Invoicing and Hedging in the Exchange Rate Risk Reduction - Example

Invoicing and Hedging in the Exchange Rate Risk Reduction Invoicing and Hedging in the Exchange Rate Risk Reduction Domestic-currency hedging and invoicing allow firms that are internationally active to reduce the exposure of exchange rate differences. This research dwell on the exchange rate problems in terms of risks incurred during transactions, translation risk, and the wider economic risk. Transaction risk refers to the exposure to differing values of future cash flow statements; translation risk is the differing value of liabilities and assets indicated in foreign currencies; and the wider economic risk deals with the effect of exchange rate differences on competitiveness. This study asserts that domestic currency hedging and invoicing with the exchange rate determinants gives the opportunity to experience a straightforward supervision of translation and transaction risk. It also states that the circumstances under which their use is optimized since it is very hard to manage economic risk. However, natural hedging can provide ways of solving the problem. The discussion section of the paper is complemented with a comprehensive analysis of how exchange rate risks management can be applied. Thus, data has been drawn from currencies used in invoicing in euro-area exports. Empirical works on hedging conducted previously has also contributed largely to the data; however, hedging has focused mainly on firms located in the US in addition to a few companies from EU. The main focus of this study is a survey of the actual hedging techniques and strategies of large firms from euro-area perspective. Findings indicate that exporters within the euro-area have equipment at their disposal to reduce the adverse effects of euro approval and that they need to make good use of these tools. Key words: hedging, exchange rate risk, invoicing currency, derivatives, pass-through rates, risk management, currency denomination, operational hedge, financial hedge, risk factor, euro-area, and risk mitigation. Introduction Concerns about the effects of the appreciating euro-era exports grew significantly as of autumn and summer of 2007. The exchange rate of euro to the dollar (US) reached its all time high. Gallois, the then chairman of Airbus claimed that the euro appreciation by 10% against the dollar cost Airbus over a billion euro since the company’s denominates its costs in euro, while the largest portion of the revenues are denominated in US dollar. Studies and analyses conducted before (for example, European Commission, 2007) indicate that exports from the euro-countries have managed to hold up well as per the appreciation of the euro in the last few years. The explanation to this phenomenon is that the world is demanding more than what is available to compensate it economic processes (Allayannis, George, Jane and James, 2001). Others argue that appreciation has not been able to match the bilateral rate of exchange of US dollar against the euro. This research paper studies how firms engaged in export in euro-countries are protecting themselves against the impacts of exchange rate risks through hedging and invoicing and analyses the interaction between local currency hedging and invoicing. As much as the paper focuses on the effects of exchange rate risk for the exporting businesses, differences between net importers and net exporters are briefly illustrated where they apply. When domestic currencies are used to invoice exports, the exchange rate risk that results (short-term) will affect the importer as opposed to the exporter. This study uses several literatures to understand the possible conditions under which shifting risks can be conducted. It also assesses the application of invoicing using euro by euro-countries based on the information collected. It is possible to hedge (neutralize) exchange rate risk through financial institutions, such as operational hedges and financial hedges among other exchange rate hedging avenues. Risks that are related to commodity prices, interest rates and exchange rates can to day be hedged through the application of financial derivatives. Therefore, this study analyses hedge designs and hedging instruments and reviews the available literature on the application of hedging. There is an empirical documentation of hedging instruments and strategies for the United States. The study presented by this paper indicates that different research works have been carried out in individual countries of the European Union, but no single study have been effective in its perception of the euro-area. This research adds to the quest for closing the existing limitation of literature by surveying self-reported hedging instruments and strategies of euro-countries blue chip organizations. While the discussion in this paper has assumed the microeconomic approach, a number of macroeconomic consequences exist for firms’ invoicing and hedging strategies. These touch on the effect of variations in exchange rates on the balance of trade and the international mandate of the euro. These two parameters have not been discussed in this paper. The remainder of the paper has been organized following the sequence: the aims and objectives, literature review, data methodology, results and discussions, conclusion, and the references. Objectives and Aims of the Research The effect of exchange rate risk on firms involved in exports How exchange rate risk can be mitigated (strategies) Understanding different aspects or dimensions of exchange rate risks What importers and exporters are doing to foster a favourable platform on which to transact These objectives together with their answers to pressing questions in the area of exchange rate risk will help the reader to understand the principles of risk management in the international arena. Notably, the international economic zones usually have different and varied risk