Analysis of Exchange Rate Risk & Hedging Strategies - Study
on Dutch Listed Firms
Author: Akash Kumar (11133317)
Contact: akashk86@gmail.com
Supervisor: Prof. Jeroen Ligterink
ABSTRACT
Currency risk arises from a combination of foreign currency exposure and volatility in foreign currency exchange rate with respect to domestic currency. As the firms may experience considerable exposure to foreign exchange rate risk because of foreign currency based activities and international competition. Many currencies are volatile as they show high fluctuations in the value due to various factors, such as trading speculation, change in global political and economic scenario, policy of central banks and many other factors. To minimize the effect of exchange rate risk, many firms use hedging techniques to over exposed risk, which may help to minimize the effects of exchange rate risk. In this paper, some hedging strategies will be discussed, for minimizing the firm’s exposure due to exchange rate fluctuations and test whether hedging diminishes the firm’s exposure.
We analyse the relationship between the change of exchange rate and stock returns of 17 Dutch firms over a period of 10 years (2006-2016). We find that 41% of the firms are significantly exposed to exchange rate risk. We also examined the relationship between the coefficient of exchange rate exposure and foreign currency derivatives used by the firm to hedge the currency exposure. We were not able to any significant relationship between coefficient of exchange rate exposure and foreign currency derivatives.
Abstract
List of Abbreviations
I. Introduction ………. 1
A. Background ……… 1
B. Research Objective ………. 4
II. Conceptual Framework : Theory Review, Tools & Framework ………. 7
A. Foreign Exchange Risk ………... 7
B. Type of Foreign Exchange Risk ………. 7
C. Factors Affecting Exchange Rate Fluctuations ………... 9
D. Hedging ………. 10 E. Hedging Instruments ………. 12 a. Currency Forwards ……… 12 b. Currency Futures ………... 13 c. Currency Options ……….. 13 d. Currency Swaps ………... 14 F. Literature Review ……….. 15 III. Framework ……… 18
A. Exchange Rate Fluctuations and Stock Return ………... 19
B. Currency Derivative and Exchange Rate Exposure ……….. 21
C. Empirical Findings ……… 21
IV. Managerial Implications ………... 25
V. Conclusion ……….... 29
Forex / FX – an abbreviation of ‘foreign exchange’ Euro (€) – Currency of 19 Eurozone countries
USD (US$) – United States Dollar, currency of U.S.
Foreign Exchange Fluctuation – The change in value of one currency with respect to another currency.
Domestic currency – the currency issued for use in a particular jurisdiction. For example, for Netherlands it would be Euro
Forward exchange contract – an agreement to exchange one currency for another currency on an agreed date (for any date other than the ‘spot’ date)
Hedging – A transaction which protects an asset or liability against a fluctuation in the value of foreign currency.
option – A derivative instrument.
A call option is in the money if its strike price is below the current spot price.
A put option is in the money if its strike price is above the current spot price.
Spot rate – Arrangement to exchange currencies in two working days.
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I. Introduction
A. Background:
An exchange rate of two currencies is the rate at which one currency can be exchanged for another currency or simply the value of one country’s currency with another country’s currency.
Currency trading has been prevailing since the ancient times. During the early time, Byzantine government kept a monopoly on the exchange of currency (Hasebroek, 1933: 155-157). The trade was taking place in the ancient world and different kingdoms used different currency (mostly made of gold or silver), the value of this currency was determined by the amount of gold/silver in one kingdoms coin with respect to another kingdom’s. The coin with less gold was cheaper, hence more coins had to be paid for the lower value coins.
During the 15th century, Italian Banks, such as those run by the Medici family, started to open foreign branches to effect payments and currency exchange for their clients (Smith, Walter, DeLong, 2012: 3). In order to facilitate currency exchange and international payments Nostro and Vostro bank accounts were started during this time (Roover, 1999: 130). These accounts are even used today by firms doing international transactions.
During the modern era, Bretton Woods Accord was signed in 1944. Under this system, each country was obligated to maintain its currency fluctuations within a range of ±1% from the currency’s par exchange rate. The member states were required to control their country’s currency within the ±1% parity by intervening in their foreign exchange markets. This gave rise to pegged rate currency regime, wherein different currencies were pegged to dollar and the dollar was linked to gold at the rate of $35 per ounce.
Bretton Woods system ended in 1971, after the United States unilaterally terminated convertibility of the US dollar to gold. This was the starting of free floating exchange rate regime, wherein most of the currencies were determined by the market conditions. The central bank could only control their local currency rate by intervening in the market (by purchasing or selling the currency).
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Exhibit 1 - Timeline of Foreign Exchange Evolution
Since the collapse of Bretton Woods system in 1971, many currencies became free floating and in the present era of globalization, firms have businesses in many different countries, and thus these firms have exposure to different currencies. The multinational corporations are exposed to risks of currency exchange rate fluctuation with respect to the domestic currency. As firms have diversified business interests in different countries and currencies, the exchange rate fluctuation can greatly affect a firm’s activities, such as its cash flows and firm value.
The adoption of Euro in 1999, eliminated currency exchange rate between some countries. The Netherlands being a part of Europe Monitory Union has been using Euro since, 2002. The creation of single currency and formation of a monetary zone helped to provide monetary stability in the countries of Euro zone and move towards a single market. The formation of EU was motivated by several factors. Firstly, formation of EU has ruled out unfair competition practices by EU countries, which devalued their currencies vis-à-vis other member countries. Secondly, the creation of a single market (euroland) should help to reduce the exposure of euroland countries to international monetary instability (Fouquin, Malek, Mansour, Mulder, Nayman & Sekkat, 2001).
Currently 19 out of the 28 Euro Zone member states are using Euro as their currency. This is beneficial for intra Europe trade, but there are total of 180 (approximate) different currencies
Byzantine governtment keeps a monopoly on currency exchnage •4th Century AD Medici family open Banks to exchange currencies •15th Century First Forex Market is maintained in Amsterdam •18th Century Foreign exchange was successfully completed by financial agents of England and Holland •1704 Birth of modern foreign exchnage in the form of Gold standard •1880 integration of Forex trrade in financial functioning of London •1928 Start of Bretton Woods System •1944
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worldwide, many of which may expose a firm to exchange rate fluctuations. The single currency has helped to eliminate the exchange rate fluctuation risk within the Euroland countries, but the single currency is still vulnerable to the exchange rate fluctuations of the other major currencies, such as the US Dollar, Pond Sterling, Yen and currencies of other major trading partners(countries).
