Another operational technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments. To lead. means to pay or collect early, where as ?lag? means to pay or collect late. The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables. To the extent that the firm can effectively implement the Lead/Lag strategy, the transaction exposure the firm faces can be reduced. On translation exposure, Managers, analysts and investors need some idea about the importance of the foreign business. Translated accounting data give an approximate idea of this. Performance measurement for bonus plans, hiring, firing, and promotion decisions. Accounting value serves as a benchmark to evaluate a discounted-cash flow valuation, for income tax purposes and legal requirement to consolidate financial statements.
Translation exposure is therefore defined as the likely increase or decrease in the parent company�s net worth caused by a change in exchange rates since last translation. This arises when an asset or liability is valued at the current rate. No exposure arises in respect of assets/liabilities valued at historical rate, as they are not affected by exchange rate differences. Translation exposure is measured as the net of the foreign currency denominated assets and liabilities valued at current rates of exchange. If exposed assets exceed the exposed liabilities, the concern has a =positive� or =long� or =asset� translation exposure, and exposure is equivalent to the net value. If the exposed liabilities exceed the exposed assets and results in =negative� or =short� or =liabilities� translation exposure to the extent of the net difference. In addition, translation exposure is the change in accounting income and balance sheet statements caused by changes in exchange rates. Under the rules of Financial Accounting Standards Board, a US company must determine a functional currency for all and each of its offshore subsidiaries. If such a subsidiary is a stand alone firm with vertical or horizontal integration with the particular country, the functional currency can be the local currency otherwise it has to be the dollar. Translation exposure arises from the need to translate foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. A typical example of translation exposure is the treatment of foreign currency borrowings. Thus, Translation loss or gain is measured by the difference between the value of assets and liabilities at the historical rate and current rate. A company which has a positive exposure will have translation gains if the current rate for the foreign currency is higher than the historic rate. In the same situation, a company with negative exposure will post translation loss. The position will be reversed if the currency rate for foreign currency is lesser than its historic rate of exchange. The translation gain/loss is shown as a separate component of the shareholders� equity in the balance-sheet. It does not affect the current earnings of the company. Increasing hard-currency (likely to appreciate) assets, decreasing soft-currency (likely to depreciate) assets, decreasing hard-currency liabilities, increasing soft-currency liabilities i.e. reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward.
Economic exposure is the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. An economic exposure is more a managerial concept than an accounting concept. Moreover, economic exposure, the most important of the three, is the change in value of a company that accompanies an unanticipated change in the exchange rates. There is a clear distinction between the anticipated and the unanticipated change of exchange rates. The anticipated change has already been factored into the valuation of the company by the market forces. The unanticipated comes as an unforeseen risk. In simple words, economic exposure to an exchange rate is the risk that a change in the rate affects the company�s competitive position in the market and hence, indirectly the bottom-line. Broadly speaking, economic exposure affects the profitability over a longer time span than transaction and even translation exposure. While transaction and translation exposures can be hedged, economic exposure cannot be hedged. There are two types of economic exposure namely asset exposure and operating exposure. Exposure to currency risk can be properly measured by the sensitivities of (1) the future home currency values of the firm�s assets (and liabilities) (2) the firm�s operating cash flows to random changes in exchange rates. Operating exposure is ?the extent to which the firm�s operating cash flows would be affected by random changes in exchange rates?. Operating exposure may affect in two different ways to the firm, viz., competitive effect and conversion effect. Adverse exchange rate change increase cost of import which makes firm�s product costly thus firm�s position becomes less competitive, which is competitive effect. Adverse exchange rate change may reduce value of receivable to the exporting firm which is called conversion effect.
