rates, and if so, what hedging techniques do they use?
A practical research approach has been used by investigating a number of sample firms to identify whether an optimal hedging strategy could be identified. Based on this field research, conclusions have been drawn with regard to the identification of an optimal hedging strategy, whether the firms in question were using an appropriate strategy, or whether a different approach was needed.
In order to get a thorough answer to the main research question, a number of sub-questions have been used, including the following:
1. What are the motivations behind (not) hedging exposure to exchange rate risk faced by SMEs?
2. How do SMEs in the Netherlands and importing from China hedge their foreign currency exchange risks?
3. Does intervention by the Chinese government constrain companies to hedge against unexpected changes in the value of the Chinese Yuan (CHY)?
on Chinese components to a great extent, with exchange rate-related risks therefore being considered prominent, they have asked the author to come up with a number of tips, tricks, and advice on how to best deal with these exchange rate risks in a smarter and more active way. These requests were made as soon as the author introduced the research project generally, and led to a slight change in direction of the research approach. One of the main objectives of this research, therefore, is to provide insight into the issues faced by firms trading with China with respect to protecting themselves against foreign currency risk. These issues relate to what (trading) currencies these firms can use, if, and how, these currencies can and should be hedged, and whether or not the situation allows these firms to hedge. The abovementioned questions have been designed in such a way as to provide those interested with useful answers to generally acknowledged issues.
2.1. RESEARCH APPROACH
Two distinct methods to collect the required data to answer the research questions have been utilised: specific questions derived at by using issues discussed in prior literature as well as hypotheses generated based on arguments given by other authors. The use of specific questions was deemed most appropriate as no specific hypotheses could be developed due to the large diversity of opinions of different authors on the issues in consideration.
In order to answer the research questions and to test the hypotheses, the author has made use of in-depth interviews with Financial Officers or other management staff members dealing with (foreign) financial matters. These parties were asked to complete a questionnaire (of which a copy can be found in Appendix A), and where necessary, these parties have been contacted to further discuss and analyse the answers provided in the questionnaires. Following the data collection, the author has analysed the responses given by the participants and has categorised the answers to generate general conclusions. As soon as the data had been analysed, the author has discussed the responses by linking them to the existing literature. This, ultimately, led to a thorough answer to the research question(s).
conclusions and to thoroughly answer the research questions. The answers to the research questions, in turn, have been used to provide conclusions to advise the managers of the companies used in the data collection process on the issue of dealing with foreign currency exchange risk. Some of the managers, as soon as they were approached, were very interested in participating and asked the author to provide them with professional advice on how they could best deal with (their) foreign currency exchange matters. Without in-depth knowledge of hedging on the side of the firms, no specific issues or cases were requested to be investigated. These firms were more interested in generally-applicable advice on how to successfully deal with exchange rate related risk and, more specifically, how to more actively and smarter deal with these situations. This was one of the incentives to further investigate the issues of foreign currency exchange risk with which small firms in the Netherlands are faced.
2.2. INFORMATION SOURCES
A variety of information sources has been used for this research project, including primary and secondary data sources. These are described in more detail next. With the topic of this research project being quite specific for each company in question, the main focus was on the collection of qualitative data (instead of going for the masses by using quantitative data). It was deemed this would provide better and more specific answers to the research questions and advice for financial managers with regard to foreign currency hedging. Qualitative data have been collected by looking at historical research findings as well as by approaching companies directly. Questionnaires and in-depth discussions have been used to collect qualitative primary data.
2.2.1. SECONDARY DATA
Secondary data have been obtained from numerous books, academic journals, and research reports about hedging, the CHY, the Chinese capital market(s), and international exchange rate regimes. A considerable amount of information has been written on hedging practices and the CHY that could significantly contribute to the identification of a hedging strategy for Dutch firms importing from China.
2.2.2. PRIMARY DATA
were asked additional questions for clarification purposes where necessary. The people that were directly approached consisted of Chief Financial Officers, Owners, and Managing Directors. It was decided to approach these people as they were most familiar with and/or responsible for hedging foreign currency exchange risk.
The firms were initially selected based on their trade transactions with China. Only firms importing from China or delivering services in China (i.e. making/receiving payments to Chinese counterparts) could be used for this research. Three different methods have been used to find appropriate candidates: (1) Government trade databases (for example, Agentschap Nederland); (2) Friends and relatives working in companies trading with China or familiar with people working in firms importing from China; and, (3) online searches for firms located in the Netherlands and trading with China.
Once potential candidates were selected, these firms were investigated first to see whether they fulfilled all required criteria for this research. This process consisted of researching company websites (where appropriate), talking to third parties about the firm in question, and contacting the firms directly to ask some required details, such as company activities with regard to China, who was responsible for trade (i.e. financial transactions) with China, and who the author could contact to submit the questionnaire and to ask further questions.
The firms were directly contacted by telephone and by email. First, the companies were phoned to ask for the correct person to enquire about hedging. In almost all cases the author had to make a second phone call to talk to the correct person. In some cases the author had to discuss the issue directly over the phone. In other cases the author was given an email address during the telephone conversation to which the enquiry and questionnaire were submitted. Although communication was, in all cases, done by telephone and via email, the author had also offered to visit the company if this was appreciated or required. In some cases the author had to make a number of follow-up calls and send a number of additional emails when no further correspondence was received.
industry they were active in. This was preferred, as the author was interested in collecting data on financial currency hedging of small firms in general, and not in particular industries only. This would lead to better, generally-applicable, advice, instead of industry-dependent advice that was not relevant for some firms.