Exchange rate fluctuations have a substantial effect on firms. The fluctuation of foreign exchange rates affects both the cash flow and discount rate and hence the value of the firm. We will try to analyze the impact of exchange rate on the firm’s value by means of impact of foreign currency exchange rate on the share price of the firm. Exposure represented the sensitivity of the value of the firm to the exchange rate movements and can be measured by the regression coefficient of the change in the value of firm on the change in exchange rate (Jorian, 1990).
Some of the most common factors which affect the value of a country’s currency are:
(Which in case of our study are factors faced by Euro Monitory Union combined and as guided by ECB):
a. Current account deficit of the country. b. Public debt of the country.
c. Political stability and economic performance. d. Rate of inflation for the country
e. Interest rates
The exchange rate risk is a mixture of exposure to a currency and its volatility. As the firms may experience considerable exposure to foreign exchange rate risk because of foreign currency based activities and international competition. The volatility can be understood as the amount of fluctuation in the value of currency due to market conditions (It is assumed the market has factored in all factors impacting the exchange rate). Some of the most volatile currency pairs are US dollar and Mexican peso, US dollar and Turkish lira (Fouquin et al., 2001).
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As we see, firms may have exposure to many different currencies and the exchange rate fluctuations of these currency can affect the firm’s cash flow and value. In order to minimize the effect of exchange rate risk and safeguard itself from the currency fluctuations, firms use hedging. Hedging is a financial instrument which reduces the risk of adverse price movements in an asset. In more simple words hedge is an investment position used to reduce any substantial gain or losses that can be gained or suffered by a firm.
Hedging can be seen like an insurance policy. While taking an insurance policy someone does not know if the specific scenario will occur or not, but to protect the assets from the worst scenario, a person takes the insurance policy and pays a certain premium for the same. There is an inherent risk-reward tradeoff in hedging, while it reduces the potential risks, it also takes away any potential gains that may occur. The method to reduce/eliminate a company’s foreign exchange risk resulting from transactions in foreign currencies is called as foreign exchange hedge. Forward covers are used widely as a hedging instrument for offsetting the currency exposure.
Different strategies can be used to hedge the foreign exchange risk, many financial instruments are also used for hedging the foreign exchange risk. Hedge is a type of derivative or financial instrument, that derives its value from the underlying asset. Some of the most common hedging strategies are natural hedging, use of derivatives such as forward and options. It is important to understand that, as there is an inherent risk-reward tradeoff in hedging and also there are certain costs associated with the hedging. So, it is important for firms to find an optimum balance, where in they need to also check the potential gains of hedging with the cost of hedging.
B. Research Objective
This paper addresses the key issues mentioned above. Firstly, we will find the effect of foreign exchange exposure on firms listed in Dutch stock market by analyzing the effect of exchange rate fluctuations on the stock returns of the firms. For this, we will use the 17 firms listed on Euronext, AMX Index (Appendix - 1). These firms have assets in different countries and some of these firms are also listed in different stock exchanges, which makes them exposed to exchange rate fluctuations. When foreign currencies appreciate/depreciate, it affects the earnings of Dutch listed
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firms. Adler and Dumas (1984) defined the exchange rate exposure as the extent to which the stock market value of a firm varies with changes in exchange rates.
The Netherlands is one of the most open economies in the world. In 2016, the imports and exports of the Netherlands were 69.9% and 80.8% of GDP, respectively. In comparison the imports and exports of US were 15.4% and 12.5% of GCP. The other European Union power Germany was even lagging behind the Netherlands, as imports and exports of Germany were 30.3% and 45.9% of the GDP (World bank) respectively. This shows that the Dutch listed firms with operations in multiple countries combined with the trade openness of the Netherlands will significantly make firms more exposed to the exchange rate risk as compared to firms of other countries.
In the second part of this paper, we will test whether hedging helps in diminishing firm’s exchange rate exposure. Hedging, by definition, is the strategy of minimizing or eliminating risk, mostly using financial instruments. As we have discussed earlier hedging is like an insurance cover, insuree/s pays a certain amount of premium to the insurer for cover provided by the insurer against certain kind of risks. If the risk occurs, then the underwriter, which is the insurer, pays the compensation towards the losses incurred by the insuree/s upto the limit covered in the policy. But on the flip side if the risks don’t occur than the insuree/s ends up paying the premium, with no return on the premium, this premium is the cost associated with the insurance.
The same is also true for the certain derivative products such as FX options. Currency option is an agreement that provides its holder the right but not obligation to purchase or sell an amount of one currency into another currency at pre-determined price at a specified time in the future. The holder of option has to pay premium to the broker/firm/individual who executes orders of currency option contracts on the behalf of holder. The advantage of FX option is that if the foreign currency strengthens, the can still benefit fully from this move, as holder do not have the obligation to exercise the option and will only loose the premium paid. Another derivative product regularly used is the forward contract, wherein two parties or more enter into a contract with the intention of exchanging one currency for another at an agreed upon rate and at a certain quantity on a specified future date. It is a non-standardised contract. As the forward contract is a legally binding contract, if the exchange rate moves against the holder’s interest, then the holder is not allowed to
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gain from the profitable rate movement and holder may have to pay a relatively high cancellation cost.
One of the main reasons for undertaking hedging is for shielding the revenue stream, balance sheet and profitability of the company against adverse price movements (Allayannis & Ofek, 2001). For the hedging strategy to be most effective, companies should get a clear picture of their risk profile, their risk appetite and benefits from risk aversion by hedging. Hedging does not eliminate risks but helps to transfer risks to someone who is well equipped to manage the risk or is ready to risk in return for higher returns. A properly designed hedging strategy enables corporations to reduce risks (Lewent & Kearney, 1990).
As we have discussed earlier, Firms may use different hedging tools to safeguard themselves from different risks, we will discuss about the various hedging strategies and tools available for protecting against currency fluctuations. Some of the tools and strategies used for currency hedging are, hedging the cash flow by using natural hedge to offset their currency exposure, or by use of forward contract to lock the future currency rate, such as in case of receivables. Apart from these, there are other hedging tools available such as, futures, options and swaps.
