Limited Foreign Exchange Exposure Through Hedging - Research Paper Example

LIMITING FOREIGN EXCHANGE EXPOSURE THROUGH HEDGING: THE AUSTRALIAN EXPERIENCE SUMMARY This research paper discusses different kinds of foreign exchange hedging instruments of direct balance sheet and evaluates their extensive implications for the Australian economy. Basically the Australian economy has proven flexibility to fluctuations in considerable exchange rate risk. This proven resilience is attributed to the increased use of financial derivative contracts by the financial and non-financial Australian firms for hedging of foreign exchange risk exposures. This paper does not only examine the nature and kind of hedging behavior but it also examines its implications on Australian economy. The research paper discusses different kinds of hedging instruments employed by firms all over the world. The risk of exchange rate is raised from the assets and liabilities or transactions dominated in foreign currencies or existing. The hedging activities of all firms are not alike and they may vary based on core business of firms and kinds of their foreign exchange risk. The paper described the kinds of Hedging instruments including Natural Hedging and Foreign Exchange Derivatives. In order to evaluate hedging practices in Australia, data of up to March 2005 has been used apart from hedging surveys for Australia. The previous surveys show that banking sector of Australia has always been well-protected from currency fluctuations. In the period following the floating of Australian dollar, Australian banks had very little exposure to exchange rate risk because of the restrictions of regulations on international transactions. After the removal of these restrictions banks have been financing their domestic assets through short term liabilities abroad. In order to limit their net exposures, the banks used to match foreign currency liabilities to their assets. For further eliminating the residual risk exposure, Australian banks has been using derivatives. The current market risk guidelines ask the Australian authorized deposit-taking banks to determine their foreign currency exposure daily. The evaluation of adaptations of non-financial firms to exchange rate fluctuations show that these firms have been facing difficulties because of poor or little experience. In 1986, borrowers made 3000 foreign currency loans dominated in Swiss francs and they incurred huge losses when Swiss francs appreciated by 50% against Australian dollar. The survey of Riethmuller and Phillips (1986) showed that these losses stemming from Australian dollar depreciation enhanced the use of hedging instruments. In 1991, the BIE report also showed the increasing hedging practices in Australia and it was found that every year about 10% average proportion of exchange rate exposure hedged by the exporters is raised. The findings of Teoh and Er (1988) showed that prior to float; foreign-owned firms in Australia were involved in more hedging activities as compared to domestic firms. The improvements in hedging practices of Australian firms started in the early 1990s. This paper also provides the kinds of hedging practices used by Australian firms. In consideration to the importance of findings of Australia Bureau of Statistics (ABS) survey of hedging practices 2001, the Reserve Bank asked ABS to conduct a second survey in 2005. The findings of second survey complement the findings of first survey of ABS. It was found that at 31 March 2005, net foreign currency asset position of Australia residents was $218 billion and the banking sector has the largest foreign currency liability but that was fully hedged through foreign derivative contracts. The common hedging practices that were highlighted include foreign exchange contracts and cross-currency interest rate swaps. The most surprising result was that residents of Australia were well-insulated from unfavorable exchange rate fluctuations as compared to non-residents. This paper also discusses the time horizon of firm’s hedging because generally hedging practices cover relatively near-time horizon of less than one year. Basically a firm always faces ambiguity while determining the extent of their exposures beyond one year therefore, firms only hedge for those transactions that have certain anticipated risk exposure. Apart from that, the banks consider long-term derivatives as having high credit risk that ultimately reduces the ability of the firm to get long term forward cover because of the lack of strong credit rating. Furthermore, exporters such as mining companies seek to hold longer contracts as compared to importers such as wholesalers. The paper discusses that importance of Australian’s exports, since 1997 nearly 70% of Australia’s trade has been demanded in foreign currency particular US dollar. Therefore, Australian firms’ foreign currency exposure is mainly to US dollar. The last section of this paper discusses in detail the measurement of foreign currency exposure. The gross foreign assets and liabilities of Australia show that at March 2005, the 40% of total liabilities had foreign claims in Australian dollars thereby, reducing the exchange rate fluctuations risk. On the other hand, 60% of foreign assets dominated in foreign currency consisted of equities. The Australian economy is entitled to the status of mature industrialized economy because of its favorable credit ratings. It has been possible because significant portion of foreign debt liabilities was dominated in local currency. In addition, the foreigners were also willing to hold their foreign assets dominated in local currency of Australia. The foreign debt assets of Australia include purchases of domestic residents issued by foreign buyers and some portions of these debt assets are also dominated in Australian dollar. It has found that Australian economy had a positive net foreign currency asset position at the end of March 2005 which means that considering other things constant, the appreciation of Australian dollar would have reduced the net foreign liabilities of Australian residents. The evaluation of hedging practices show that Australian residents have larger net long position in terms of foreign currency after opting for hedging practices. The hedging of foreign currency risk is actually playing a very significant role in