Following the candidate selection phase, the selected firms (15 in total) were contacted and asked whether the author could submit a questionnaire. In some cases (8) this consisted of contacting the company receptionist (in case a general number was used), whom was asked for the relevant contact details of the person responsible for foreign currency hedging. Sometimes the author did not manage to get any further than the reception desk as companies were unwilling to take part in this research (2 out of the 8 cases). In the other cases (6) the author had managed to get the contact details of the person responsible for currency hedging practices and this person was then emailed a copy of the questionnaire (no direct telephone number was given, only an email address). In all other cases (7) the author contacted the relevant person directly via email and/or by phone, or in person (2). Only in a few cases (7) did the author get a response, with (5) or without (2) a written completed questionnaire. A few companies replied they were not interested in participating (8), a few companies were contacted to discuss the issues over the phone directly (2), and some firms stated they were interested in participating but never responded (2). These firms had been contacted by email and telephone a week later, but without any success. With the questionnaire, the respondents were directly asked whether the author could contact them for more in-depth analysis of the answers provided. Most of the respondents were happy to accept any further questions (6 out of 7). This constituted the final stage of the data collection process, in which these respondents were contacted (by phone and/or email) to explain some of the specific answers in more detail.
3. HEDGING AND THE CHINESE YUAN
3.1. CURRENCY CONVERSION AND THE CHINESE YUAN
Nowadays, many companies are dealing with China and the Chinese Yuan (CHY) one way or another. Especially for multinational enterprises (MNEs), though, this often brings with it particular risks directly related to international trade. One of the most prominent types of risks is exchange rate risk. Exchange rate risk is present as a result of companies trading in different currencies. Unexpected changes in exchange rates can therefore lead to sudden deviations from accounted-for expenses or income. For many firms exchange rate-related risks are a prominent threat to survival due to the large impact they can have on (expected) cash flow. This might especially be the case for smaller firms trading with China as a result of the smaller cash reserves to cover for sudden losses – something large MNEs might be able to do easier if necessary.
As argued by Alon and Drtina (2006), currency conversion, and in this case conversion of the CHY in particular, is an extremely important factor for companies dealing with the CHY. Fluctuations in exchange rates and currency conversion are both a considerable risk for companies dealing with foreign currency, for example in capital budgeting. Capital budgeting consists of numerous estimates based on expectations about future values of a currency. MNEs in the Netherlands and trading with China, for example, base the value of the traded goods on a particular value of the CHY (and Euro (EUR)). Here one can think of underlying value, sales price, or other costs related to the import of goods dependent on exchange rates. For the capital budgeting process, foreign companies investing in China must make an estimate of the long-term expectation for conversion of the CHY. Such an estimate is needed for calculating financial figures in terms of home currency. “Currency conversion is particularly critical in developing capital budgets since calculations depend on the accuracy of forecasting the amount and the timing of project cash flows” (Alon and Drtina, 2006).
year-to-year currency conversion” (Alon and Drtina, 2006). There are several ways in which MNEs can incorporate this risk in their capital budget estimates. For example, they can reduce estimates for revenues or they can increase expenses based on losses arising from this risk. “They can gauge these losses through the cost of insurance policies or futures contracts” (Clark and Judge, 2009). This is called hedging foreign currency exposure.
3.2. HEDGING
From the above it can be concluded firms face many risks related to, for example, unexpected changes in exchange rates. It is therefore of great interest to MNEs if they can protect themselves against unexpected currency fluctuations. Generally, they can do this by means of hedging: “the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position” (Eiteman, et al., 2007). There is an ongoing debate on the effectiveness of hedging, though, and research by Al-Shboul and Alison (2009) indicates that, although it is generally assumed that derivatives are used to hedge an existing exposure, it is not obvious whether this is truly the case. We have witnessed a number of worldwide corporate catastrophes of using derivatives, such as Metallgesellshaft in 1994, Baring Bank in 1995, and the 2004 National Australia bank losses – all showing derivatives could lead to a destruction of firm value.
The impact of exchange rate risk on cash flows of MNEs located in the Netherlands and importing from China is directly influenced by foreign currency-denominated asset and liability structures. Additionally, another source of exposure arises when exchange rate movements indirectly affect the cash flows of these MNEs by affecting the cash flows of the MNEs‟ customers, competitors, and funds suppliers. MNEs importing goods from China face risks related to the variability of earnings when reselling these items or when utilising these goods as inputs in the production process due to exchange rate changes.
reproduced by shareholders through asset diversification.” Essentially, this means risk management strategies implemented by MNEs cannot create value as investors can undertake such activities equally well.
Nevertheless, although Modigliani and Miller and other authors argue hedging exchange rate risk does not add value to the firm, many firms do hedge currency exposures. Recent literature covers several reasons why the costly hedging may be beneficial for MNEs – these authors directly challenge the implicit hedging irrelevance proposition put forward by Modigliani and Miller and others. For example, Fabling and Grimes (2010) argue firms may hedge currency exposure as soon as one of the following circumstances prevails: financial distress costs, underinvestment costs, scale and export intensity, managerial risk aversion, information asymmetry, governance issues, convex tax schedules, or country-specific factors such as accounting conventions or nature of capital markets. This is in line with Smith and Stulz (1985) who argue that hedging can be a rational response to non-linear risk exposure caused by taxes, financial distress, and investment distortions. “A firm facing a convex relation between tax liabilities and net profits might reduce the value of its expected taxes by hedging in order to reduce the volatility of its net profits” (Frestad, 2010). Indeed, market imperfections, such as taxes, agency problems, asymmetric information, and dead-weight costs associated with financial distress may provide incentives for corporations to hedge exchange risk (Chowdrhy and Howe, 1999).
In accordance with Fabling and Grimes, Eiteman et al. (2007) indicate the following reasons why MNEs should hedge: (1) A reduction in risk in future cash flows improves planning capabilities of the firm; (2) Reduction of risk in future cash flows reduces the likelihood that the firm‟s cash flows will fall below a necessary minimum; (3) Management is in the best position to hedge actual currency risk of the firm compared to the individual shareholder because of a knowledge advantage; and, (4) Management can make best use of selective hedging (more on selective hedging below) as a result of better being able to recognise disequilibrium conditions in markets than shareholders.