As we have discussed, the firms may experience considerable exposure to foreign exchange rate risk because of foreign currency based activities and international competition. Due to highly volatile nature of the foreign exchange market, there is a considerable movement in the value of different currencies which makes the firms exposed to exchange rate risk. In this paper we will find the effect of foreign exchange exposure on firms listed in Dutch stock market by analyzing the effect of exchange rate fluctuations on the stock return of the firm. We will also test whether hedging actually diminishes the firm’s exposure.
This paper is organized as follows. Section II discussed the conceptual framework, which encompasses different theories on Currency risk, hedging strategies and hedging instruments. section III is the framework, where we discuss about the data and model used for analysis, we will also show the empirical findings in this section. Section IV deals with the managerial implications of the research followed by Section V and VI, conclusion and references respectively.
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II. Conceptual Framework : Theory Review, Tools & Framework
A. Foreign Exchange Risk
Foreign exchange risk is the risk that affects financial performance or position of a firm by fluctuations in the exchange rates between currencies. Currency risk is the mixture of exposure and volatility of the currency.
There are different modes through which firms can be exposed to exchange rate risks. For instance, a firm which exports its products, is susceptible to exchange rate risk, because when exchange rate of the buyer country with respect to the domestic currency changes than this will affect the receivable of the firm. Some firms can also import resources from abroad, in such a scenario the change in exchange rate will affect the payables of the firm. In case of receivable appreciation of domestic currency will reduce the receivable of the firm, where in case of payables, depreciation of currency will increase the payable of the firm. Usually both the scenarios can substantially affect the cash flow of the firm.
Another scenario is for a multinational firm, which are substantial assets and liabilities abroad. Firms need to prepare a consolidated Financial statement for reporting purposes, in case of firms with overseas assets and liabilities need to translate these or the foreign subsidiaries financial statement needs to be changed to domestic currency and consolidate in firms financial statement. This could greatly affect reported earnings and hence the stock price.
B. Type of Foreign Exchange Risk
The three main types of exchange rate risk are (Papaioannou, 2006):
1. Transaction risk – It is the cash flow risk and deals with the effect of exchange rate exposure, related to receivables (export), payables (Import) or repatriation of dividends. Change in exchange rate in the currency of denomination (which is usually
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the foreign currency) of any such contract will result in a direct transaction exchange rate risk to the firm.
An easy example would be a Dutch carpet showroom importing carpet from India. In such a case there exists a transactional risk in the contract for example is the Euro/INR exchange rate at the time of contract stands at INR 70 for € 1 and the Dutch importer makes a contract for buying carpets worth € 10,000 in the month of December 2017. The transaction risk is the uncertainty of the same Euro/INR rate as on the date of contract. If the Euro/INR rate moves to INR 35 for every euro than the Dutch buyer will end up paying twice the amount. This situation makes parties involved in the international trade exposed to currency risk.
2. Translation risk – This risk is related to the valuation of foreign assets and liabilities of a foreign subsidiary which in turn can affect the parent company’s balance sheet. Translation risk for a foreign subsidiary is usually measured by the exposure of net assets (assets less liabilities) to potential exchange rate moves. Translational risk is also known as an accounting risk and it might not affect the cash flow of the firm, but it can have significant impact on the firm’s reported earnings and value which can impact the stock price.
An example of translational risk could be by looking at the consolidated financial statement and balance sheet of Philips, Dutch multinational. Philips have many subsidiaries all over the world, and after the end of each financial year, the corporate head office of Philips global has to present a consolidated balance sheet, which will have assets and liabilities of its global subsidiaries in a single currency. While reporting the consolidated position Philips needs to convert assets of subsidiaries from local currency to parent company’s currency. This gives rise to translation risk, as Philips will witness foreign currency gains or losses when its assets, liabilities and financial obligations are converted in currency of parent company.
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3. Economic risk - it is the risk to the firm’s present value of future cash flows from exchange rate movements. It is the effect of exchange rate fluctuations on revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports). Economic risk is usually applied to the present value of future cash flow operations of a firm’s parent company and foreign subsidiaries.
C. Factors Affecting Exchange Rate Fluctuations
There are a number of factors which can be attributed as factors which determine the volatility or fluctuations in exchange rate. These factors range from economic indicators to international factors.
Exchange rate system is a system in which one currency say Euro exchanges with other currencies or indices denominated in foreign currency. With the collapse of Bretton Woods system and later on the Smithonian Agreement and the formation of Euro, countries started to move towards free floatation of their currencies. There are various factors affecting the currency exchange rate, these are:
1. Inflation – Inflation plays an important role currency exchange rates. Lower inflation rates in a country helps to appreciate the currency value of that country. For example if rate of inflation in India is lower that other countries this will help India to increase its exports. This will also help to increase the demand for rupees to buy Indian goods. As the increase demand for Indian currency will appreciate the value of Rupee and the imports will become cheaper. Therefore, lower inflation helps to appreciate the value of currency.
2. Interest Rate – it is important to know that interest rate, inflation and forex rates are highly correlated. A country with interest rates higher that others will attract more foreign capital, as foreign investors will get higher returns on their investments and this will cause the exchange rate to rise.
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3. Current Account Deficit – Current account is the balance of payment between country and its trading partners. A current account deficit indicated that the country is spending more on foreign trade than it is earning, in other words country is importing more than exporting higher imports resulting in shortage of foreign currency. This excess demand of foreign currency lowers the domestic currency of the country.
4. Public Debt – Countries spending on public sector projects and other social funds through deficit financing becomes less attractive for foreign investors. As the such countries face the problem of higher inflation. A important determinant in this sector is the debt rating provided by rating agencies to the country. A country with lower rating has the risk of defaulting, which will stop foreign investors to hold debt in that currency as the country might default. Hence, rating provided to a countries debt is an important determinant of the exchange rates.
5. Political Stability and Economic Performance – Countries with stable political government and strong economic performance attracts foreign investors. As a stable government can give strong economic performance through completion of projects and initiating new developments projects.
As we have seen, there are different type of exchange risks to which a firm may be exposed, due to its business activity and geographical distribution. We have also seen that there are many factors which affect the currency exchange rate, it can be seen that these factors can substantially affect the value of currency. In the next sections, we will discuss about the hedging strategies and tools which can be used by the firms to protect themselves against currency risks.
