Multinational Corporation Foreign Currency Trading Risk and Management - Essay Example

Proposed "Multinational corporation foreign currency trading risk and management" Rational of the project Participation in international markets may result in a foreign exchange risk known as transaction exposure. This risk occurs when a company has a payable (or receivable) denominated in a foreign currency (FC). The risk lies in the fluctuation of the FC exchange rate. For example, if the FC appreciates before the liability is settled, the company has to pay more dollars to purchase the FC needed to settle this liability. As a result, the company will experience a foreign exchange loss. Conversely, a company with a liability position in a weakening FC will experience a foreign exchange gain between the date the liability is incurred and its settlement. Opposite relationships hold for net asset positions, which are denominated in an FC. As a result of the cash flow impact of transaction exposures and the requirements of Financial Accounting Standards Board Statement no. 52, Foreign Currency Translation, to include foreign exchange transaction gains and losses in the determination of net income, most companies are hedging these exposures. In fact, a 1986 FASB research report, Foreign Exchange Risk Management under Statement 52, revealed that 84% of 162 company treasurers engaged in foreign trade regularly or selectively hedge foreign transaction exposures. The research of the problem of the foreign currency risk is important because the globalization of the world economy and the devaluation of the U.S. dollar have allowed more American companies to enter the export/import markets. Additionally, many managers who previously avoided these markets are finding that international transactions can make their companies more competitive in marketing products and procuring parts and/materials. As new companies are exposed to foreign exchange risk, managers will necessarily be concerned with the development of an effective hedging program. While the task of managing financial risks generally falls to the CFO or treasurer, it is often others in the accounting department who are asked to evaluate the bottom line impact of these risks. The proposed research paper will introduce several of the most widely practiced hedging policies and strategies that will add a new knowledge to the field of foreign exchange currency trading risk and management through the research within a number of multinational companies that face the risk. Besides providing a real organizational case, the research focuses on the modern risk management strategies that include applying foreign exchange derivatives. Employing the sample of firms for the research, current paper focuses on foreign currency and interest rate derivatives. Review of the literature Foreign exchange exposure is defined as the effect of unexpected changes in the real exchange rate on firms (see Adler and Dumas, 1980; and Cornell and Shapiro, 1983). There are two types of economic exposure: Transaction exposure is the effect of unexpected changes in the nominal exchange rate on cash flows associated with monetary assets and liabilities (i.e., contractually fixed cash flows). Transaction exposure is usually a short-term exposure that can be easily hedged using currency derivatives. Operating exposure is the effect of unexpected changes in the exchange rate on cash flows associated with a firms non-monetary (real) assets and liabilities. Operating exposure is typically a long-term exposure that can usually be best managed through the implementation of operational hedges (see Flood and Lessard, 1986). For example, consider a firm with foreign currency cash flows that are known with certainty. The sole source of uncertainty for the firm is the exchange rate. This (transaction) exposure can easily be hedged using forward contracts. However, the use of derivatives cannot eliminate risk if the quantity of the foreign cash flows is also uncertain and not perfectly correlated with the exchange rate. These firms can rely on operating adjustments such as shifting their production in countries where significant sales revenues in the local currency are expected. Thus, the impact of unexpected changes in the exchange rate on the parent country (domestic) currency value of sales revenues would be offset by similar changes in the value of local production costs. Empirical research documents that many corporations actively manage exchange rate risk through the use of currency derivatives (see Geczy, Minton and Schrand, 1997; Allayannis and Ofek, 2001; Allayannis and Weston, 2001). In view of the extensive use of currency derivatives and their potential for affecting exchange rate exposure, it is important to control for financial hedges in trying to understand companies exposures. We define financial hedges as the use of currency derivatives. Recent rules passed by the Financial Accounting Standards Board (SFAS 105, 107 and 119) require firms to disclose significant use of currency derivatives. We have examined these disclosures in detail by reading 1993 10-K filings. We use an indicator variable to measure currency