Although Eiteman et al. (2007) provide a number of reasons in favour of hedging, they also give a number of reasons why MNEs should not engage in currency hedging, including: (1) Shareholders are much more capable of diversifying currency risk than the management of the firm; (2) Currency risk management does not increase expected cash flows of the firm (often on the contrary); (3) Hedging activities are often conducted at the benefit of management and at the expense of shareholders (see for example research by Al-Shboul and Alison (2009) reaching such conclusions); (4) Managers cannot outguess the market and, as argued by Modigliani and Miller (1985), the net present value of hedging is zero when markets are in equilibrium; and, (5) Management‟s motivation to reduce variability is sometimes driven by accounting reasons (i.e. irrational behaviour).
Research over the last four decades has led to numerous contrasting conclusions in the area of hedging – leading to the ongoing debate of whether MNEs should or should not hedge. Solnik (1974), for example, reaches the conclusion that currency hedging certainly leads to greater risk reduction in an international portfolio. Thomas (1988) also finds that international equity portfolios benefit from currency hedging. Black (1989) reaches similar conclusions and also finds it beneficial to hedge currency risk (he eventually went so far as to design the universal hedging formula). Kawaller (1989), doing research on corporations with foreign entities, states that “a policy of not hedging is patently inappropriate.” Investigating investment portfolios, Glen and Jorion (1993) find that hedging significantly improves the performance of portfolios containing bonds. Cantaluppi (1994) also finds that currency hedging is beneficial. Nguyen and Faff (2003) looked at non-financial Australian listed firms and investigated the impact of the use of foreign currency derivatives on foreign currency exposure. Their study found evidence that foreign currency derivatives were successful in reducing foreign currency exposure in the shorter term. This finding is confirmed by the same authors three years later by using a sample of Australian and French firms. In both cases the use of derivatives is found to be associated with lower exchange rate exposure.
supporting the use of corporate risk management initiatives, mainly as a result of existing market imperfections: “financial distress and bankruptcy costs, corporate taxes, more costly external financing, and agency problems such as managerial risk aversion and information asymmetry between managers and shareholders.” An interesting conclusion of these authors, in direct contrast to the arguments given by for example Eiteman el al. above, is their statement that “shareholders might prefer corporations to manage their risk exposures in order not to re-establish their portfolios very frequently.”
On the other end of the spectrum there are a number of authors arguing firms should not hedge. Modigliani and Miller (1958), for example, showed that in a perfect market world of financing irrelevancy, corporate hedging would not increase the value of a firm as individual investors can organise their own hedging strategies by holding well-diversified portfolios. Many studies, including studies by some of the abovementioned authors, have challenged the Modigliani and Miller position arguing that hedging can be a value enhancing exercise because of the possibility that investors cannot, or do not wish to, replicate the hedging techniques and strategies which firms can deploy (Al-Shboul and Alison, 2009). Perold and Schulman (1988) agree with Modigliani and Miller (1985) and assume expected returns from currency hedging are zero in the long-run. Froot (1993) also presents evidence against currency hedging over longer time horizons. This is the case, he argues, because exchange rates are mean-reverting, over the long run, and currency hedging therefore only leads to additional costs. For short-term results, however, he does argue in favour of the importance of hedging. Winston and Bailey (1996; in Chincarini, 2007) agree with Froot, in the sense that currency hedging per se may be too costly for firms. Investigating emerging equity portfolios, Hauser et al. (1994) find that hedging currency risks might not be beneficial either. By looking at stock returns (a measure often used to track company value in relation to exchange rate volatility) they conclude “the hedging of currency risk is an inferior policy because of the negative correlations between the exchange rate and stock returns when measured in the local currencies of emerging markets” (Chincarini, 2007).
the same year, using a weighted least squares model to test the effect of derivatives usage, also showed weak evidence of a reduction of foreign currency exposure with foreign currency derivatives. Although not exhaustive, the results described above indicate the wide
contrasting conclusions with regard to currency hedging.
With an approximately equal number of arguments in favour of and against currency hedging, it is expected that around 50 percent of all firms in the Netherlands and trading with China make use of hedging. The author expects these firms to hedge most, if not all, considerable trade transactions involving the CHY as a result of the considerable risk faced by firms importing from China. Alon and Drtina (2006) put forward a few arguments of particular relevance to this research. They argue that, although the situation has changed slightly following the change in exchange rate regime in 2005, the CHY can still be considered a soft or exotic currency. The currency only floats against a few other major (hard) currencies and it is not traded easily in open markets. Another important aspect is the limited information availability of the CHY. Alon and Drtina therefore argue that, although the CHY is fairly stable, it is a very difficult currency to forecast in the long-term because of the historical context of the currency, the current situation of the CHY, and because of the market forces working on the Chinese Yuan-U.S. Dollar (USD) exchange rate. Since no specific conclusion can be reached as to whether firms should hedge the CHY or not, due to the many arguments put forward by authors supporting both sides of the discussion, the author will investigate this issue in particular detail by means of primary research. In order to find an answer to the main research question the author will investigate whether small and medium-sized enterprises (SMEs) located in the Netherlands and importing from China hedge their foreign currency-denominated trade transactions to reduce exchange rate-related risks as much as possible.
currency derivative instruments – indicating “economies of scale in costs are important determinants of currency derivatives use” (Géczy et al.,1997). Simply put, “firms with greater variation in cash flows or accounting earnings resulting from exposure to foreign exchange rate risk have greater potential benefits of using currency derivatives.” A major conclusion of their research is that costs play a role in a firm‟s decision to use currency derivatives. In relation to economies of scale and hedging, they argue costs associated with implementing and maintaining a risk management programme, as well as firm size, are proxies for economies of scale in the costs of hedging.