D. Hedging
Hedging is a risk management technique which is used to reduce or eliminate losses due to adverse movements. It is one of the most common methods that firms use to eliminate financial risks. There are different kind of hedging strategies and tools which are used for mitigating various risks, such as the operational risk, credit risks and other financial risk. This paper is focusing on currency exchange risk, and how that affects the value of the firm. Hence, we will discuss about tools
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available for hedging foreign exchange risk and test weather hedging helps to reduce the currency risk.
Firms use different financial hedging products, such as future contracts, forward contract, options, currency swaps and others, for minimizing the effect of currency risk. Currently there is an availability of large number of hedging instruments, their variety and complexity has increased the specific hedging needs of the modern firm (Hakala and Wystup, 2002; Jacque, 1996; Shapiro, 1996). Apart from regular hedging instruments, treasuries are developing efficient hedging strategies as a more integrated approach to hedge currency risk than using normal forward covers to hedge certain foreign exchange exposure (Kritzman, 1993). From the perspective of corporate manager, currency risk management is viewed as a sensible approach to reduce vulnerabilities of a firm from major exchange rate movements (Van Deventer, Imai, and Mesler, 2004).
Previous studies (Allen, 2003 & Jacque,1996) have found that firms with significant exchange rate exposure often need to establish an operational framework of best practices. They further recommended that these strategy should revolve around 5 points namely –
1. Identification and measurement of exchange rate risk – Firms need to identify the type/s of currency risk it is exposed to, such as transaction, translational and economic risk and also specific currencies to which they are exposed. In addition, they need to measure these currency risks, this can be accomplished by using models, such as the VaR (Value at Risk).
2. Development of exchange rate risk management strategy – Firm need to develop a strategy for dealing with the currency risk. This strategy should be able to answer some basic questions, such as if the firm need to fully or partially hedge the currency exposure, what are the different instruments that firm needs to use under specific cases and how the firm will monitor the hedge positions.
3. Creation of a centralized team - To deal with the practical aspects of currency risk hedging execution, a centralized entity should be created in the firm’s treasury. The entity will be responsible for mechanism of hedging, cost of hedging, accounting
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procedure for hedging, forecasting of exchange rates, establishing benchmark for currency hedging performance management and other tasks related to hedging.
4. Developing monitoring mechanism - Firm’s needs to develop a set of controls for monitoring the currency risk in the firm. This should include position limits for each hedging instrument should be set, for periodic monitoring of hedging performance benchmarks should be established.
5. Establishing risk oversight committee – This committee would review risk management policy on regular basis. They will approve limits on position taking and check the appropriateness of hedging instruments.
E. Hedging Instruments
In this section we will discuss about the various hedging instruments which are available for a firm to hedge their currency risks. Currency hedging is defined as protecting a firm against movement of exchange rate in the direction opposite to their position in the market by taking an offsetting position in that currency.
There is an availability of large number of complex hedging instruments. These include both OTC (Over the counter) and exchange traded products. In this paper we discuss about the four widely used hedging instruments. Currency forward and cross currency swaps are OTC hedging instruments whereas currency futures and currency options are exchange traded hedging instruments.
a. Currency Forwards
It is a contract between two or more parties to buy or to sell certain amount of currency (asset) at an agreed upon price on a specific future date.
As forward contract is an non-standardized contract, this makes it highly customised which makes it apt for hedging. The contract can be customized according to the needs of parties and they can
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decide on delivery date, quantity and price. Many firms use forward contract to hedge their currency risk. As forwards traded over the counter and not in exchange, they possess a high degree of default risk.
b. Currency Futures
It is a contract to exchange one currency for another at an pre-determined price (exchange rate) on a specified future date.
Future contracts are an standardized exchange traded contracts and can be seen as an upgradation of forward contracts, designed to solve problems encountered in forwards. Future contracts have a number of standardized features such as maturity date, contract size, quoting convention (i.e: EUR/USD), price limit (i.e. daily maximum price fluctuation ) and position limits (number of contracts a party is allowed to buy or sell). The delivery price on future contract is determined on an exchange as it primarily relies on the market demands.
Another change from the forward contract is the deposit of security amount in futures. There is no need to deposit cash in a forward contract, whereas in future, traders are required to open a futures account, where both (buyer and seller) need to make a security deposit, this provides guarantee that the traders will fulfill their contractual obligations.
c. Currency Options
It is an agreement that provides the holder the right but not the obligation to exchange one currency into another currency at a pre-agreed rate on a specified date in the future.
As the option holder has the right but not the obligation to exercise the contract, the holder has to pay a premium for this right to choose. Options trading is not and is not heavily regulated and they are traded in exchanges such as International Securities Exchange . Premium is regarded as the upfront cost which the holder is required to pay upfront to gain the possession of option, regardless of whether option will be exercised or not.
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Depending on buying or selling of currency option can be classifies into call option and put option. Call option gives holder the right to buy specific quantity of currency at a fixed date and price, whereas put option give holder right to sell an specific quantity of currency at a fixed date and time.
d. Currency Swaps
It is also known as cross currency swap. It is an agreement between two parties to exchange interest payments and sometime principal denominated in one currency into another currency at an agreed upon exchange rate for a specific period of time.
Apart from helping in hedge against forward exchange rate fluctuations currency swaps may help to secure cheaper debt, as the company can borrow at the best available rate regardless of currency and then swapping for debt in desired currency.
One of the major drawback of swap is default and creditworthiness risk of the counterparty. If one party fails to meet the financial obligation on maturity date than the other party may also face situation of default on principal payment along with interest.
As we have discussed earlier, there are many different factors which affect the foreign exchange rates. In the last two decades the world has seen many currency crisis such as economic crisis in Mexico (1994), Asian Financial Crisis (1997), Russian financial crisis (1998) and the Argentine economic crisis (1999-2002). Apart from these there are many different events which affected the currency rates. The 2008 European debt crisis, wherein countries had to be bailed out of debt, this lead to recession and economic instability. The Euro and other European currencies fluctuated during the crisis. More recently following the Brexit, GBP depreciated by 10% in value. We can see there are many events which influence the currency rates and the fluctuations can substantially effect the firm’s cash flow and firm value. In order safeguard gains adverse price movements, it is important for firms to hedge their currency positions.