Australia. Taking into consideration the hedging practices, it has found that balance sheet position of Australian would make the residents to face losses in the case of Australian dollar appreciation however; the losses would be less significant. Therefore, balance sheet position of Australia in 2005 shows that balance sheet of Australia does not have risk exposure to exchange rate depreciation. The paper winds up by providing some suggestions to avoid residual currency risk. It has been suggested that rather than debating on macroeconomic effects of currency fluctuations, more focus should be given towards quantifiable financial gains and capital flows. Secondly, the effectiveness of hedging is limited in insulating trade flows unlike its effectiveness in the case of insulation of balance sheet positions. Third, hedging does not offer full cover to risk exposure for several years. In conclusion, although Australian dollar has been facing huge fluctuations however the economy of Australia, especially the banking sector has proven stability to the fluctuations in the nominal exchange rate. APPRAISAL There are different kinds of research studies based on their qualitative or quantitative approach.1 The approach that has been used in this research paper involves the gathering of extensive narrative data to get an insight into the problem under discussion. Furthermore, the numerical data has been also collected to explain the topic under discussion. It means that this research paper uses both the qualitative as well as quantitative approaches. The qualitative approach that has been used is historical approach while the quantitative approach that has been used is descriptive research approach. There are some basic components of an abstract of a research paper, regardless of the discipline of research paper. These components include problem statement, methods or approach, results and findings and conclusions or implications.2 The abstract of this research paper beautifully explains the crux of the research paper but it does not explicitly explain the problem statement. Secondly, the method or approach used to conduct the research paper has not been discussed. However, the findings of the research have been provided in the abstract. Therefore, abstract could be made better by incorporating all basic components mentioned above. The introduction of paper clearly gives a brief opening to the problem under discussion and it also highlights the gap because of which the need of conducting this research study was felt. Introduction also briefly covers each section of the research paper, thereby providing enough idea about the areas covered in research paper. There is no literature review in the research paper which may show the findings of other similar research studies. Although in analysis part of paper, the findings of Riethmuller and Phillips surveys, Teoh and Er and other have been provided however, if all these findings would have been consolidated in the form of literature review then a reader could get the context of research study in a batter manner. Furthermore, the section of methodology is also absent therefore, the approach used to conduct this research study has not been described. Even the timeline of data series have been described in a single line in the analytical part. The data has been collected from reliable sources such as ASB which enhances the reliability of the study. The secondary data sources have been referenced by following APA referencing style. The bibliography is extensive and provides references of all data collection sources. The content of the paper is very logical and sequential. It starts from the description of different kinds of hedging instruments which give the readers an opportunity to understand all basic concepts related to hedging. The discussion of hedging practices in Australia has been well interpreted because the sections of Australian firms’ adaptations, hedges in place and issues of time horizons provide the reader an organized approach to understand the implications of the study in Australia. Similarly, the three steps of measuring foreign currency exposure and its implications in Australia have been also presented in an excellent manner. The use of different kinds of graphs such as line graph, bar graph etc. and summarized data tables give clear data interpretation. The suggestions provided in the end give more food for thought to the researchers and readers. Furthermore, the findings of this paper are consistent to the other research studies conducted on similar topic. In short, this research paper explains the foreign currency exposure and hedging practices and their implications in Australia in an understandable, comprehensible and logical manner. (Appendix – Figure 1) BIBLIOGRAPHY Chris, B., & Fabbro, D. (2006, August). Limiting Foreign Exchange Exposure Through Hedging: The Australian Experience. Australia. Department of Psychiatry, University of Oxford . (n.d.). Critical Appraisal form for an Overview. Moorhead, M. S. (n.d.). Ed 603 - Lesson 2 - Types of Research Studies. Minnesota. Undergraduate Research at Barkley. (n.d.). How to Write an Abstract. APPENDIX Figure 1 Critical appraisal form for an overview3 Are the results valid? YES 1. Did the review address a clearly focused issue? YES Did the review describe: the population studied? NO the outcomes considered? NO 2. Did the authors select the right sort of studies for the review? YES The right studies would: address the reviews question YES have an adequate study design YES 3. Do you think the important, relevant studies were included? YES Look for: which bibliographic style was used APA personal contact with experts NO search for unpublished as well as published studies YES 4. Did the reviews authors do enough to assess the quality of the included studies? YES Did they use: description of randomization? NO a rating scale? NO What are the results? 5. Were the results similar from study to study? YES Are the results of all the included studies clearly displayed? YES Are the results from different studies similar? NO If not, are the reasons for variations between studies discussed? 6. How precise are the results? Very Precise Is there a confidence interval? NO Can I use the results to conduct further studies? YES 7. Can I apply the results as a context of my study? YES Read More