Selecting low cost production sites: When the domestic currency is strong or expected to become strong, eroding the competitive position of the firm, it can choose to locate production facilities in a foreign country where costs are low due to either the undervalued currency or under priced factors of production. Recently, Japanese car makers, including Nissan and Toyota, have been increasingly shifting production to U.S. manufacturing facilities in order to mitigate the negative effect of the strong yen on U.S. sales. German car makers such as Daimler Benz and BMW also decided to establish manufacturing facilities in the U.S. for the same reason. Also, the firm can choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes. Consider Nissan, which has manufacturing facilities in the U.S. and Mexico, as well as in Japan. Multiple manufacturing sites provide Nissan with great deal of flexibility regarding where to produce, given the prevailing exchange rates. When the yen appreciated substantially against the dollar, the Mexican peso depreciated against the dollar in recent years. Under this sort of exchange rate development, Nissan may choose to increase production in the U.S. and especially in Mexico, in order to serve the U.S. market. This is, in fact, how Nissan has reacted to the rising yen in recent years. Maintaining multiple manufacturing sites, however, may prevent the firm from taking advantage of economies of scale, raising its cost of production. The resultant higher cost can partially offset the advantages of maintaining multiple production sites. Flexible sourcing policy: Even if the firm manufacturing facilities only in the domestic country, it can substantially lessen the effect of exchange rate changes by sourcing from where input costs are low. Facing the strong yen in recent years, many Japanese firms are adopting the same practice. It is well known that Japanese manufacturers, especially in the car and consumer electronics industries, depend heavily on parts and intermediate products from such low cost countries as Thailand, Malaysia, and China. Flexible sourcing need not be confined just to materials and parts. Firms can also hire low cost guest workers from foreign countries instead of high cost domestic workers in order to be competitive. Diversification of the market: Another way of dealing with exchange exposure is to diversify the market for the firm�s products as much as possible. Suppose that GE is selling power generators in Mexico as well as Germany. Reduced sales in Mexico due to the dollar appreciation against the peso can be compensated by increased sales in Germany due to dollar depreciation against the euro. As a result, GE�s overall cash flows will be much more stable than would be the case if GE sold only in one foreign market, either Mexico or Germany. As long as exchange rates do not always move in the same direction, the firm can stabilize its operating cash flow by diversifying its export market.
Research and Development (R&D) efforts and product differentiation: Investment in R&D activities can allow the firm to maintain and strengthen its competitive position in the face of adverse exchange rate movements. Successful R&D efforts allow the firm to cut costs and enhance productivity. In addition, R&D efforts can lead to the introduction of new and unique products for which competitors offer no close substitutes. Since the demand for unique products tend to be highly inelastic, the firm would be less exposed to exchange risk. At the same time, the firm can strive to create a perception among consumers that its product is indeed different from those offered by competitors. This helps firm to pass-through any adverse effect of exchange rate on to the customers.
2.3 Hedging Strategies:
Contractual Hedge: Forward, money, futures and options market hedges. Operating Hedge: Risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies. Natural Hedge: Offsetting operating cash flows. Financial Hedge: Offsetting debt obligation or some type of financial derivative such as a swap. Currency futures, swaps, options, forward contracts can be used to stabilize operating Cash flows or firm can borrow or lend in a foreign currency. Financial hedging may be a more cost-effective strategy than operational hedging for many firms since it doesn't involve major redeployment of resources like building factories in other countries. While not a substitute for the long-term, financial hedging can be used to stabilize the firm�s cash flow. For example, the firm can lend or borrow foreign currencies as a long term basis. Or, the firm can use currency forward of options contracts and roll them over if necessary.
Forward contract: Forward Cover is an OTC contract and here the rate is fixed between two counter parties for taking the underlying currency at a particular date at a predetermined rate. In option forward contract, delivery can be taken during any date in a given month of delivery. For example a second month forward can be taken delivery any time during the end beginning of the second month td end of second month. Date of delivery of the Forward contact is two days after the end of the month of delivery. Since option forward contact gives option to take delivery any time during a month, most of the adverse rate during this period is passed on to the constituency. Since the liquidity of the forward contract depends on the ability to predict the movement of the currency, long dated forward contracts are always less liquid compared to short dated forward contracts. A loan involving repayment over a long period can be hedged using roll over forward contacts, which even though do not act as perfect hedge gives partial protection against adverse rate movement. Forward cover can be settled through delivery, cancellation, extension and early delivery. Banks usually act as intermediaries and charge a commission for the same. Futures: Futures are exchange traded instruments. Clearing house of the exchange, act as a counter party in each transaction. Margins are taken both from seller and buyer. Since Value at Risk does not factor in event risk, models are built taking into consideration event risk and this model building process is known as risk metrics. When the margin level falls below maintenance margin, then the margin call is made to make it equal to initial margin. Since there are no counter party risks in Futures, it acts as an efficient instrument for price discovery. Even though cost of carry of underlying in the form of interest rate, storage cost and dividend, the price of future cannot be determined by cost of carry alone and this is known as Convenience Yield. Futures are more liquid compared to forward, futures do not have counter party risk as compared to forward, future calls for margins while there is no need for margins in forward, future facilitate price discovery due to absence of counter party risk, same is not the case with forward, futures are standard in delivery, size etc. while forwards are customized. Minimum price changes which will be recognized in future contract is called as Tick size. Option: this means right without obligation. Since it involves such flexibility premium has to be paid upfront. The players involved in option market are option writer and option holder. Option is both OTC as well as exchange traded instruments. Option holder�s maximum loss is option premium, while option writer�s maximum loss is without limits. When there is significant uncertainty in the direction of movement, underlying options are used. Options can be classified as call and put option. Call option is a right without obligation to buy, while put option is right without obligation to sell an underlying at a future date which is known as option period at a particular price called strike price or exercise price.