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F. Literature Review
Various studies have shown that the effect of Foreign exchange risk on a firm’s stock price depend on a variety of firm characteristics. A sample of 287 U.S. multinationals was analyzed by Jorion (1990) and found that the ratio of foreign sales is a significant determinant of a firm’s exchange rate exposure and the ratio of foreign sales and total sales is positively related with depreciation of the US dollar. Adler and Dumas (1984) define exchange rate exposure as the effect of exchange rate changes on the value of a firm.
By analyzing a sample of automotive firms from the United States and Japan, it is reported that foreign sales increased the exposure to currency risk whereas foreign operations reduced the exposure (Williamson, 2001). He also found that industry competition and the structure of the firm's operations play vital roles in the exchange rate exposure to firm-value relation.For instance, if a firms exports its product to an overseas market and does not directly compete with the firms in that market, than exposure of the firm is simply a function of its foreign currency revenues. If the foreign firm faces competition in the local market, than the exposure is a function of its foreign currency revenues and also to the elasticity of its own and its competitor's product (Williamson, 2001). It is also reported that domestic competition from foreign firms is an important determinant of exposure. The results of the research have shown the U.S automotive firms have significant exposure to the Japanese yen, which the home country currency of their major competitors. As the sales in Japan is low for U.S firms, the source of exposure should be from the Japanese firm's U.S sales and not from U.S. firm's sales in Japan.
It is reported that exposure can cause revenue of MNC’s to increase (decrease) when foreign currencies appreciate (depreciate) because goods and services produces domestically become relatively less (more) expensive. Alternatively, appreciation (depreciation) in the foreign currencies could lead to increased (decreased) cost due to exposure because the foreign-sourced inputs and foreign-denominated debt become relatively more (less) expensive (Martin Madura, Akhigbe, 1990).
Some studies of foreign exchange rate exposure are done in some specific industry sector. Allayannis (1996) studies he effect of exchange rate exposure in U.S manufacturing industries and
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found that the exposure has to do with the level of export and import. The study also found a relationship between exchange rates and time. In this study, the stock return is used as a proxy for a firm’s value and a strong evidence was found that the industry exchange rate exposure varies over time in a systematic way with the share of imports and exports in the industry.
Study was conducted about the exposure of exchange rate changes of large firms in UK, France and Germany in the pre-Euro setting. The exchange rate sensitivity was found to be considerably strong. For the firms of all three countries, firms gain value when local currency depreciates against the US dollar (William & Sanjay, 2005).
Euro was adopted in 1995 and introduced as an accounting currency in 1999. This eliminated exchange rate variability between some member Eurozone countries. The physical Euro currency (bank notes and coins) entered into circulation in 2001 and by May, 2002, Euro had completely replaced former currencies. Currently 19 out of the 28 euro member states are using Euro. Bartram and Karolyi (2006) studied the effect of the introduction of the Euro as a common currency which affected 3220 corporations in 20 countries around the world. They found that a common currency leads to lower foreign exchange rate risk and, thus, lower foreign exchange rate exposures of nonfinancial firms.
Jong et al (2006) studies about foreign exchange rate exposure of Dutch MNC’s (non-financial firms)finds that over a period 1994-1998, over 50 percent of a sample of Dutch firms are significantly exposed to foreign exchange risk. They also found that firms with significant exposure benefit from a depreciation of the Dutch guilder relative to a trade-weighted currency index and that the firm size and the foreign sales ratio are significantly and positively related to exchange rate exposure.
Some studies such as by Jorion (1990) found only a small number of firms with significant exchange rate exposure. As a consequence, somewhat surprisingly, researchers concluded that, the effect of exchange rate changes on firms value is economically and statistically small (Griffin and Stulz, 2001).
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Two models which are used by prior researchers for measuring exchange rate exposure are discussed by Bodnar and Wong (2003). In the first model, the coefficient on the exchange rate variable in a linear regression between the return on stock of the firm and the change (percentage) in an exchange rate (home currency price of foreign currency) variable gives the exposure elasticity. In the second model return to the market portfolio is added with the exchange rate variable to control for the common “macroeconomic” influences on “total” exposure elasticities. The market portfolio return improves the precision of the exposure estimates by reducing the residual variance of the model, hence, it is a commonly estimated exposure model.
Study (Doidge, Griffin & Williamson, 2006) assessed the economic magnitude of exchange rate exposure by using a new approach, known as portfolio approach to measure the economic importance of exposure. According to this model, the wealth is allocated among alternative assets including domestic money, domestic bonds and equities and foreign securities (Phylaktis, Ravazzolo, 2005). Their result shows that the exchange rates play an important role in explaining stock returns. Bodnar and Wong (2002) show that the different constructions of a market portfolio have different exposures to exchange rates due to a significant size effect in exchange rate exposures. They claim a significant inverse relation between firm size and exchange rate exposure.
Many research paper encounter methodological shortcoming in the research. Alayannis & ofek (2001) compare financial hedging versus operational hedging. They used several alternative measures of geographical distribution of subsidiary companies as a proxy for the level of operational hedging of a firm. They found that the dispersion of subsidiaries across multiple countries does not reduce exchange-rate exposure. Bodnar and Marston (2000) find that foreign exchange exposure is low for the majority of 103 US firms surveyed, because these firms make effective use of operational hedging (matching foreign currency receivable and payables). The conclusion of Bodnar is in direct conflict with the conclusion of Alayannis. The biased result of Bodnar may be because, only those firms that do have a good track record with respect to exchange rate exposure participate in the survey, this is a shortcoming of the survey method.
He and Ng (1998) conducted research on 171 Japanese companies to investigate the incentives of hedging. They found that firms with high financial leverage or firms with weak short-term liquidity positions have more incentive to hedge and have smaller exchange rate exposures. “Within the
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framework of hedging the exchange rate risk in a consolidated balance sheet, the issue of hedging a firm’s debt profile is also of paramount importance”, (Marrison, 2002; Jorion and Khoury, 1996). Allayannis and Ofek (2001) examine whether firms use foreign currency derivatives for hedging or for speculative purpose by using a sample of S&P 500 nonfinancial firms for 1993. They find evidence that firms use currency derivatives for hedging to significantly reduce the exchange rate exposure. They also find that the decision to use currency derivatives depends on exposure factors such as foreign sales and variables largely associated with theories of optimal hedging such as R&D expenditures; the level of derivatives used depends only on a firm’s exposure through foreign sales.