management concerns that must be analysed distinctively and effectively towards understanding these zones. Literature Review Several research have been conducted in the area towards determining the effects of the exchange risk by several financial institutions or organizations interested in understanding or solving the problem in exchange rate risk. The research conducted by Grisse & Nitschka (2013; Pg. 54) has analysed the bilateral exchange rate of Swiss franc in asset pricing platform to identify the safe characteristics of Swiss franc. There research is important in understanding the fundamentals of exchange rate risks in relation to asset pricing, something that other literatures (that will be listed herein) have not tackled. The approach employed by Grisse and Nitschka makes use of UIP regressions to understand the connection between risk factors and exchange rates. The recent economic systems of handling exchange risks that have been widely used by their research will help in achieving the objectives of this study. There is rich information on managing exchange rate risks in different nations and economies. The study conducted by Ito, Koibuchi, Sato, and Shimizu (2010) dwells on how Japanese firms are managing their exchange rate risks. They base their findings from using questions for surveys. Ito et al (2010) talks about the view of the people working in Tokyo Stock Exchange concerning hedging, invoicing and pricing regulations to control the effects of Yen fluctuation on the Japanese economy. The analysis done by these scholars will contribute a lot in answering the research questions of the project especially in determining the real time risks that are usually associated with the exchange rate. Additionally, Chermbalain, Howe, and Poper (1996; Pg. 172) have also dealt with the subject of exchange rate risk between Japanese and US banking institutions. The richness in information about major economies such as the US, Japan, Europe, Switzerland, and China among others will aid in developing this research to produce findings that will further the understanding of what is involved in exchange rate risk. Chermbalain et al (1996; Pg. 64) have used a sample of Japanese and US banking firms to examine exposure to foreign exchange. Their study approves the consistencies between cross-sectional evidence and using foreign exchange deals as hedging strategies. Burnside & Graveline (2012; Pg. 98) have also contributed to the determination of exchange rate, asset market view and risk sharing. The significance of their research lies in how they compare real rates of exchange rates with variations in marginal utility development of delegates in different states. The way in which they determine exchange rate will aid the proposed research to compare its findings with the analyses done by past researches. Parameters used by Burnside and Graveline such as nature of production or endowments, the available assets to be traded, market frictions for goods, and preferences will also add value to the overall discussion of the research. Methodology The purpose of conducting this research is to examine the impact of hedging and invoicing using domestic currency in managing economic risks of the euro-area. The main purposes of this section are to (1) define the methodology that has been applied in the research, (2) explain the selection of samples, (3) describe the steps that have been followed in data collection and instrument design, and (4) give an description of the statistical procedures and decisions used in data analysis. Research Methodology This study has used both qualitative and quantitative research methodology to collect, analyse data, and determine the data trend in understanding the research questions and concerns. A survey was conducted on a chosen sample of firms in the United States and European Union by the auditing firm charged with the duty of collecting and analysing the data from the survey. In this setting, the term survey has been used to refer to a research methodology modelled to collect information from a given list of firms from the US and EU. It may also refer to a sample from the same list, and specifically makes use of documented information and interviews to compare and contrast the collected data (Robson, 1993; Pg. 18). The choice of qualitative research methodology is important because it gives insight on the nature of exchange rate risk on the economies of the chosen countries (EU member states and the United States). On the other side, the application of the quantities is used to help in determining the degree of effect of the exchange rate risk and risk management within the selected areas of study. Moreover, different data sets have been collected to identify the relationship between invoicing and hedging. Under invoicing currencies, two different data sets (1 from euro-area exports and the other from non-euro area countries importing goods from euro-area). Table 1 shows how the role of euro in invoicing has increased over time as was predicted by Bacchetta and van Wincoop (2005; Pg. 214). Source: (Dohring, 2008; Pg. 67) Euro-area exports use euro as the dominant currency for the invoicing. In addition, the euro accounts for half of the invoices on exports that are traded out of the euro-area region. On the other hand, the dollar has been crucial in acting as the strongest means of exportation outside the euro zone. That is why the data chosen compares the contribution if the euro and dollar in shaping the exchange rate risk of euro exports (Bartram et al, 2010; Pg. 84). Table 2 (indicating the invoicing % in euro of imports by states outside the euro zone) will assist with the comparison of exchange rate risks when different currencies are used in a transaction within the selected regions. Source: (Dohring, 2008; Pg. 51) Local currency has been used as a reference point to understand the strength of both the dollar and euro in explaining