derivatives usage because the reported notional principal amounts are missing or aggregated for approximately 20 percent of the derivatives users. Furthermore, notional principal amounts are noisy proxies because of aggregation and netting in reporting values and because the types of contracts and terms vary widely. In addition to the operational and financial variables, there are other factors that may influence the MNCs currency exposure. These variables are size, the level of foreign sales, firm risk, and industry diversification. We include the natural log of the firms total assets in the analysis as an indicator of firm size. Bodnar and Wong (2000) find that large firms with no foreign operations actually exhibit exposures that are more negative than small firms with extensive operations. As a result, a failure to control for size in cross-sectional regressions causes a correlated omitted variable problem, which will misstate the significance of other variables in the regression. The firms degree of international involvement is measured by the foreign sales to total sales ratio. Firms with a large proportion of foreign sales are expected to be more exposed because prior studies have identified foreign sales ratios as important determinants of exposures in cross-sectional tests (Bodnar and Wong, 2000). We include total risk in order to investigate whether the foreign exchange exposure is a significant part of the firms overall risk. Therefore, we hypothesize a positive relationship between total risk and foreign exchange exposure. Industry diversification is measured as the number of reported business segments in which the firm operates. This variable proxies for the capability to reduce exposure through diversification across multiple business lines (Heston and Rouwenhorst, 1994). Allayannis and Mozumdar (2000) showed that the use of FCDs reduces exposure to exchange rate risk through its effect on internal cash flow. In their sample, firms that hedged exchange rate risk experienced a lower sensitivity of investment expenditures to changes in exchange rates. Similarly, Haushalter, Heron and Lie (2001) showed that companies with a higher likelihood of low investment due to low levels of internal cash flow are adversely affected by uncertainty of future cash flows. Their study of oil producers showed that this result is consistent with the imperfect capital markets assumption of the Froot, et. al. model. The results presented here further this work by testing the implication of the model that firms coordinate their investment and financing decisions across areas of risk. More specifically, firms coordinate their investing and foreign currency hedging activities across the different currency denominations of such investment. A variety of other hedging strategies are available to assist managers in controlling such foreign transaction risks. These include pricing, settlement, forward contracts, leading and lagging, netting and re-invoicing. Pricing. The most fundamental of the strategies to control risk is pricing, or controlling the billing currency. Exchange risk is eliminated if the company bills customers in the companys reporting currency. For example, a company can negotiate a price for a receivable in its own reporting currency and thereby shift the exchange risk to the other party in the transaction. Settlement. When a company cannot bill in the reporting currency, it can use the settlement strategy to help mitigage foreign exchange risk. This strategy requires that management consistently negotiate or offer discounts for the early settlement of payables or receivables denominated in an FC. Overall, this strategy forces a company to relinquish the benefits of the time value of money in order to avoid the risks of foreign exchange fluctuations. Forward contracts. When the company does not wish to settle early and it cannot control the billing or payment currency, it must use other techniques to control future cash flows. Probably the most well-known hedging technique is buying and selling forward contracts in FC. These are contracts to buy or sell FC at a future date at a fixed exchange rate. The benefit is that the companys exposure associated with an FC asset or liability position can be offset, fully or partially, by taking an opposite position in the forward market. The costs of this hedging technique are the transaction cost of buying a forward contract and the cost of currency conversion. Leading and logging. Larger, more centralized corporations have additional options that may be employed to help control the foreign exchange risk of intercompany transactions. One effective and potentially profitable approach involves leading (prepaying) payments when the payers currency is devaluing against the payment currency and lagging those payments if the payers currency is appreciating. From a companywide standpoint, the treasurer can direct leading and laging policy in order to take advantage of the favorable effects of exchange rate fluctuations. Additionally, leading and lagging policies may be used to shift funds from cash-rich to cash-poor affiliates, thereby improving short-term liquidity. Netting. Netting