Sarah et al (1998) examines currency exchange risk to financial institutions which are doing business internationally. The research concluded that financial institutions are increasingly facing foreign currency exposure and recommending hedging and financial strategies. Papaioannou (2006), discusses about various risk management tools for calculation of currency risk and also discusses the general hedging strategies for translational, transactional and economic risks. Further various hedging instruments such as forward, future, options and swaps are discussed.
Papaioannou(2006) also finds that, based on the reported U.S. data, it is observed that the larger the size of a firm the more likely it is to use derivative instruments in hedging its exchange rate risk exposure; the primary goal of U.S. firms’ exchange rate risk hedging operations is to minimize the variability in their cash flow and earning accounts.
III. Framework
The paper consists of two parts. Firstly, we will find the relationship between change in foreign exchange rate and return on stocks. Secondly, we will check if the hedging helps to minimize the effect of exchange rate fluctuations.
The first part will be analyzed using the regression test, to find the relationship between exchange rate and return on stock value. The sample for our research contains 17 firms listed in Euronext, AMX Index. All of these firms have operations in different geographical locations, and they deal in different currencies which makes them exposed to currency risk.
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The study covers a period of 10 years (2006-2016). The time period have seen some global events taking place, causing a substantial fluctuations in the different exchange rates. In the second part the relationship between ratio of foreign currency derivate and total assets in a firm will be checked with the exchange rate exposure. The length of the return measurement horizon, is taken to be one month (Bodnar and Wong, 2003). They also state that “exchange rate exposure estimates are more statistically significant at longer horizons. However, lengthening the horizon beyond one month does not reduce the model sensitivity of the exposure estimates arising from the relation between exposure and firm size”.
A. Exchange rate fluctuations and stock returns
Floating rate has bought unanticipated exchange rate movements in the international business environment. It is also known that these unanticipated movements in currency value create risks for multinational companies, forcing company managers to take actions to prevent or avoid the risk. The value of Firms operating in multiple countries are affected by the changing exchange rates. When foreign currencies appreciate, the sales and earnings of operations in those currencies translate into more parent currencies, thus, increasing consolidated sales and earnings. Dumas (1978), Adler and Dumas (1984) and Hodder (1982) defined the exchange rate exposure as the extent to which the stock-market value of a firm varies with changes in exchange rates.
The exchange rate exposure of a firm is the way in which value of the company changes, as real value of local currency changes. The currency exposure of a firm can be calculated by regressing the firm’s stock return with the change in local currencies value. In accordance with He and NG (1997), the following regression model will be used to measure the exposure. The model was used in earlier researches by Adler and Dumas (1984), Jorion (1990), Allayannis (1996)
R
it= β
0+ β
ixR
xt+ β
imR
mt+ ε
it ……… (1)R
it is the return on the ith corporation’s stock,β
0 is the intercept,R
xt is the return on nominal effective weighted exchange rate index andR
mt is the return on a market portfolio in time t.β
ix measures the exchange rate exposure.ε
it is the error term.Page | 20
As a sample we initially started with 17 firms listed on Euronext, AMX Index. Out of the 25 firms, we took 17 firms(Table 1, Appendix) for our research, as there was non-availability of data for the other 8 firms. The firms not included in the research were newly inducted in the AMX index, hence we were unable to gather data for the complete duration of 10 years for these firm (2006-2016). The monthly return on exchange rate is calculated using nominal effective exchange rates of the euro as calculated by the European Central Bank (ECB). The nominal effective exchange rate is a weighted average of nominal bilateral rates between the euro and a basket of foreign currencies (19 trading partners).
As is the common practise in studies of exchange rate exposure, we use return on market index as a proxy which helps to reduce noise. The index selected is, AMX index of Euronext, which was started in 1995. It is a midcap market index and encompasses 25 Dutch companies which are traded on Euronext. It is a free float market capitalization weighted index, with total market capitalization of €58.10 billion. We calculate returns on monthly basis. For the monthly data we use data on the 15th day of every month, taking January, 2006 as a base year. In case 15th day of the month is a holiday, than we selected the next working day for calculations of returns.
Exhibit 2 – Return on market portfolio and change of nominal exchange rate
-0.6000 -0.4000 -0.2000 0.0000 0.2000 0.4000 0.6000 16/01/2006 15/06/2006 15/11/2006 16/04/2007 17/09 /20 07 15/02/2008 15/07/2008 17/12/2008 15/05/2009 15/10/2009 15/03/2010 16/08/2010 17/01/2011 15/06/2011 15/11/2011 16/04/2012 17/09/2012 15/02/2013 15/07/2013 16/12/2013 15/05/2014 15/10/2014 16/03/2015 17/08/2015 15/01/2016 15/06/2016 15/11/2016
Chart Title
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Exhibit 2 shows the variation of return on market portfolio and change of exchange rate over a period of 10 years (2006 – 2016), which is also the duration of our research. It can be seen that there is a relationship between the two. The two independent variable seem to be correlated. The coefficient is calculated to be -0,38, implying that return on market portfolio and return on exchange rate have a moderate negative linear relationship. There was no significant multicollinearity found in the model.
B. Currency Derivative and Exchange Rate Exposure
In this part we will examine the impact of firms use of currency derivatives and its exchange rate exposure. The exchange rate exposure of a firm is determined by its financial hedging. Therefore, we use the following equation
β
ix= α + ϒ
i(FCD/TA) ………(2)β
ix is the firms exchange rate exposure as measure in (1), FCD/TA is the ratio of nominal value of foreign currency derivatives to the total assets of the firm,ϒ
i measures the effectiveness of hedging against currency exposure. Hereβ
ix is the coefficient of currency exposure that we will find from equation (1), and use liner regression to find the coefficient of currency derivativeϒ
i i.e. (FCT/TA)C. Empirical Findings
Exchange rate fluctuations and stock returns
We estimate equation (1), for each firm in our sample using liner regression. Table 1 represents the regression of changes in the ECB’s nominal effective weighted exchange rate and returns on stock at 0.05 level.