Swap: it means exchange, which involves exchange of stream of currencies or interest rate either between fixed and floating rate of interest. Floating rate of interest involves different basis like treasury and Libor which involves a basis swap. Swap is based on Ricardo�s theory of comparative advantage. Sometimes spread of borrowing between fixed and floating occurs due to Quality Spread Differential. Quality Spread Differential occurs due to credit rating difference due to which fixed interest loan whose interest cannot be repriced during the tenor of the loan carries a higher spread depending on credit rating of borrower, compared to a floating rate interest loan. Swap is an OTC market. Currency Swap can be treated as a series of forward contracts used for hedging long term exposures. Banks had warehoused swaps and sold them off the shelf and took position and hedged their exchange risk thereby standardizing the instruments and avoiding costly search for counter party for each transaction. Today, Swap documents are standardized throughout the world by International Swap Dealers Association (ISDA). Parties can cover their interest rate risk by taking or writing a Forward Rate Agreement (FRA).
2.3.1 Kinds of Foreign Exchange Exposure
Risk management techniques vary with the type of exposure (accounting or economic) and term of exposure. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries� financial statements into the parent�s reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent. Economic exposure is the extent to which a firm's market value, in any particular currency, is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the value of the firm�s operating cash flows, income statement, and competitive position, hence market share and stock price. Currency fluctuations also affect a firm's balance sheet by changing the value of the firm's assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign currency, investments in foreign banks; this type of economic exposure is called balance sheet exposure. Transaction Exposure is a form of short term economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility. The most common definition of the measure of exchange-rate exposure is the sensitivity of the value of the firm, proxied by the firm�s stock return, to an unanticipated change in an exchange rate. This is calculated by using the partial derivative function where the dependant variable is the firm�s value and the independent variable is the exchange rate (Adler and Dumas, 1984).
2.3.2 Hedging foreign exchange risk
There is a spectrum of opinions regarding FX hedging. Some firms feel hedging techniques are speculative or do not fall in their area of expertise and hence do not venture into hedging practices. Other firms are unaware of being exposed to foreign exchange risks. There are a set of firms who only hedge some of their risks, while others are aware of the various risks they face, but are unaware of the methods to guard the firm against the risk. There is yet another set of companies who believe shareholder value cannot be increased by hedging the firm�s foreign exchange risks as shareholders can themselves individually hedge themselves against the same using instruments like forward contracts available in the market or diversify such risks out by manipulating their portfolio (Giddy and Dufey, 1992). There are some explanations backed by theory about the irrelevance of managing the risk of change in exchange rates. For example, the International Fisher effect states that exchange rates changes are balanced out by interest rate changes, the Purchasing Power Parity theory suggests that exchange rate changes will be offset by changes in relative price indices/inflation since the Law of One Price should hold. Both these theories suggest that exchange rate changes are evened out in some form or the other. Also, the Unbiased Forward Rate theory suggests that locking in the forward exchange rate offers the same expected return and is an unbiased indicator of the future spot rate. But these theories are perfectly played out in perfect markets under homogeneous tax regimes. Also, exchange rate-linked changes in factors like inflation and interest rates take time to adjust and in the meanwhile firms stand to lose out on adverse movements in the exchange rates. The existence of different kinds of market imperfections, such as incomplete financial markets, Positive transaction and information costs, probability of financial distress, and agency costs and restrictions on free trade make foreign exchange management an appropriate concern for corporate management (Giddy and Dufey, 1992). It has also been argued that a hedged firm, being less risky can secure debt more easily and hence enjoy a tax advantage (interest is excluded from tax while dividends are taxed). This would negate the Modigliani-Miller proposition as shareholders cannot duplicate such tax advantages. The MM argument that shareholders can hedge on their own is also not valid on account of high transaction costs and lack of knowledge about financial manipulations on the part of shareholders.
There is also a vast pool of research that proves the efficacy of managing foreign exchange risks and a significant amount of evidence showing the reduction of exposure with the use of tools for managing these exposures. In one of the more recent studies, Allayanis and Ofek (2001) use a multivariate analysis on a sample of S&P 500 nonfinancial firms and calculate a firms exchange-rate exposure using the ratio of foreign sales to total sales as a proxy and isolate the impact of use of foreign currency derivatives (part of foreign exchange risk management) on a firm�s foreign exchange exposures. They find a statistically significant association between the absolute value of the exposures and the (absolute value) of the percentage use of foreign currency derivatives and prove that the use of derivatives in fact reduce exposure.