In literature one can find interesting arguments with regard to the relation between firm size and the amount of hedging a firm should undertake. On the one hand, as mentioned above, large firms might experience economies of scale in hedging due to the size of their international operations. On the other hand, it could be argued small firms should hedge more due to the inverse relationship between firm size and bankruptcy costs (Warner, 1977). Another important factor is information asymmetries. Often, small firms do not have access to as much (relevant) information with regard to hedging opportunities, for example, as large firms. As research by for example O‟Brien and Bhushan (1990) has found, this leads to the existence of a negative relationship between firm size and information asymmetry.
The author agrees with the arguments given in literature about the existence of economies of scale and scope with regard to hedging and expects firms with greater import activities from China (in this case measured in terms of monetary value) to be more familiar with the exchange rate-related risks and, in turn, to hedge more of their exposure. This has been tested by means of the following hypothesis:
H1: Smaller MNEs, in terms of import value, are less likely to hedge than larger MNEs.
As soon as firms decide to hedge particular foreign currency transactions they have a variety of hedging tools to choose from – depending on the specific aspects of trade transactions and requirements of the firm. These different methods are described next.
3.3. TYPES OF HEDGING
financial hedging, firms can also make use of contractual and operational hedges. “The main contractual hedges employ the forward, money, futures, and options markets.” Some of the
main financial and operational hedging tools include risk-sharing agreements, leads and lags in payment terms, balance sheet hedging, currency swaps, the use of foreign-denominated debt (Allayannis and Ofek, 2001), import of raw materials denominated in the exposed currency, denomination of exports in the home currency, adoption of a liquidity buffer as a quasi-hedging tool, and flexibility to vary the nature and location of production (Fabling and Grimes, 2010). Clark and Judge (2009) further distinguish between firms that swap foreign debt into domestic debt (creating synthetic domestic debt) and firms that swap domestic debt into foreign debt (creating synthetic foreign debt). Boyabatli and Toktay (2004) also state firms have a significant number of tools to put to use in managing their exposures, including “taking short or long positions in financial derivatives (forwards, futures, options, swaps etc.), carrying large cash balances, adopting conservative financial policies or holding foreign denominated debt.” They further argue “financial derivatives, tailored contracts written over asset prices such as interest rates, exchange rates and commodity prices, which provide risk transfer between the transacting parties, have been utilised extensively at the firm level through well-developed financial markets for a long time.”
MNEs can also insulate themselves from the effects of exchange rate variability by building diversified portfolios of production facilities – a form of operational hedging. Boyabatli and Toktay (2004) define operational hedging as “the course of action that hedges the firm‟s risk exposure by means of non-financial instruments, particularly through operational activities.” Van Mieghem (2007) defines it as “mitigating risk by counterbalancing actions in a processing network that do not involve financial instruments.” From both definitions it becomes clear that the emphasis of operational hedging is on not using any financial tools – indicating these authors suggest financial and operational hedging strategies to be substitutes.
Research by Chod et al. (2010) shows that product flexibility and financial hedging tend to be complements (substitutes) in the sense that “product flexibility tends to increase (decrease) the value of financial hedging, and, vice versa, financial hedging tends to increase (decrease) the value of product flexibility – when demands are positively (negatively) correlated.” They also find that the type of flexibility is of importance. “Thus, when demands are positively (negatively) correlated, (i) product-flexible firms should be willing to spend more (less) on financial hedging, and (ii) in the presence of financial hedging, firms should be willing to invest more (less) in product flexibility.”
Chowdrhy and Howe (1999) also use the location of production in a country where significant sales revenues in the local (i.e. foreign) currency are expected as an example of an operational hedging policy. In such a case, “the effect of unexpected changes in exchange rates and foreign demand conditions on domestic currency value of sales revenues is hedged by similar changes in the domestic currency value of local production costs.” Most likely MNEs will correspondingly adjust their production, sales, or import levels in the different countries. Eichengreen (2004), however, argues “there is no reason why a somewhat more variable CHY should cause […] a company significant financial distress.” Allayannis et al. (2001) go even further and show that geographic dispersion through the location of subsidiaries across multiple countries or regions does not reduce exchange-rate exposure. To the contrary, they find that financial hedging strategies are related to lower exposures instead. Additionally, they find that geographically dispersed firms are more likely to use financial hedges to protect themselves from exchange rate risk. This is an interesting finding in contrast with what one intuitively might expect – that firms with geographically dispersed operating facilities would try to use operational hedging to reduce exchange rate related risk as much as possible as they have the ability to do so. Directly related, Allayannis et al. also find that operational hedges on their own are not associated with higher company value, but the use of operational hedges in conjunction with financial hedges (i.e. foreign currency derivatives) is. They argue firms should therefore not solely rely on operational hedges.
are low enough, they can still affect a firm's choice among instruments.” One can therefore argue and expect MNEs to make use of financial hedging strategies at an earlier stage (of for example company development (i.e. size of international operations) or commitment) before committing to operational hedging strategies. This is in contrast to what Allayannis et al. (2001) conclude.
Nevertheless, Chowdrhy and Howe (1999) also argue there are particular advantages to operational hedges over financial hedges. For example, if the quantity of foreign currency revenues the firm is expected to generate is certain, it is easy to hedge the exchange risk exposure associated with it by using a forward contract for that certain quantity. However, fluctuating foreign currency cash flows and demand conditions represent great sources of uncertainty for many firms. “If the quantity of foreign currency revenues is uncertain (and not perfectly correlated with the exchange rate), no financial contract (that must be agreed upon
ex ante) that is contingent only on ex post observable and non-manipulable variables such
as the exchange rate, can completely eliminate the exchange risk.” An operational hedge, however, allows the firm to align domestic currency production costs and revenues more closely, and thereby dominates a fixed financial forward contract. Chowdrhy and Howe (1999) furthermore argue corporations will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present.