intercompany transfers is another common international cash management strategy that requires a high degree of centralization. The basis of netting is that, within a closed group of related companies, total payables will always equal total receivables. The advantages of netting are * A reduction in foreign exchange conversion fees and funds transfer fees. * A quicker settlement of obligations reducing the groups overall exposure. Reinvoicing. Reinvoicing goes one step beyond the centralized approach of multilateral netting by way of a clearing center. A reinvoicing center buys goods from the manufacturing subsidiary or parent, without taking possession, and reinvoices other company affiliates or third parties when it sells the goods. By conducting all transactions in the affiliates functional currency, the reinvoicing center bears all currency risks. This prevents the FC exposures from distorting the subsidiarys operating profit (loss). In addition, the reinvoicing center allows for centralized cash flow management, increase international business expertise and oppotunities for arbitrage. The center also improves and centralizes banking relationships and acts as a central purchasing agent for subsidiaries. Research questions and objectives Research questions are as follows: 1) What is a foreign currency risk and how important it is within contemporary organizations? 2) To hedge or not to hedge? 3) What are different techniques of measuring foreign currency risk? 4) What are the instruments for hedging a currency risk? 5) How the contemporary organization manages the foreign currency risk? 6) What is the difference in managing the foreign currency risk for the organizations of different sizes? 7) What are the advantages of the exchange-traded currency products over the inter-bank over-the-counter (OTC) market? The research has several major objectives: 1) To investigate whether a firm is more likely to use foreign currency derivatives to hedge foreign currency risk; 2) To evaluate the organizational capital structure: debt or capital based; 3) Define whether the type of derivative used by a company depends on whether it is small or big; 4) To apply the theory to the practice of the firm and investigate whether interest rate derivatives are more likely to be used if a firm is larger, more levered, more liquid and pays higher dividends; 5) Basing on the research undergone, to provide recommendations for companies with regards to hedging foreign currency exposure. Research plan a) Research design Benet (1992) studied foreign currency derivatives and suggested that using out of samples or ex-ante to evaluate hedging effectiveness would be more meaningful for investors. Hence, in my research I will adopt Benets suggestion to evaluate hedging performance out-of-sample results. The estimated time expansion is 800 days. Utilizing the form of a moving window to analyze the effect of the length of hedging periods to the hedging performance in different economic models, we take two, four, eight, twelve, 24, and 48 weeks as the hedging periods in this study and perform daily rolling to hedge. Taking two weeks as an example, the first loop uses the first 800 days spot and futures markets to estimate the hedge ratio and then performs hedging for the next two weeks (ten days). At the end of the ten days, the hedging performance is evaluated and so on. In this study we take five methods, including VAR, ECM, bivariate GARCH(1,1), Kalman filter, and Markov regime switching, to evaluate the dynamic hedging process clearly and completely. In order to obtain the out-of-sample empirical results, we use the latest information to estimate the next periods hedge ratio. Therefore, the entire hedging ratio we derive is a dynamic process, not a constant hedging ratio. It is found that most hedge ratios are less than one, especially for the S&P500 index. This implies that it is not necessary to take up 100 percent hedging of a futures position for a long spot position. This can reduce the hedging cost for investors. It is worth noting that the hedge ratio estimated by the GARCH model on Nasdaq-100 is higher than others, and the ratio is close to one. This result supports the perfect hedging strategy in the Nasdaq-100 market. Comparing the various models, we calculate all possible HEIs with the moving window method. The HEI are positive under each model and hedging period, indicating that the variance of a hedged portfolio is lower than that of an unhedged portfolio. We find that regardless of whether we take floor-traded or E-mini futures, the bivariate GARCH and Markov regime switching have higher HEI performances, while the Kalman filter is the lowest on average. b) Data collection This paper makes use of the sample employed by Nguyen and Faff (2002)--namely, a sample of non-financial companies, represented by 469 firm/year observations sourced from the Connect database. Two levels of analysis--Logit and Tobit are reported to assess the factors that impact the adoption and intensity decisions, with regard to the usage of foreign currency (FCD) and interest rate derivatives (IRD), respectively. The dependent variable of the Tobit