Exchange rate exposure, hedging, and the use of foreign currency derivates

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1 Exchange rate exposure, hedging, and the use of foreign currency derivates George Allayannis, Eli Ofek Presented by: Inés Horváthová, Tadeáš Kopecký, Radan Papoušek, Hana Štefanová

2 Outline Introduction Sample description Estimation framework Results Drawbacks Robustness tests Determinants of hedging Summary

3 Motivation Exchange-rate movements affect expected future cash flow. US internationally operating firms are not significatntly affected by exchange rate movements. Do corporations use foreign currency derivatives and other hedging instruments to protect themeselves? Derivatives can also be used for speculative purposes. What role do derivatives actually play in corporations?

4 Main objects of the research & Hypothesis Objects of the research: the effect of foreign currency derivative use on its exchange-rate exposure the determinants of the amount of derivative use Hypothesis: Using foreign currencyy derivatives for hedging reduces firm s foreign exchange-rate exposure.

5 Sample description S&P 500 nonfinancial firms in 1993 Foreign currency derivatives as continuous variable Short/long position unknown 378 firms, value of sales $7345 million Ratio of foreign currency derivatives to total assets

6 Estimation framework Economic exposure to ER movement Regression coefficient of the value of the firm on the ER movements Model First stage: Impact of ER exposure on the firm s value Second stage: Impact of a firm s currency derivative use on its ER exposure

7 Estimation framework Data US firms Examination period: Monthly data Hypothesis Less noisier than daily and weekly ones Nonsynchroneity problems Use of FX derivatives as a hedge should decrease ER exposure (in absolute values!)

8 Estimation framework Expectations: USD appreciation (decrease of the ER index) hurts exporters (positive relation) and benefits importers (negative relation) Increase in revenues from abroad should increase ER exposure ER exposure should be positively related to the ratio foreign sales total sales Use of FX derivatives for speculation should increase ER exposure (in absolute values!)

9 Results Strong positive relation between ER exposure and the ratio Negative relation between ER exposure and absolute values!) FX derivatives value total assets foreign sales total sales (in

10 Drawbacks Only ex-post exposure observed, which is determined by both foreign sales and FX derivative use Both variables have to be included in the model to prevent omitted variable issue But foreign sales and FX derivative use are positively correlated Focus on either the positive or the negative exposure (see the third column in the previous table)

11 Robustness tests I. Several tests to check the robustness of the results Time interval Re-estimate the model with 5 year interval Similar results as for base case regression Positive significant relation between foreign sales and exchange rate exposure Negative significant relation between currency derivative use and currency exposure

12 Robustness tests II. Alternative exchange-rate index broad, real, dollar index published by the Dallas Fed (against 101 currencies) similar results as base case regression Different estimation methods Re-estimation the model using weighted least squares consistent results Re-estimation the model using probit estimation consistent results

13 Robustness tests III. Alternative sample Data for all US manufacturing firms with available data in Compustat with assets above 100 million dollars in 1994 and 1995 Sample with a lot of smaller firms compared to the original sample Re-estimation of original model consistent results Moreover all other robustness tests as for original sample presented earlier robust results

14 Determinants of hedging exchange rate exposure optimal hedging theories factors influencing the decision to hedge: managerial risk aversion reduction in expected taxes expected transaction costs of financial distress agency costs (underinvestment) size of the firm due to existence of large fixed start-up costs of hedging

15 Decision to hedge and the level of hedging estimated in two steps (Cragg model): estimating binomial probit model using all firms regressing a binary variable which equals one if the firm hedges and zero if it does not on variables consistent with theories of optimal hedging and controls for exchange-rate exposure estimating truncated regression using only firms that decided to hedge regressing the amount of derivatives on the same variables as in the first step

16 Determinants to use foreign currency derivatives include firm size, R&D expenditures and level of exposure (foreign income and trade), level of hedging only depends on exposure factors.

17 Hedging using foreign debt since foreign debt represents an outflow of foreign currency, it can only be used as a hedge when a firm has foreign revenues (foreign sales or exports) decision to use and the extent of using foreign debt are influenced by the share of foreign sales and by the firm size due to high fixed start-up costs of issuing debt smaller firms issue larger foreign debts exporters prefer the use of foreign currency derivatives over the use of foreign currency debt

18 Summary Firms use currency derivatives as a hedge rather than for speculative purposes in the foreign exchange markets. This result is robust to changing the time interval, sample, exchange-rate index and estimation method. Firm s exposure through foreign sales and trades is the key factor in deciding about the use and the extent of hedging using derivatives. Foreign debt is another way how to hedge. Decision about the use and the level of foreign debt is influenced by the exposure through foreign sales.

If the market is perfect, hedging would have no value. Actually, in real world,

2. Literature Review If the market is perfect, hedging would have no value. Actually, in real world, the financial market is imperfect and hedging can directly affect the cash flow of the firm. So far,