Géczy et al. (1997) find that “firms with a combination of high growth opportunities but low accessibility to internal and external financing are most likely to use currency derivatives.” In more general terms, these authors find that there are three factors affecting a firm‟s derivatives decision: (1) The incentives to use derivatives; (2) The exposure to foreign exchange rate risk; and, (3) The costs of implementing a derivatives strategy.
From the above discussion it can be concluded there are widely differing opinions with regard to whether and when MNEs should make use of financial versus operational hedging. Nevertheless, some of the general conclusions that can be derived at include: (1) due to higher costs and complexity issues MNEs will make use of financial hedging strategies easier, (2) financial hedging tools will especially be used as soon as foreign currency cash flows (and demand conditions) are relatively certain, and (3) MNEs with geographically diversified operating facilities will most likely make use of financial hedging strategies – in contrast to what intuitive expectations might suggest.
Netherlands and importing from China will make use of financial or operational hedging by means of primary research (which he thinks is more appropriate than individual hypotheses). By investigating what the specific reasons are for the SME to make use of particular hedging strategies, the author can find out why SMEs importing from China will make use of a particular hedging strategy and why these SMEs think this is the most appropriate hedging strategy in a particular situation. From these answers it can be deduced whether there are common approaches to hedging and what the advantages and disadvantages of particular hedging strategies are.
As mentioned by Zakamouline (2009), it is important for MNEs to choose the correct hedging strategy as “the same hedging strategy can show the best empirical performance for hedging some option position, but the worst empirical performance for hedging another option position. Also, some strategy can be better than others when a hedger is highly risk averse, while a risk tolerant hedger needs to choose another hedging strategy.” This means MNEs have to consider a number of factors before deciding what hedging option is most appropriate. Hedging short-term or long-term exposure is one important factor having an influence on the decision what hedging technique to use.
3.4. LONG-TERM AND SHORT-TERM EXPOSURE AND HEDGING
Indeed, since short-term exposures generally involve relatively certain cash flows, MNEs can successfully utilise existing financial instruments such as forwards, futures, swaps, and options to manage this form of exposure. In contrast, longer-term exposures are frequently more difficult to assess because these depend on indirect economic aspects such as the economic circumstances of the MNEs customers and competitors. Brookes et al. (2000; in Fabling and Grimes, 2010) also argue forwards have advantages for short-term transactions relative to other forms of hedging owing to their relative flexibility: “contracts can readily be rolled forward, or closed out, according to the firm's view of the exchange rate.” Chowdrhy and Howe (1999) add that “firms are likely to use financial instruments to a greater extent to hedge short term exposure and rely on operational hedging more heavily to hedge long term exposure.” One of the reasons they argue is that demand uncertainty will be smaller for the short-term as firms can better forecast sales for shorter time horizons.
From the above it can be concluded that firms often adjust their hedging strategies according to the time horizon of the hedged entity – financial instruments for short-term transactions and operational hedging tools for long-term exposure. In accordance with the arguments given by Clark and Judge (2009), it is expected SMEs importing from China and located in the Netherlands will mainly use financial hedging strategies to protect themselves against unexpected changes in short-term transactions (as a result of importing). The following hypothesis will therefore be tested:
H2: Firms operational in the Netherlands and importing from China use financial
instruments to hedge their foreign currency exposure.
As the accessibility of capital markets has an influence on the type of hedging, it is important for MNEs importing from China to have an understanding of the Chinese capital markets prior to making a decision on using particular hedging techniques. The following section gives a short overview of the developments of China‟s capital market.
3.5. DEVELOPMENTS OF THE CHINESE CAPITAL MARKET
initiatives with regard to the liberalisation of the Chinese capital market, specifically designed to accompany a faster development pace. For example, the in 2002 implemented Qualified Foreign Investor Program allowed selected foreign investors access to China‟s domestic equity and debt markets.
Such liberalisation acts indicate the Chinese government is beginning to liberalise the CHY as of 2010. Currently the CHY is both fixed along a narrow range of international currencies and convertible at the capital accounts to a limited extent (approximately 70 percent in 2010) (Alon and Drtina, 2006). This means the value of the CHY is very stable (a result of the narrow band between which it is allowed to fluctuate) and, in case one wishes to do so, there are transaction costs involved in exchanging CHY with another currency. In fact, one can only move considerable sums of money (the case of MNEs) from, for example, CHY to EUR after getting prior approval from the Chinese government or through another currency such as the Hong Kong dollar (HKD). The CHY is convertible into HKD and the HKD, in turn, is convertible against the euro. Hu (2008) argues, however, “the lack of a fully convertible currency and the semi-closed domestic financial markets have greatly limited China‟s importance in global financial flows.” He further argues “clearly, the key-limiting factor for the Chinese Yuan‟s international role is its lack of convertibility under the capital account.” In relation to what has been discussed before, this leads to the following hypothesis:
H3: Limited access to the Chinese capital market causes firms to make more use of
foreign currency swaps instead of foreign debt as a hedging tool.
3.6. SELECTIVE HEDGING
Recent studies have found evidence of selective hedging behaviour of MNEs – “time-varying behaviour in response to the price of the variable being hedged” (Brown et al., 2006). Basically, this means taking hedge positions so as to „time the market‟ (Fabling and Grimes, 2010). Eiteman et al. (2007) define selective hedging as: “the hedging of large, singular, exceptional exposures or the occasional use of hedging when management has a definite expectation of the direction of exchange rates.”
exposures but not others based on perceptions of future price movements. As indicated by Fabling and Grimes (2010), “if the constraints facing the firm are invariant over time, theories underpinning the optimal hedging approach suggest that a firm's overall hedging behaviour should also be time invariant.” These authors conclude there is a difference in selective hedging between the Australian Dollar (AUD)/ New Zealand Dollar (NZD) and the USD/NZD. They argue this difference is based on the differing behaviour of the two exchange rates. “The AUD/NZD has moved within a much smaller band, and with a greater degree of mean reversion than has the USD/NZD.” This may have encouraged firms to believe that they can predict future (mean-reverting) movements of the AUD/NZD with some accuracy whereas this is not the case with the more volatile (non-mean-reverting) USD/NZD.