exchange rate risks. The data from these two tables can be analysed to give a clear understanding of what is happening in the market in terms of exposure to exchange rates. The data collected describes the status of exchange rates as of 2006. Financial factors such as hedging should also be studied to get a clear picture of how euro-area countries are struggling to solve the stalemate in exchange rate risk. The data that was collected under this subtopic tabulates how firms have employed the use of financial derivatives to tackle transaction, translation and economic risks. Empirical works on hedging conducted previously has also contributed largely to the data; however, hedging has focused mainly on firms located in the US in addition to a few companies from EU. Results In 2006, the first quarter was realized to dominate the exports particularly within the non-EU states and this was in euro. This accounts for 49.7% of the exports. Euro-denominated export shares have increased and became established in 2003. As much export services are slowly increasing, the contribution of euro is still commendable. US dollar comes in the second position with total share allocation of 44% on all exports within the euro-area located outside the European Union. This is 3 times the shares that are destined for the United States-14.9% by 2005. The other currencies account for a mere 6.3%. Table 2 left panel indicates exports of euro-area goods to countries not within the euro area or among EU member states, the middle panel shows exports to non members of EU, and the right panel shows the European countries located outside euro-area. Notably, most member states within the Euro area accounts for 50.5 to 61% of export goods invoiced in euro. Spain and Germany are at the fore-front of the scale, while France lags behind. Greece is considered as an outlier since its large share of ships is denominated in US Dollars, including the total exports from Greece. Even though the data might appear to be limited, there is clear indication of pattern development. Exports that are destined for European Member States practicing their transactions with local countries instead of the euro are more likely to undergo invoicing denomination in terms of euro. The pound Sterling and US dollar are competing for the second position in the EU countries that are non-EMU. The shares are around 1/6. In the euro area, the exporters are better placed at benefiting from euro invoicing. Share of euro in the new member states of the European Union are higher due to the import share denominated in domestic currencies (table 2). Discussion Euro shares are lower in imports from countries outside the euro zone. The assumption of Grassman’s law predicted exactly in line with the shares in export in nearly all euro areas. On the other, import shares are denominated in US dollars more than the US shares in imports denominated in euro. The emerging trend in this case is that the US dollar is the vehicle through which international trade is enhanced since from the research it emerges the most predominant within the international trading activities. The euro acts as a factor for enhancing regional trade particularly for the nations with euro as their main currencies. It is worth noting that when the US dollars are lower in exports than in imports, the euro benefits in terms of the net gains in welfare. Such cases involve the appreciation of the euro, but only when all other things are kept constant. Transaction risks have the ability to shift transaction risks to foreign business counterparts in the event that the imports are denominated in the currency of the importer. The firms that are involved in importing differentiated products have very less opportunities of controlling how transaction risks can be shifted. The other firms dealing with homogenous imports are better placed at controlling shifts in transaction risks since they often stay the same side with the interest of the exporter in terms of the currency denomination to be used for invoicing. This applies particular to the cases where the local market is enormous (ECB, 2007; Pg. 152). Denominating imports invoice in dollars as the propelling currency is also vital in understanding the impacts of invoicing on the exchange rate risk. For example, lubricants and mineral fuels alone stand for 1/5 of imports in euro area. Looking at the medium term effect on the costs of the imports, the dollar and foreign exchange risk will lead to the realization of cases of economic and transaction risks. However, they are able to pass a large portion of the resulting economic risks. Euro appreciation, in the last few years, has greatly lessened the influence of the euro-area’s strategy to increase the commodities prices globally. For example, there was an increase in Brent’s dollar price by 68% in 2007, while the euro price of the same commodity increased by a mere 50%. Several oil exporting countries try to reduce their exposure to the effects of exchange rate risks by ensuring that they use the dollar in their transactions. The conditions for trade are affected as much that they decide to deal with the US dollar in their export business. The mismatch in the currency allocation of exports and imports and the variation in the values of the exchange rate of the dollar enhance the exposure to exchange rate risks. Many people do not understand the hedging strategies of several firms in Europe. Empirical literatures put mush focus on the United States, although limited comparisons of some European nations are available to help in explaining how exchange rate risks may negatively affect transactions between nations (Wei, 1999; Pg. 1317). Wei argues that among nations where application of hedge is evident, volatilities in the exchange rate have no impact on transaction. Traditional literature also supports Wei’s hypothesis. Variability in exchange rate can affect trade relations among member countries in the situation where hedging is not incorporated in the transactions. Source: (Dohring, 2008) Cases of hedging practices in the US have been borrowed from “Whaton Surveys for Financial Risk Management” that was conducted between 1944-and 1988. The research was conducted on several firms and articles by various scholars of 1980s. nonetheless, this survey indicates that 44% of the respondents made use of financial derivatives. 