ALTERNATIVE FOREIGN CURRENCY HEDGING INSTRUMENTS

Advantages and Disadvantages of Alternative Foreign Currency Hedging Instruments



Advantages and Disadvantages of Alternative Foreign Currency Hedging Instruments

Introduction

For many companies exchange rate movements are a major source of uncertainty. Due to the rapid globalization of the business environment over the last decades few firms today could be thought of as purely domestic and unaffected by exchange rate fluctuations. The view that exchange rates affect a firm's value and therefore the price of its stock is widely held by economists, financial analysts and corporate managers. What is surprising is the lack of empirical support for a statistically significant relation between firm value and the exchange rate (exchange rate exposure).

Bartov and Bodnar (2004) try to explain the limited success in finding a significant correlation by two possible drawbacks of earlier studies. One is the sample selection. They argue that it is important to only study firms that are heavily exposed to currency rate changes. Furthermore firms included in the sample should have the same 'sign' of exposure, i.e. either all firms benefit from a depreciation of the exchange rate or they benefit from an appreciation. A second possible drawback of earlier studies pointed out by Bartov and Bodnar is the existence of mispricing. When investors estimate the relation between firm value and exchange rate movements they might do this incorrectly and therefore introduce systematic errors. Therefore Bartov and Bodnar suggest the inclusion of lagged changes of the exchange rate and not only, as in most earlier studies, the contemporaneous effect. For a sample of firms, selected so as to maximize exposure, they investigate the correlation between abnormal returns, derived from the market model, and both contemporaneous and lagged changes in the dollar. They find no correlation with the dollar movement in the same time period but a one period lagged change has significant impact on the abnormal return. Other tests are performed in Bartov and Bodnar (2004) but the main result still is that it is hard to establish a clear link between stock returns and changes in the exchange rate.

Exchange rate exposure

In this section we discuss various types of exchange rate exposure. It should be noted that it is not obvious that a firm cares about its exposure and wants to hedge it. Miller and Modigliani (1958) show that a firm cannot increase its value by hedging (or any other financial policy). Their results however assume perfect markets. For example, the cost of financial distress is assumed to be zero. The real world on the other hand is not perfect and financial distress (and bankruptcy) can be very costly. Hence if hedging reduces cash flow variability and decreases the likelihood of financial distress, it will also increase the firm's value. For a more thorough discussion on how hedging can increase a firm's value see Sercu and Uppal (2005,ch. 5).

Exchange rate exposure is usually divided (e.g. Shapiro, 2006) into three different types: transaction, translation and operating exposure. The combined effect of transaction exposure and operating ...