This issue of time-variance can also be extended to the EUR/CHY exchange rate for importing MNEs in the Netherlands. As the exchange rate has been fixed, there have not been any large movements. The only freedom the CHY has is to float between a particular, very small, band. As the currency is only moving within this very small band, MNEs can predict future movements quite accurately. The author expects this either means MNEs dealing with the CHY do not hedge their exposure (as there is little risk of unexpected changes) or they engage in almost perfect hedges as their prediction capabilities of future values of the CHY are enormous. He will therefore test the following hypothesis:
H4: MNEs use selective hedging (by basing their hedge ratios on historical norms or
forecasts) for the CHY because of better prediction capabilities as a result of the narrow exchange rate band.
In order for companies to find appropriate hedging techniques, they should not only look at available hedging tools, but they should also consider characteristics of the currency to be hedged. In our case, this is the CHY.
3.7. HEDGING THE CHINESE YUAN
them from insuring themselves against unexpected currency fluctuations. The associated risks are especially prevalent for firms located abroad and (solely) importing goods from China as part of the process of producing and selling exports. MNEs with Chinese partners or entities can self-insure against such risks by means of, for example, operational hedges (Eihengreen, 2006).
From the above it can be concluded that, when it comes to currency conversion, the traditional risk adjustments do not work well, especially not for the long-term. Insurance policies or long-term hedging instruments for conversion of CHY to USD are extremely limited or non-existent (Pennington, 2003). It is possible to buy forward contracts for the CHY for up to one-year, however, these are of little help in protecting long-term investments. Alon and Drtina (2006) further argue discount rate adjustments for capital investments also do not suffice. When companies use the discount rate adjustment method to incorporate the underlying exchange rate risk, they assume there is a systematic risk involved directly related to general market conditions. Alon and Drtina argue, due to the controlled nature of the CHY, “projections for its future rates of conversion relate more to political decisions by the Chinese central authority.” This means the (currency exchange) risk present when trading with China has much more to do with political aspects and less with market factors. This aspect makes it particularly difficult in forecasting or protecting oneself from the underlying risks of trading with China.
Another interesting aspect, and one that should definitely not be overlooked, is that most East Asian countries, including China, can collectively be considered a “natural dollar area” (McKinnon, 2005). Very often, if not always, these countries invoice their trade in USD instead of in their own local currency. Many manufacturers “price-to-market” in USD, and outside Europe the USD could be considered the prime invoice currency. For example, “when China trades with Korea, Thailand, or Malaysia, all transactions are in dollars” (McKinnon, 2005). The author assumes this might also have a tremendous impact on firms operational in the Netherlands and importing from China with regard to their invoice currency and, directly related, the foreign currency that needs to be hedged. He will therefore test the following hypothesis:
H5: Firms operational in the Netherlands and importing from China hedge the USD
because trade transactions are all made in USD (and not CHY).
4. DATA ANALYSIS
For this research, companies located in the Netherlands and importing from China have been approached to enquire about their respective hedging activities. The individuals contacted were all responsible for, or dealing with, foreign currency transactions (and hedging, or not, hereof). This section contains an analysis of the data collected by means of primary research.
Figure 1: Industry composition of the sample firms (in %).
One the main requirements for this research was that the firms were importing goods or services from China. The companies were therefore asked whether they were only importing goods from China, only using services in China, or importing as well as exporting products and services from/to China. All three options were considered as this might have a considerable influence on the hedging activities of the firm. In this sample, all firms, except one, were only importing goods from or using services in China. One of the firms was both importing as well as exporting goods and services to/from China.
The size of the companies was determent based on the number of employees, as well as on the amount of annual imports in monetary value (i.e. in U.S. Dollar (USD), Euro (EUR), or Chinese Yuan (CHY)). The number of employees within the firms varied considerably; however, the main focus of this research was on micro firms and small to medium-sized firms (according to the 2011 definition and classification by the European Commission for Enterprise and Industry). With the firms being located in the Netherlands, the definition of company size provided by the European Commission has been used. They define companies with less than 10 employees as micro firms, companies with 10-50 employees as small firms, and companies with 50-250 employees as medium-sized firms. Three of the firms in this research had less than 10 employees and were basically run by the owners. They could therefore be classified as micro firms. One of the firms had between 10 and 50 employees and could therefore be classified as a small firm. The three other firms had between 50 and 250 employees and could therefore be considered medium-sized firms. All companies used for this research can therefore be considered as either micro firms or small
12,5% 12,5% 12,5% 37,5% 12,5% 12,5%
Sample industry composition (in %)
Food service
Manufacturing/import: construction products
Manufacturing/wholesale: consumer goods Manufacturing: (agri-) industrial products Manufacturing: Automotive
to medium-sized enterprises with regard to the number of employees. Figure 2 below shows the distribution of the sample firms of different size. As the figure shows, the number of firms in the sample with less than 10 employees (micro firms) and firms with 50-250 employees (medium-sized firms) is equal. The number of firms with 10-50 employees (small firms) was the smallest group in the sample, accounting for only 14,3 percent.
Figure 2: Sample firm company size (in %).
The value of the imported goods also varied considerably between the companies, with one firm having annual imports from China of more than EUR 10 million, four firms with imports valued between EUR 500,000 and 1,000,000, and two firms with imports of approximately EUR 100,000. The distribution of the number of sample firms with their respective imports (in EUR) is shown in Figure 3 below. The largest group of firms in the sample had annual imports from China valued between EUR 500,000 and EUR 1,000,000, accounting for 57,1 percent of the sample. The number of firms with imports of EUR 100,000 or less accounted for 28,6 percent of the sample, and the firm with imports of more than EUR 10 million of imports from China accounted for only 14,3 percent of the sample.