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Table I – Regression analysis using equation (1)
Company Intercept βix βim R square
AIR FRANCE -KLM -0.57 +5.42 1.495 57.30
APERAM -0.50 +2.16 0.258 17.00
ARCADIS 0.81 -2.360 1.382 36.10
ASM INTERNATIONAL 0.80 -10.22 1.249 77.50
BAM GROEP KON -0.63 +4.11 1.080 51.80
BE SEMICONDUCTOR 1.21 -22.87 2.566 65.10
CORBION -0.28 +1.13 0.912 52.70
EUROCOMMERCIAL 0.042 -0.22 0.841 79.80
FUGRO 0.24 +4.56 0.513 25.30
POSTNL -0.58 +4.65 0.896 53.40
SLIGRO FOOD GROUP 0.32 -1.60 1.075 71.80
TKH GROUP 1.05 -8.88 1.762 73.20 TOMTOM -0.75 +4.16 1.446 47.00 VASTNED -0.29 +2.60 0.839 58.40 WDP 0.095 -3.45 0.759 67.40 WERELDHAVE -0.28 +2.07 0.682 55.90 WESSANEN -0.63 +0.67 1.495 31.80
The 17 companies were selected from the AMX index of Euronext. Liner regression analysis for exchange rate exposure coefficient βix, using equation (1): Rit = β0 + βix Rxt + βim Rmt + εit where Rit is the monthly
stock return on the ith corporation’s R
xt is the monthly return on nominal effective weighted exchange rate
index for the Euro and Rmt is the monthly return on a market portfolio. Intercept is the value of constant β0.
It can be seen from the above table, for the full sample period of 2006 to 2016, R square value is more than 50% for 12 firms out of the 17 firms, hence, it can be said that the model was able to explain the variations in stock due to currency exposure. When we further analyze the exchange rate exposure coefficient in the Table II we find that out of 17 firms 8 firms (47%) are significantly exposed to exchange rate index at 5% level (95% confidence interval).
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Table II. Descriptive Statistics of Exchange Rate Exposure Coefficient Statistic Beta Minimum -22.8660 First quartile -2.360 Median 1.130 Third quartile 4.108 Maximum 5.419 Mean -1.063 Standard deviation 7.203
Firms with significant exposure at 95%
confidence interval 7 ( 41%)
Firms with significant positive exposure
at 95% confidence interval 4 (24%) Firms with significant negative exposure
at 95% confidence interval 3 (18%)
Liner regression analysis for exchange rate exposure coefficient βix, using equation (1): Rit = β0 + βix Rxt +
βim Rmt + εit where Rit is the monthly stock return on the ith corporation’s stock, α is the intercept, Rxt is the
monthly return on nominal effective weighted exchange rate index for the Euro and Rmt is the monthly
return on a market portfolio of the market capitalized weighted AMX index of Dutch stock market in time t. βix measures the exchange rate exposure. εit is the error term.
There are 4 firms with significant positive value of exchange rate coefficient (βix). On the other
hand there are 3 (18%) firms with significant negative exchange rate coefficient. Overall 41% of the Dutch listed firms are exposed to exchange rate exposure. This results are similar to previous study conducted by Jong et al (2006), they found more than 50% of the Dutch firms exposed to currency exposure for Dutch guilder. But our results, to an extent also support the results of Bartram and Karolyi (2006) who study the introduction of Euro on exchange rate risk exposure. They found that common currency leads to lower foreign exchange rate risk and, thus, lower foreign exchange rate exposures of firms. Jong et al (2006) found more than 50% of the Dutch firms exposed to currency exposure whereas in our research it has decreased 41%.
The mean of exposure coefficient is -1.063, the negative is due to a presence of an outlier. After removing the outlier, if we check again, we find the mean value of exposure coefficient to be 0.30, showing that if Euro depreciates with 1 percent average Dutch firms of the sample gain 0.30 per
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cent. The positive value of currency exposure coefficient suggest that depreciation of Euro against basket of currency has a positive impact on the stock returns of the Dutch firms. The negative value of coefficient implies that depreciation of Euro has a negative impact on the value of firms.
There are 4 (24%) firms with significant positive exposure coefficient, ranging from 0.67 to 2.60. These firms are exporters, a possible explanation can be that these firms have assets in foreign currency and when the Euro depreciates, it cases positive impact on their consolidated books. These firms can also be very big firms, and they can be net exporter of goods or services. The results show that almost 41% of the firms in sample are exposed to currency exposure, which is more than other researches.
Currency Derivative and Exchange Rate Exposure
We use equation (2), to find the potential impact of a firm’s currency derivative use on its exchange-rate exposure. We calculated the coefficient of currency exposure by equation (1). Foreign currency derivate is the nominal value of Forward contracts and options which companies use to hedge their risk. Total assets and nominal value of currency derivatives can be found in the financial statement of the firm for the year 2012.
Table III – Descriptive statistics
βix FCD Total Assets FCD/TA Beta Minimum -22.8660 0.00 689 0.00 First quartile -2.360 11.72 1638 0.53 Median 1.130 64 2182 2,80 Third quartile 4.108 170 3749 4.72 Maximum 5.419 6934 22932 30.24 Mean -1.063 540 3879 5.22 Standard deviation 7.203 1770.47 5413 7.97
Linear regression for coefficient of currency derivative ϒi using equation (2): βix = α + ϒi (FCD/TA) βix is
the firms exchange rate exposure as measured in (1), (FCD/TA) is the ratio of nominal value of foreign currency derivatives to the total assets of the firm, ϒi measures the effectiveness of hedging against
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Table III, see the statistical analysis of dependent and independent variable of equation (2). On performing the regression analysis we find that coefficient of foreign currency derivatives is +0.39, implying that ϒi is positively related to exchange rate exposure (βix ).
As shown by Allayannis and Ofek (2001), If firms use foreign currency derivatives to hedge against currency fluctuation, then use of derivatives should reduce the currency exposure. We can also say that the use of derivatives should decrease exchange-rate exposure for firms with positive exposures and increase (decrease in absolute value) exchange-rate exposure for firms with negative exposures. Therefore, the absolute values of derivatives used should be negatively related to the absolute values currency exposure (βix ). A positive relation between the absolute values of
derivatives used and the absolute values currency exposure (βix), implies, that firms are using
derivatives to speculate in the foreign exchange market.
We have a positive relationship between the absolute value of currency exposure and absolute value of the percentage use of foreign currency derivative. This implies that the Dutch listed firms use currency derivative products for the purpose of speculating in the foreign exchange market. this statement is not consistent with our sample, as all the companies in the sample are non-financial firms. Other factors which may have biased our results and influenced the value of ϒi,
can be due to the small size of our sample, another important factor is that we only tool foreign currency forward/futures and options as foreign currency derivative and excluded the swaps.