79% of the 44% used the hedge funds to in hedging currency risk. Comparable data is available from the research conducted by Bodner and Gedhard (1999) on the impacts of derivates in combating exchange rate risks. Source: (Dohring, 2008) The general argument forwarded in this paper states that invoicing can be used to replace hedging when devising ways of managing exchange rate risk management (Dohring, 2008; Pg. 651). After conducting and intensive survey into hedging and invoicing as complements or substitutes for exposure to exchange rate risks, the paper concludes that geographical orientation of firms can also affect market structure in relation to the exchange rate that will be incurred (Dohrin, 2008; Pg. 167). While the discussion in this paper has assumed the microeconomic approach, a number of macroeconomic consequences exist for firms’ invoicing and hedging strategies. These reflect on the effect of variations in exchange rates on the balance of trade and the international mandate of the euro. These two parameters have not been discussed in this paper. Relationship between hedging and pass-through, as discussed by Bartram, Brown and Minton (2010: Pg. 288) indicate that firms undergo some sort of currency changes that will affect the financial and operational hedging strategies to combat the effects of currency fluctuations. Conclusion The study has addressed the issue on exchange rate exposure in relation to the terms of economic risk, translation risk, transaction risk and has analysed the risk mitigation or reduction strategies of the firms located within the euro-area. Hedging and invoicing policies have affected the exchange rate risk of the entire euro-area. The paper asserts that domestic-currency hedging and invoicing may be complementary strategies depending on the circumstance they are applied. The research has expounded on the previous empirical information by surveying self-reported hedging instruments and strategies of the blue-chip organizations in the entire euro-area. Analysis of non-financial organizations and empirical literature in EuroStoxx50 index show that the exposure to varying exchange rates has been a major issue in the transactions of euro-area organizations. The contrast comes in when looking at the writing on a number of US corporations. It is evident that the euro-area (since it is described as an open entity) is exposed to variations in exchange rates than the United States. Euro invoicing has been able to shift its risks to importers from foreign nations. Transaction risks of up to 50% of the exports to overseas countries are channelled by invoices denominated in euro. Export shares in euro are also identified as higher than other EU member states. The literature on the actual selection of the invoicing currency suggests that invoicing using domestic currency for euro-area exports has increased with the designation of euro as the optimal medium of exchange. Consequently, invoicing in dollars has continued to be vital in determining the share values of euro-area exports in the US markets and business preferences. The study indicates that hedging by employing the use of exchange rate derivatives including options and forwards are very versatile, and that they go hand in hand with the literature supporting its effectiveness in mitigating exchange rate risk exposure, at least during short term periods. However, it is difficult to determine whether derivative hedging or domestic currency invoicing are able to solve the problems of exchange risk management. Economic risk has been described in this paper as the threat of losing the competitive advantage due to the fluctuations in the exchange rate. The paper has tried to indicate that economic risks can be effectively managed by hedges that are financially non-derivative. The survey has also indicated that the larger euro-area has employed the use of this strategy to solve the problem of economic risk. In particular, the suggested policy aims at matching the assets (foreign money revenues) with liabilities (expenditure) in one currency and to diversify production, sales, and sourcing of trade activities. Generally, this study proposes that the euro-area traders (specifically, the exporters) have enough equipments to enable them secure themselves against the appreciation of euro. Moreover, they may also decide to make use of the available instruments in solving future problems that may arise because of exchange economic, transaction, and translation risks in the euro-area. However, handling economic risks that are medium term are limited in their scope as compare to the short-term shifts in the exchange rates. Therefore, this research has been vital in understanding the exchange risks in export and import trades and in different regions as well as means of reducing such problems. References ALLAYANNIS, G., IHRIG, J., & WESTON, J. P. (2001). Exchange-Rate Hedging: Financial vs. Operational Strategies, American Economic Review Papers & Proceedings, 91 (2), 391-395. BARTRAM, S. M., BROWN, G.W., & MINTON, B. A. (2010). Resolving the exposure puzzle: The many facets of exchange rate exposure. Journal of Financial Economics, Volume 95, Issue 2, February 2010, Pages 148-173. BODNAR, G. M. & Gentry, W. M. (1993). Exchange Rate Exposure and Industry Characteristics: Evidence from Canada, Japan, and the USA. Journal of International Money and Finance. 12. BURNSIDE, A. C., & GRAVELINE, J. J. 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