Theory Lecture 7 Flashcards
Firms operating outside of home market are exposed to exchange rate changes. What are the exposure associated with it?
A. Transaction exposure: gains/losses to current cash flows when monetary transactions
are settled in foreign currency
▪ When selling/buying on credit (with time gap) a good/service priced in for. curr.
▪ When borrowing/lending in for. curr.
➢There is uncertainty about the price of for. curr. in the future.
B. Translation exposure: a bookkeeping issue when having assets/liabilities in FX
▪ There is uncertainty about the own currency value of A/L denominated in for. curr. in the
future.
C. Economic exposure or residual risk adverse effects of FX changes on long-run cash
flows.
• These risks have consequences for the value of the firm!
Describe the key principles of value-creating corporate hedging.
Principle 1: Tradeoff between various corporate risks
• Company’s capacity to bear risk is finite: By taking one type of risk you have to give up
another.
• The core business of companies is to take on business risk.
• If you are at risk-bearing capacity, not hedging (=taking FX risk) would not allow you
to start new investment projects.
➢By hedging FX risk you may focus on core activities →that way the FX hedging
creates value!
Principle 2: Comparative advantage in RM
• In trade theory, comparative advantage is one of the key principles:
Countries use finite resources to produce and export goods in which they have
comparative advantage.
• Comparative advantage works in case of RM too.
➢Companies should retain and focus on managing those risks where they have a
“comparative advantage.”And let investors or specialized companies bear other risks.
Principle 3: RM is a strategic, forward-looking activity
We must not evaluate effectiveness or success of RM based on its short-term impact.
➢RM is a strategic, forward-looking activity –not for-profit activity or speculation.
• Think of a scenario analysis in your corporate valuation class:
▪Scenario 1: the long-run expected value of the firm with hedging.
▪Scenario 2: The value of the firm without hedges.
Principle 4: Preventing the financial distress –Not earnings smoothing
RM is not about minimizing the volatility of the firm earnings or cash flows.
▪ Investors can (should) do it better themselves.
▪ Companies destroy value by diverting attention (and resources!) from what they must
be doing…
➢RM should help avoid the consequences of what is beyond management control:
▪ Fluctuation in input prices; FX risks; interest rates, credit risk, etc.
Principle 5: RM is a substitute for fresh equity
RM affects the value of firm’s equity via riskiness of the firm.
RM gives you flexibility regardless your cost of capital.
Principle 6: RM should be well communicated
• CEOs and Boards should understand the possible outcomes of the strategy, and how
the strategy increases expected value.
• In turn, top management should explain investors / markets that a RM program:
• is not about the profitability of the hedging instruments themselves;
• is about the overall shareholder value (and how this value is created).
There is a tension with risk management by corporations. Why?
The benefits are there but less obvious, difficult to quantify and communicate.
▪Effective RM program increases the stability of earnings and CF.
Hedging is costly. The costs are explicit and visible.
▪Reduced reported earnings and cash flows.
Why do we hedge?
Short answer is to limit the risk associated with Foreign exchange but only if it has value creating hedge.
• X and Y need to determine whether their shareholders are better off as a result of a
hedge ex ante, or before-the fact of loss
• The company and investors should see benefits of the hedge
➢when the firm enters the hedge
➢regardless of how the future price movements, or the profitability of the hedge
itself would develop.
How to determining these contingencies ex ante?
➢Pragmatic approach is to understand and manage the overall level or risk (the “risk
appetite”).
➢The key question is: How much risk we can bear without jeopardizing our ability to
achieve the company goals?
Define Foreign EXCHANGE exposure:
▪FX exposure is the sensitivity of company’s economic value or stock price to FX
changes (Heckman ‘83FAJ) –created by company’s operations.
▪Exposure brings about the probability of loss –or the FX risk.
MNC that operate in many countries manage their exposures differently. How do they do it?
A. Transaction exposure may be reduced by the financial RM (with fin instruments), operational
hedging (having operations in many countries), parallel loans, invoicing currency, etc.
B. Translation exposure is hedged rarely and non-systematically (see Papaioannou ’06 in
recommended reading).
C. Economic exposure or residual risk: may be hard to measure and manage
✓See the paper Prasad & Suprabha ’15: brings attention to ec. exposure and popularizes the theory-based
“cash flow approach” of Bondar & Marston ’14 to measuring FX exposure.
✓Measuring ec. exposure is based on company’s observable economic variables, as opposed to the “capital
market approach” relying on the factor model for stock returns (Jorion ’90JB)
What does Allayannis et al. ’01AERP&P say about FX risk hedging? What are the key takeaways
➢Operational hedging is a complement to financial RM, a part of corporate RM
program.
➢Operational hedges alone are not significantly related to value (as measured by
Market-to-Book). They do, when used in together with financial hedges.
Focus on managing the transaction exposure by the financial and operational RM
strategies simultaneously.
Firms use currency derivatives and foreign debt as hedges
➢Operational hedging is not an effective substitute for financial RM.
• Consistent with Guay ‘99JAE, Allayannis& Ofek’01JIIMF
Notes:
• Foreign/total sales proxies for FX exposure (why?)
• No control for , say, size of co’s…
Table 2 in Allayannis et al. ’01 as in Geczy, Minton, Schrand ‘97JF
• Logit regression.
• Other controls: R&D expenditures ×debt/equity (-); size (+); the percentage of shares owned by institutions (+).
➢Operational hedging is not used by itself to hedge FX risk –only as a complementto financial RM.
Table 3 in Allayannis et al. ’01 as in Allayannis and Weston ’01RFS
• “Value” is log Market/Book.
• Other controls: size, industrial diversification, leverage (-); growth opportunities and
profitability (+).
➢Operational hedges alone are not significantly related to value.
➢They do, when used in together with financial hedges.
➢The net effect is positive
Can we exploit the forward discount anomaly?
• Recall from Lecture 3: The basic CIP hypothesis implies that in the regression
𝑠𝑡+𝑘 −𝑠𝑡 =∆𝑠𝑡+𝑘=𝛽0 +𝛽1 𝑓𝑡 −𝑠𝑡 +𝑢𝑡+𝑘
the estimated 𝛽0 =0,𝛽1 =1and 𝑢𝑡+𝑘 is orthogonal to the info at t (rational expectations).
Or in case of UIP we are replacing 𝑓𝑡 −𝑠𝑡 by 𝑖𝑡 −𝑖𝑡∗.
• Many studies (starting from Fama ’84 JME) find 𝛽1 typically close to minus unity.
• Intuitively , the result 𝑠𝑡+𝑘 −𝑠𝑡 =∆𝑠𝑡+𝑘=−1 𝑓𝑡 −𝑠𝑡 implies that the forward premium
𝑓𝑡 −𝑠𝑡 mispredicts the direction of the subsequent change in the spot rate ∆𝑠𝑡+𝑘.
Thus, we can exploit it.
How can we exploit the forward discount anomaly?
• The finding of the forward discount bias has an interesting practical implication, the carry trade
speculative strategy.
• We borrow in the low-interest currencies and investing in the high–interest currencies
▪ FX risk in a carry trade is seldom hedged