regression is the extent of derivative usage, proxied by the total notional value of FCD or IRD contracts scaled by firm size (being the sum of market value of equity and book value of debt) and measured in the range 0% to 100%. In this study I will examine spot indexes and futures contracts through two different transaction mechanisms, including S&P500 and Nasdaq-100. The data include S&P500 and Nasdaq-100 index spot, floor-traded futures, and E-mini futures that are taken from Bloombergs database. All are daily data, and the sample period is from 2002.6.21 to 2007.6.10. As long as one of the data is missing on the same day, all the data on the same day will be deleted. c) Data analysis Following Nguyen and Faff (2002), the independent variables developed to proxy for various corporate motives for hedging are: leverage; firm size; the ratio of market value to book value of equity (MTBV); liquidity; current ratio; dividend yield; executive shareholding and executive option holding. In particular, the financial distress hypothesis is tested using leverage and firm size. Whether firms use financial derivatives to ensure internal liquidity is explored via three variables: (a) MTBV to capture the growth opportunities of the firm, (b) liquidity (the ratio of cash and cash equivalents to firm size) and (c) the current ratio--the latter two proxying for the financial capability of the firm to undertake the investment. Furthermore, dividend yield is used as a substitute for hedging while the hypothesis of managerial wealth maximization is tested using the amount of executive shareholding and executive option holding as proxies. Data analysis is done with the help of VAR, ECM, bivariate GARCH, Kalman filter, and Markov regime switching in the S&P500 and Nasdaq-100 markets. The moving window technique is adopted to analyze the effect of the length of time expansion to the hedging performance in different hedging models. The empirical results are predicted to show that both the floor-traded or E-mini futures can be good instruments to be used as hedge objectives either in the S&P500 or Nasdaq-100 markets. As the hedging period is extended, the correlation coefficient between spot and futures increases and hedging effectiveness goes up. Second, the bivariate GARCH and Markov regime switching methods are predicted to have higher HEI performances in short-term and long-term hedging periods, respectively, while the Kalman filter is the lowest on average. Third, except for the short-term hedging period (two weeks) in the Nasdaq-100 market, a perfect hedging strategy is not appropriate. Investors can lower the portfolio risk with fewer transaction costs, and it is not necessary to take a 100 percent hedging of a futures position for a long spot position. In the Nasdaq-100 market, however, investors will take a higher futures position relative to their spot position in the short-term period in order to lower the portfolio risk. Fourth, floor-traded futures with an open outcry system do better than E-mini futures contracts. The main reason is the higher transaction cost of large trading with E-mini futures relative to floor-traded futures. Finally, this study proposes meaningful evidence of hedging strategies for investors with different spot indexes and hedging periods. All the portfolio risk can be lowered by different strategies. d) Limitations The current body of research on this topic is limited and in development stage, thus I shall look at reserving for these unexpected events, and possible mitigation procedures. Timetable Gantt chart looks like this: Depending on the planning of your dissertation you can make the plan of your dissertation by downloading a simple software from the following website: http://www.smartdraw.com/specials/projectchart.asp Bibliography: 1) Adler, Michael, & Bernard Doumas. 1980. Foreign Exchange Risk Management, in B. Anti (ed.). Currency Risk and the Corporation. London: Euro-money Publications: 145-158. 2) Allayannis, & E. Ofek. 2001. Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives. Journal of International Money and Finance, 20:273-296. 3) Allayannis, & James Weston. 2001. The Use of Foreign Currency Derivatives and Firm Market Value. Review of Financial Studies, 14:243-276. 4) Bodnar, Gordon M. & M.H. Franco Wong. 2000. Estimating Exchange Rate Exposures: Some Weighty Issues. National Bureau of Economic Research (NBER) Working Paper 7497. 5) Cornell, Bradford & Alan Shapiro. 1983. Managing Foreign Exchange Risks. Midland Corporate Finance Journal, Fall : 16-31. 6) Flood, Eugene & Donald Lessard. 1986. On the Measurement of Operating Exposure to Exchange Rates: A Conceptual Approach. Financial Management 15 (1, Spring): 25-36. 7) Geczy, Christopher, Bernadette Minton, & Catherine Schrand. 1997. Why Firms Use Currency Derivatives. The Journal of Finance 52 (4): 1323-1354. 8) Heston, Steven & K. Geert Rouwenhorst. 1994. Does Industrial Structure Explain the Benefits of International Diversification. Journal of Financial Economics 36: 3-27. 9) Nguyen, H. & Faff, R. 2002, On the determinants of derivative usage by Australian companies, Australian Journal of Management, vol. 27, pp. 124. Read More