The Various Financial Instruments - Essay Example

Finance Table of Contents Table of Contents 2 Research Objectives 3 Research Method 8 Research Ethics 10 Research Objectives This study aims at finding out the various hedging strategies used by the companies for hedging their overseas exposures. Previously the companies used to rely on traditional methods like forward contracts but with the modernization of financial markets a number of other hedging instruments like swaps, options etc are being used for hedging foreign currency exposure. This research paper will explore the various financial instruments that the companies use for hedging their overseas exposure. The annual reports of various companies will be analysed in detail to understand the strategies adopted by them to hedge their overseas exposures. Research Question: 1. What are the various hedging strategies adopted by the companies for hedging their foreign currency exposure? 2. Has there been a change in the currency hedging strategies as compared to the previous years? 3. Which is the most preferred hedging option- foreign currency debt or currency derivative? Literature Review The global nature of business operations has given rise to foreign currency denominated transactions. This means that the companies have a significant amount of foreign currency receivables and payables in their financial statements. Therefore any adverse movement in the exchange rate can have a serious impact on the profitability position of the company. For this reason the companies hedge their position using financial derivative products like foreign currency options, forward contract, currency swaps, currency futures etc. The modernization of financial markets and the consequent development of advanced hedging techniques mean that the companies no more rely only on the traditional hedging methods rather now they employ various financial instruments to protect the value of their receivables. Many studies have been conducted about the foreign currency hedging practices of the companies. Academic literature relating to hedging has developed various theories that explain the incentives derived by an individual from hedging. Hedging protects the position of the hedger. Keynes states explicitly that the process of hedging eliminates risk (Ullrich, 2009, pp.107). In fact the financial derivatives can also be used for making speculative gains. This can be done by the companies who maintain a specialized risk management department as these professionals can take a position based on market anticipations. Various studies have been done to find as to why the firms hedge their overseas exposures. Some of these studies have focused on the usage of hedging tools like foreign currency derivatives and foreign currency debt (Judge, 2003). The strategy is chosen on the basis of the term of the exposure. For short-term exposures one expects that the firms will rely on derivatives. The long term exposure can be hedged using methods like issuance of debt and geographical asset diversification. A study of foreign debt issuance by the firms conducted by Elliott, Huffman and Makar (2003) revealed that debt issuance and geographical diversification help in hedging the long term transactions. As per Smith and Stulz et al (1985) theories suggest that the firms adopt hedging strategies for reducing the risk associated with financial distress and for lowering tax burden. A group of large firms investigated by Geczy, Minton and Schrand (1997) concluded that most of the firms hedge with the help of currency derivatives for avoiding “underinvestment problems”. Starks and Wei (2006) highlight that foreign currency exposure, is more likely to impact the firms that are close to the situation of financial distress, and thus should have a strong desire to insulate their revenues. However it was observed by them that these firms are impacted by large fluctuations in exchange rates indicating that they do not hedge their positions. According to Nance, Smith and Smithson (1993) the small sized firms have a significant amount of counterparty credit risk but are unable to use the expensive financial derivatives (Bartram et al., 2007). Empirical investigation of theories on hedging has been affected due to the non-availability of data on such activities. Even in the first half of 1990s the exact position of the firms in derivatives was not disclosed publicly as it was considered to be an important factor determining strategic competitiveness. However in recent years the corporations have to make necessary disclosures relating to “notional amount of derivatives” used by them in their annual reports. Due to lack of relevant information most of the studies that were conducted in the past used to focus on the “survey data” for examining “why firms use derivatives”. For instance studies conducted by Nance et al (1993) used “survey data” of Fortune 500 firms regarding the use of futures, swaps, forwards and options along with data relating to characteristics of the firms. Studies conducted recently revolve around the “type of hedging” as there are various factors that are considered to be crucial for each “type of hedging”. The research conducted by Geczy, Minton and Schrand (1997) revealed that the use of foreign currency derivatives has a positive relation with the amount of Research & Development expenditure. Mian (1996) examined 3022 companies with respect to all three hedging types and found evidence suggesting that were not in support of the theories on financial distress and rather the evidences supported the view that the larger firms extensively use hedging (Allayannis & Ofek, 1998). A survey conducted by Jesswein, Kwokand Folks (1995) investigated the knowledge level and use of risk management products by US companies. By surveying Fortune 500 companies they found that the most commonly used instrument used by the corporations for hedging is ‘forward contract’. Nearly 93 percent of the companies in the sample used the forward contract. This was followed by ‘foreign currency swaps’ and ‘over-the-counter currency options’. This suggests that most of the companies in US used forwards, options and swaps for managing their exchange related risk (Eun &Resnick, 2008, pp.210). One industry that is subject to high volatility due to changes in the economic environment is ‘airlines’. Through the use of financial instruments the risk manager designs and develops hedging strategies for reducing exchange related losses. The management of exchange rate risks is important for the airline industry as their profitability is affected by any adverse currency movements. Firstly, the revenues and expenses of the airlines are denominated in a number of currencies. Secondly their borrowings are also denominated in foreign currency. Thirdly the demand for tourism is also affected by the level of exchange rate (Loudon, 2004). Financial hedging enables the firms to lock-in the profits irrespective of the volatile market conditions. Hedging contributes to the profits of the company in the event of rising exchange rate scenario but subtracts the profits in times of falling exchange rate conditions. If the firm wants to make use of any favourable movements in the market conditions then it has to pay a premium for entering into an option contract that will give it the right without any obligation towards the transaction. As per Mello et al the immunity offered by the hedging instruments allows the firm to survive in times of cash flow squeeze. In absence of hedging any undesirable change in the exchange rate can lead to abandonment of important investment opportunities or even can endanger their solvency (Mello et al., n.d.). Derivative instruments are essential risk management tools because they allow tight control over exposure to financial risk. As a result there has been an explosion in the volume of trading in derivatives in the last decade Future and option exchanges are now sprouting all over the world , and U.S exchanges are slowly losing their dominance to foreign markets (Jorion & Khoury, 1996) The data of 94 US based firms gathered from footnotes in the annual reports by Allayanis and Ofek (2001) compares the use of foreign currency derivatives and foreign debt for the purpose of hedging foreign currency exposure. There was no evidence that the companies with overseas operations prefer currency derivatives over foreign debt in hedging. This suggests that the firms use foreign currency derivatives as well as foreign debt as complementary to each other. However it was found that the use of foreign currency derivatives was preferred over foreign debt by the exporters (Judge, 2003). This is seconded by Gezzy et al. as well, as the firms with operations abroad find both the methods of hedging to be equally viable. The findings of Chain & Ju Lin (2007) shows that the that the use of operational hedge strategies does not help reduce foreign exchange exposure for Taiwan firms, on other hand the use of foreign currency derivatives (FCD) is considered to be an effective hedging strategy (Chain & Ju Lin, 2007). Operational hedges are considered to be most effective for managing the effect of fluctuation in exchange rate on the competitive position of the firm. According to Logue (1995) and Chowdhry & Howe (1999) operational hedges are better for managing long term exposure and financial hedges like the use of foreign currency derivatives are better for managing short-term exposures (Pantzali et al., 2001). The reason for this is that there are certain long term overseas transactions and these can be effectively hedged by foreign debt of long maturity. In such situations the use of currency forwards, options or futures may not be suitable on account of their short term maturity. For instance if the sample of derivative users comprise firms that use currency swaps and others using currency derivatives then this will give the results that both the methods of hedging are substitutes. Similarly a sample comprising of only currency derivative users which does not include currency swap users may not yield the same results (Judge, 2003). Research Method Sample: This study will analyse the use of various strategies adopted by the companies for hedging their foreign currency exposure. The sample will comprise of non-financial