42,9%
14,3% 42,9%
Sample company size composition (in %)
Figure 3: The number of sample firms and their respective annual imports from China (in %).
With industry and company size identified, the author was then interested in the currencies the firms were using to finance imports from China. An interesting finding here is that, although all firms were importing from China, almost none of the firms was making payments in CHY. Only two firms were making financial transactions in CHY. The reason these firms were making payments in CHY, compared to all other firms which did not, was that their supplying companies were invoicing in CHY. An interesting fact, though, was that in both cases the Chinese corporation was a foreign entity of the firm. Dutch managers or relatives were working in the Chinese company and it was only this Chinese firm delivering the required materials. As it was a foreign entity, located in China, they used the CHY to make payments. The CHY, in turn, could be used to pay other (raw material) suppliers. All other firms were predominantly making payments in only EUR or USD. Only one of the firms was also making transactions in British Pounds (GBP), in addition to EUR and USD. The main reason was that this firm also had customers in the United Kingdom. The trading currencies, and their importance, are shown in Figure 4 below. As the figure shows, the USD was the main currency used to trade with China, accounting for 41,7 percent. The second most important trading currency, also with a considerable importance (i.e. usage), is the EUR (33,3 percent). The next important currency is the CHY (16,7 percent) followed by the GBP (8,3 percent).
28,6%
57,1% 14,3%
Sample China import ratio composition (in %)
≤ €100,000
Figure 4: Sample firm trading currencies and their respective importance (in %).
Another interesting finding is that all firms stated different types of foreign currency risk to be important to the firm. This means that, although there were considerable differences in terms of company size, for both very small as well as large(r) companies, foreign currency risks are important. To identify what foreign currency risks were most important to the firms, the respondents were asked to indicate the importance of transaction, translation, as well as economic exposure to the firm. Four firms argued none of these were of particular importance and one firm indicated only transaction exposure was relevant. The reason these four respondents argued none of the types of exposure were relevant, was that they did not consider foreign currency exchange risk important in general. These firms did not see the exposure they faced to be significant (due to operations being too small) and they did therefore not consider any particular type of exposure to be more important than any other either. Further investigation also led to the believe that a lack of knowledge could be influencing these responses, as most firms did not engage in hedging (actively) and were therefore unfamiliar with different terms and concepts. The other two firms both considered all three forms of foreign currency exchange risk as important. What was interesting, though, was that the order of importance was completely different between the two firms. One stated transaction exposure to be most important and the other indicated translation exposure to be most relevant. What these results indicate is that for most firms the different types of foreign currency exchange risk were irrelevant. For the firms for which the different types of exchange risk did matter, no particular pattern could be identified.
16,7%
33,3%
8,3% 41,7%
Sample trading currency composition (in %)
Figure 5 below shows the three different types of foreign currency exposure and their respective importance to the sample firms. The most important currency exposure is transaction exposure, accounting for 28,6 percent. The importance of this type of exposure to the sample firms is equal to the irrelevance of all types of exposure to the other sample firms. Translation and economic exposure have equal weighting and both account for almost 22 percent. What these figures indicate is that the three different types of exposure are almost equally important, or not, to the firms. Indeed, as the results indicate, for most of the firms the three types of exposure were irrelevant.
Figure 5: Sample firm foreign currency exposures and their respective importance (in %).
Following the identification of different types of foreign currency risks, the companies were asked what types of financial risks were most prominent to the firm on a more specific level. This would give a better insight into the particular risks firms are faced with in their respective cases. For all firms to which financial risks were considered important, currency risk was identified as one of the major threats, and especially the increasing EUR-value of imported goods due to an increase in the CHY/EUR or CHY/USD exchange rates. What this company meant was that an increase in the value of the CHY versus either the EUR (directly) or the USD would result in a higher price for the same product. Such an increase in exchange rate therefore would result in a more expensive product. One of the companies also considered interest risk as an important factor. For a smaller company, only importing from China, economy fluctuations and liquidity risks were considered important too.
28,6%
21,4% 21,4%
28,6%
Sample most important exposure composition (in %)
The distribution of the importance of the different types of financial risk of the sample firms is shown in Figure 6 below. As the figure indicates, for most firms no particular financial risks were important (these firms were not hedging purposefully) – accounting for 40 percent. The reasons why these firms do not consider any type of financial risk to be particularly important is the same as why they do not engage in hedging: they consider the overall financial risks to be too small (irrelevant) as they consider themselves a small firm with only limited foreign currency transactions. These firms did not consider any particular types of financial risks as well as exposure to be important. They argued, though, they would consider financial risks, especially related to foreign exchange, important as soon as their business with China (imports) became more prominent. The most important risk is currency risk, accounting for 30% of the sample. The other risks share equal importance and consist of interest rate risk, economic fluctuations, and liquidity risk – all accounting for 10 percent.
Figure 6: Sample firm financial risks and their respective importance (in %).
An interesting finding is that, although all firms consider financial risks to be important, there are no financial managers responsible for managing foreign currency risk. Only one of the companies, one of the smaller ones, indicated the Managing Director was responsible. For this firm, it was one of the duties of the Managing Director to try and reduce losses due to unexpected changes in exchange rates as much as possible. It was not a task specifically focussed on reducing this risk to the greatest extent – the process of hedging – but more to keep an eye on the changes in cash flow this caused. This way the firm might be able to better place and finalise its orders. The main reason why no “specialised” or dedicated managers were responsible for (solely) hedging was that these firms did not engage in
30,0%
10,0% 10,0% 10,0%
40,0%
Sample financial risks composition (in %)
Currency risk Interest rate risk Economic fluctuations Liquidity risk
hedging that much, or not at all. For the companies that did not use any particular (financial) hedging strategies, it was fairly obvious no financial manager was needed. For the firms that did hedge, the main reason no dedicated manager was appointed was that the firm only engaged in hedging to a limited extent. The “occasional” hedge would not require a full-time financial manager responsible for hedging. As indicated by the respondents, this would be too costly.