IV. Managerial Implications
Exchange rate fluctuations and stock returns
Currency risk arises from a combination of currency exposure and currency volatility. Firms may experience considerable exposure to foreign exchange rate risk because of foreign currency based activities and international competition. The exchange rate fluctuation has a substantial effect on firms. The fluctuation of foreign exchange rates affects both the cash flow and discount rate and hence the value of the firm.
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The adoption of Euro in 1999, eliminated exchange rate variability between major trading countries in the Eurozone. Netherlands being a part of Europe is using euro since, 2002. Currently 19 out of the 28 euro member states are using Euro. This is beneficial for intra Europe trade, but there are a total of approx. 180 different currencies worldwide, many of which may expose a firm to exchange rate fluctuations. We found that 41% of the of the 17 firms listed on the Dutch stock market are exposed to exchange rate fluctuations.
Firms with open economies exhibit more exposure to exchange rate as compare to closed/partially closed economies. As most of the previous studies such as by Jorion (1990) and Choi and Prasad (1995) studied on US firms. These results of these studies a low number of firms which are exposed to currency fluctuation. Netherlands being a more open, show a large number of firms which are exposed to currency fluctuation.
Currency fluctuations is like a two sided sword, it can be beneficial for a firm and may give favorable outcomes, but on the flip side, it can also have very unfavorable effects on the firm. One of the currency which lately saw high volatility is the British Pound (GBP). Post the Brexit referendum, GBP depreciated more than 10% in value. Any Dutch firm having assets in Britain would had suffered badly because of the depreciation of GBP. Firms exporting products to Britain, would receive less Euros, as Euro would have appreciated, whereas it is beneficial for importers. As suggested by Jong et al (2006), 24 out of 47 firms (more than 50%) had a positive exposure coefficient, implying, Dutch firms are net exporters. We found that 24% of the firms have significant positive exposure coefficient. Hence, If these firms were exporting to Britain, or have assets, then they would have had a significant effect on the value of firm.
Earlier we had discussed about various types of currency exchange risk that a firm might have to face, such as the transaction risk, translation risk and economic risk. The most common source of these risks is explained in Exhibit 3.
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Exhibit 3
Source: Export Development Canada
It can be clearly seen that in case of a trading or manufacturing firm, risk arises at the time of order initiation itself and then on different phases of different types of risk arise.As we have discussed how currency risk can have substantial effect on the value of the firm. In line with previous researches, we also collaborated that the Dutch firms are more exposed to currency exposure. Considering all the things, it is important for the corporate managers, to develop a strategy and if required hedging instruments, in-order to tackle the issue to currency exposure risk.
Exhibit 4 – Currency risk management approach
Source: Export Development Canada
Firms usually use hedging instrument to reduce the effects of currency rate fluctuations. These instruments takes away the possible losses that the firm might incur due to currency exposure, but hedging also takes away the possible gains, which a firm might get due to favorable movement of currency rates. Van Deventer, Imai, and Mesler (2004) suggested currency risk management, as a sensible approach to reduce vulnerabilities of a firm from major exchange rate movements. These approach are better suited because they form the basis of currency risk management policy of the firm. A proposed currency risk management approach is represented by Exhibit 3. It is self-explanatory, it is similar to operational framework of best practices for firms with significant
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exchange rate exposure(Allen, 2003 and Jacque’s,1996). The framework works as a currency risk management policy. Exhibit 4 represents the framework.
Exhibit 4- Operational framework of best practices
Lewent and Kearney (1990) in their paper also considered an alternative approach to the financial hedging. This approach involves the following 5 steps:
1. Exchange Forecast – The firm needs to project the exchange rate volatility and needs to understand the factors which guide the exchange rate movements, such as the economic indicators, target area of government policies and other forecasters. Firm needs to develop a model incorporating different factors, to forecast the exchange rate volatility.
2. Strategic Plan Impact – Firm needs to access the impact of adverse exchange rate fluctuations on its long term plan. Firm can compare their cash flow and earnings projects with the expected and adverse price movements.
Identification/review and measurement of currency risk Developing/updating risk management strategy
Creating a core team Developing/updating
monitoring and controling mechanism Risk Oversight
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3. Hedging Rationale – the firm needs to decide if it needs to hedge the currency volatility or not and to which extend they want to hedge the currency risk. Many companies, if not sure about the currency movement, do not completely hedge their currency exposure, as it may take away the possible gains due to favorable price movements.
4. Financial instrument – The firm needs to select the suitable instruments for hedging the risk. Forward contracts, foreign currency debt, and currency swaps all effectively fix the value of the amount hedged regardless of currency movements. Whereas options, retains the opportunity to benefit from natural position, although at a cost equal to the premium paid for the option.
5. Hedging Program – This will involve taking decisions about hedging such as analysing every year the position of hedge and find the optimum instruments, the amount which needs to be hedges, varying the strike price of options for reducing the hedging costs.
V. Conclusion
The relationship between exchange rate changes and stock returns for a sample of 17 Dutch firms was examined over a period of 10 years (2006-2016). It was found that 41% of 17 firms are significantly exposed to exchange rate risk. 24% of firms have significant positive exposure and 18% have significant negative exposure. Firms with positive exposure benefit from the depreciation of Euro. We also tested if hedging helps to diminish firms currency exposure. No significant effect on currency exposure was observed by the use of foreign currency derivative. One of the possible may be because we used single factor usage of foreign currency derivative has no significant effect on the exposure.
This study uses trade weighted exchange rate index by European central bank. The weights in trade weighted index is derived from trade figures with foreign countries and when we use such a index, it is assumed that individual firms will also be having similar characteristics. To find the effect of foreign currency derivative on the exposure, we used nominal value of Forward contracts and
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options as currency derivative. A possible source of bias can that the firms also use foreign debt as a way to hedge their currency exposure.
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Page | 34 Appendix - 1 Sr. No. Company 1 AIR FRANCE -KLM 2 APERAM 3 ARCADIS 4 ASM INTERNATIONAL
5 BAM GROEP KON
6 BE SEMICONDUCTOR
7 CORBION
8 EUROCOMMERCIAL
9 FUGRO
10 POSTNL
11 SLIGRO FOOD GROUP
12 TKH GROUP 13 TOMTOM 14 VASTNED 15 WDP 16 WERELDHAVE 17 WESSANEN