companies with a global presence that use currency derivatives and foreign debt for hedging. The companies chosen for the purpose of research are British Airways, Easy Jet, Thomas Cook, Virgin Atlantic, Wal-Mart and Ford. All these companies hedge their overseas exposures. The annual reports of these companies contain qualitative disclosure about the instruments used for hedging. The website of the company can also be accessed for other financial disclosures as this can yield important information about the strategic position of the company in the financial assets. Analysis: The quantitative data relating to the use of financial products may not be available for all the companies. Such data is not generally disclosed by the companies for reasons like confidentiality. However significant amount of qualitative disclosure relating to currency derivatives is made by the companies in various parts of the annual reports. It will not be possible to perform any structured interview as the risk management practices are business secrets and the company executives will not be willing to divulge any details in this matter. A list of the companies can be made on the basis of users of foreign currency derivatives & debt; foreign currency derivatives only, foreign currency debt only and no disclosures. The companies can be classified according to the combination of hedging strategies used by them. This will give an idea about which hedging strategy is most popular among the corporate. This can be further segregated into ‘choice of currency derivatives’ as Forwards, Swaps & Options; Forwards & Swaps; Forwards & Options; Forwards only; Swaps only and No Mention. This will help in understanding about the preferred currency derivative by the companies. Research Ethics The research is guided by essential issues like giving credence to the source used for the purpose of carrying out the research. Issues like plagiarism will be taken care of. This research paper will not involve any kind of cheating, money inducements, psychological stress of researching etc. The information relating to various companies will be accurately presented without any bias for any specific company. This means that the information will not be presented in a way as to tarnish the reputation of any company rather there will be an emphasis on fair and complete analysis. Reference Allayannis, G. Ofek, E. 1998. Related Literature. Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives. Available at: http://faculty.darden.virginia.edu/allayannisy/hedge2.pdf [Accessed on September 18, 2010]. Bartram, M.S. Burns, N. Helwege, J. 2007. Foreign Currency Exposure and Hedging: Evidence from Foreign Acquisitions. Available at: http://neumann.hec.ca/cref/sem/documents/071005.pdf [Accessed on September 18, 2010]. Chain, Y. And Ju Lin, H. (2007) Foreign Exchange Exposure, Financial and Operational Hedge Strategies Of Taiwan Firms. Investment Management And Financial Innovations, Vol. 4. Eun, S.C. Resnick, G.B. 2008. International Financial Management. Tata McGraw-Hill. Jorion, P. Khoury, S. J. 1996. Financial risk management: domestic and international dimensions / Cambridge, Mass.; Oxford : Blackwell Business. Judge, A. 2003. Overview of Related Literature. How Firms Hedge Foreign Currency Exposure: Foreign Currency Derivatives versus Foreign Currency Debt. Available at: http://www.web.mdx.ac.uk/internet/schools/bs/departments/econ_stats/docs/DPAP_ECON_NO._106.pdf [Accessed on September 18, 2010]. Loudon, G. (2004) Financial Risk Exposures in the Airline Industry: Evidence from Australia and New Zealand. Australian Journal of Management, vol. 29, No, 2. Mello, A. Parsons, J. Triantis, A. Flexibility or Hedging. Available at: http://www.mit.edu/~jparsons/publications/Flexibility%20or%20Hedging%20Risk-pages-18-19.pdf [Accessed on September 18, 2010]. Pantzali, C. Simkins, J.B. Laux, A.P. 2001. Operational Hedges and the Foreign Exchange Exposure of U.S. Multinational Corporations. JOURNAL OF INTERNATIONABLU SINESSS TUDIES, 32, 4. Available at: http://www.personal.psu.edu/sst5034/Scholarly%20Articles/3069477%20Foreign%20Exchange%20Exposure%20of%20US%20Multinational%20Corp.pdf [Accessed on September 18, 2010]. Ullrich, C. 2009. Forecasting and hedging in the foreign exchange markets. Springer. Bibliography Arnott, S. 2009. Virgin Atlantic Defies Airline Slump. Bloomberg Businessweek. Available at: http://www.businessweek.com/globalbiz/content/may2009/gb20090527_747393.htm Bartram, M.S. 2007. What Lies Beneath: Foreign Exchange Rate Exposure, Hedging and Cash Flows. Available at: http://mpra.ub.uni-muenchen.de/6661/1/MPRA_paper_6661.pdf Easy jet Plc. No Date. EASYJET PLC 2009 AGM CHAIRMAN’S STATEMENT. Available at: http://www.easyjet.com/en/news/agm_chairmans_statement_feb_09.html Stulz, M.R. 1984. Optimal Hedging Policy. Journal of financial and quantitative analysis. Vol. 19. No. 2. Available at: http://www.cob.ohio-state.edu/fin/faculty/stulz/publishedpapers/optimalhedgingpolicies.pdf Clark, E. Mefteh, S. No date. ASYMMETRIC FOREIGN CURRENCY EXPOSURES AND DERIVATIVES USE: EVIDENCE FROM FRANCE. Available at: http://southwesternfinance.org/conf-2010/E4-1.pdf Read More