Directly related, none of the firms had a specific risk management policy or another type of risk management programme in place. On the contrary, as one of the firms stated, they used a non-hedging policy. This firm, like other (especially small) firms, argued a policy of not hedging meant saving a lot of time, saving on a lot of administrative work, and therefore resulting in fewer mistakes. As soon as foreign currency was needed, the firm purchased the exact amount required. When pre-calculations were made the firm would use a slightly lower exchange rate as a measure to protect itself against adverse effects, at least to a certain extent. When enquiring further about this matter, it became clear a non-hedging policy had mostly to do with a lack of experience in the field of hedging and with avoiding additional costs. Although the firm did purposefully initiate a non-hedging policy, the main reason was that they considered the foreign currency exchange risks too small to engage in hedging as such. As soon as they would look into hedging, this would take up additional resources while the expected pay-off would not be sufficient. Even when discussing the advantages of hedging, it was expected the disadvantages would still outweigh the advantages. Saving money and time was the main argument. A smaller chance on administrative errors was mentioned to be an additional argument. Two of the firms, in turn, stated they were hedging themselves against foreign currency exposure. These were the two largest sample firms (in terms of annual imports from China). All other firms stated they did not hedge against unexpected changes in exchange rates.
Figure 7: Sample firms deliberately hedging or not (in %).
The next question related to the types of hedging the firms were using, i.e. whether they were using financial derivatives or other methods (including operational hedging). Only the two firms that had indicated they were hedging against foreign currency exchange risk made use of financial derivatives, and more specifically, forward contracts. As one of the firms explained in detail, they were purchasing USD against a then valid exchange rate, to ensure the goods purchased over the next two months had the same value as quoted to the customer. The reason these firms were only using forward contracts, while a considerable number of other hedging options are available, had to do with the ease and clarity of using forward contracts. These currency contracts could easily be purchased (when required and for the necessary amount). Additionally, the firms had only limited knowledge of hedging and therefore did not consider other (possibly more difficult) hedging alternatives. Forward contracts were sufficient in the sense that these firms were mostly (only) purchasing foreign currency to make payments (for future orders). No other hedging options were necessary.
Besides the purchase of foreign currency forward contracts or currency bonds, arguably the most commonly used method of hedging is the purchase of financial options. Nevertheless, this hedging alternative was not considered by any of the firms because they were considered to be too complex. None of the firms had any inside knowledge of the options markets and they considered the purchase and sale of puts and calls too advanced, in the sense that this was considered to be “professional” hedging for which a separate person or even department was needed. The relatively small amount of international business made this unnecessary and too expensive.
28,6%
71,4%
Sample distribution of firms using or not using hedging (in %)
Most of the other firms did not make use of any hedging techniques, with the exception of one. This firm was not using financial derivatives but other methods of hedging, including partly timing orders and order size on current or expected exchange rates. This firm was not using financial derivatives as it did not have any experience in using these hedging methods. They were not particularly interested in getting to know the different financial hedging alternatives, as they deemed the foreign currency exchange risk too small to justify the required resources. They would consider looking at different financial hedging options as soon as order numbers would increase or when currency risk was considered too big. The current (operational) hedging methods were considered appropriate as they would not consume additional resources and they could (as far as they were aware) do the job. It was mainly the ease of simply timing orders and altering order size (by discussing with clients) which were the decision-making factors to use these kinds of practices.
The timing of orders (and related payments) consisted of looking at the expected exchange rates to decide on which moment in time the exchange rate would least likely move in the opposite direction. Payments could be made when exchange rates were expected to be low (in case of the CHY versus a foreign currency) or when the exchange was deemed stable. This way the firm could be certain of the value (price) of the goods and no adverse exchange rate movements were expected to interfere. This expected or realised price could then be used to quote a customer. As soon as it was expected an exchange rate would move in the “wrong” direction and therefore lead to a loss for the company, a slightly higher price (due to exchange rate changes) could be utilised as a counter-measure. This firm also stated that as soon as foreign currency risk would become a serious threat to the firm (possibly in the future as soon as payments in foreign currency would increase considerably) they might consider more (advanced) hedging options. For the time being it was deemed too costly.
Figure 8: Hedging techniques used by the sample firms (in %).
The two firms using financial derivatives to hedge against unexpected changes in exchange rates stated they were only using financial derivatives and no operational hedging techniques. The one firm that did not make use of financial derivatives indicated it was mainly using operational hedging activities. The other firms indicated they did not use either technique. In relation to the question about the usage of financial derivatives, the firms were asked to indicate what the purpose of the use of financial derivatives was. Here one could opt between the following: hedging, arbitrage, price discovery, or speculation. These are the four most discussed reasons on why firms use financial derivatives. Both firms using financial derivatives indicated the main purpose was to hedge. They only used derivates to hedge against foreign currency exposure and for no other purposes. The other firms, not making use of hedging tactics, were unfamiliar with the other three potential purposes.
The next question related to the motivations for the firms to hedge. Here the firms could choose between 21 different options, in previous studies identified to be the most common motivational factors. An interesting finding is that three out of the four choices made by each firm were identical. The main motivational factors for the firms were “variance minimisation,” “the reduction of volatility of earnings,” and “the reduction of volatility in cash flow.” One of the firms also opted for “the protection and maximisation of profitability,” and the other firm indicated “the alteration of interest rate exposure arising from mismatches between assets and liabilities” was a drive to use hedging activities. Figure 9 below shows the results. Variance minimisation, reduction in earnings volatility, and reduction in cash flow volatility all account for 27,3 percent. These three hedging motivations are followed by the protection and
28,6%
14,3% 57,1%
Distribution of hedging techniques used by sample firms (in %)