2.4 Theoretical framework
Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management.
2.4.1 FX Exposure on firm value
The theoretical framework for the exchange rate exposure of firms is based on the fact that, exchange rate exposure has potentially positive or negative impact on the profitability and value of the firm. This is captured in the valuation process in terms of the firm�s stock returns. Thus, the approach to modeling the exchange rate exposure has been to regress the exchange rate on firms� returns. Fisher�s (1907, 1930) on interest rates made it clear that the value of an investment project is equal to the discounted cash flow that this investment generates to its owner(s). The most simple and intuitive formula illustrating this principle is the investment formula calculating the present value of a single investment project under certainty. The Modigliani-Miller Theorem is a cornerstone of modern corporate finance. At its heart, the theorem is an irrelevance proposition: The Modigliani-Miller Theorem provides conditions under which a firm�s financial decisions do not affect its value. MM (1980, p. xiii) explains that with well-functioning markets (and neutral taxes) and rational investors, who can =undo� the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm � debt plus equity depends only on the income stream generated by its assets as shown in equation.
2.4.2 Expected future cash flows
Modern principles of the theory of finance suggest that the management of corporate foreign exchange exposure may neither be an important nor a legitimate concern. It has been argued, in the tradition of the Modigliani-Miller Theorem, that the firm cannot improve shareholder value by financial manipulations. The MM theorem-based argument against risk management contended that the individual investor is a sufficient foreign exchange hedger by himself without having to involve intermediaries in hedging activity. This argument also assumes that foreign currency markets are efficient. Two main imperfections prevent the individual investor from being an efficient hedger when compared to the firm. These are entry barriers and information gaps (Dufey and Srinivasulu, 1983). Entry barriers are in the form of size and structural barriers. Minimum size requirements in financial and commodity markets tend to be too large for individual investors. They cannot, as a result, enter and efficiently operate in these markets. Moreover, internal hedging techniques are firm-structured. They are tailored along operations of a firm and are hardly available to individual investors. Structurally, the individual investor is limited in making use of these hedging avenues. Specifically, investors themselves can hedge corporate exchange exposure by taking out forward contracts in accordance with their ownership in a firm. Managers do not serve them by second-guessing what risks shareholders want to hedge.
2.6 Steps of foreign exchange risk management
2.6.1 Forecasts
After determining its exposure, the first step for a firm is to develop a forecast on the market trends and what the main direction/trend is going to be on the FX rates. The period for forecasts is typically 6 months. It is important to base the forecasts on valid assumptions. Along with identifying trends, a probability should be estimated for the forecast coming true as well as how much the change would be.
2.6.2 Risk Estimation
Based on the forecast, a measure of the Value at Risk (the actual profit or loss for a move in rates according to the forecast) and the probability of this risk should be ascertained. The risk that a transaction would fail due to market-specific problems should be taken into account. Finally, the Systems Risk that can arise due to inadequacies such as reporting gaps and implementation gaps in the firms� exposure management system should be estimated.
2.6.3 Benchmarking
Given the exposures and the risk estimates, the firm has to set its limits for handling foreign exchange exposure. The firm also has to decide whether to manage its exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm are not adversely affected beyond a point. A profit centre approach on the other hand is a more aggressive approach where the firm decides to generate a net profit on its exposure over time.
2.6.4 Hedging
Based on the limits a firm set for itself to manage exposure, the firms then decides an appropriate hedging strategy. There are various financial instruments available for the firm to choose from: futures, forwards, options and swaps and issue of foreign debt. Hedging strategies and instruments are explored in a section.
2.6.5 Stop Loss
The firms risk management decisions are based on forecasts which are but estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there should be certain monitoring systems in place to detect critical levels in the foreign exchange rates for appropriate measure to be taken.
2.6.6 Reporting and Review
Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/ loss status on open contracts after marking to market, the actual exchange/ interest rate achieved on each exposure and profitability vis-a-vis the benchmark and the expected changes in overall exposure due to forecasted exchange/ interest rate movements. The review analyses whether the benchmarks set are valid and effective in controlling the exposures, what the market trends are and finally whether the overall strategy is working or needs change.
2.7 External Hedging Strategies / Instruments
A derivative is a financial contract whose value is derived from the value of some other financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. The main role of derivatives is that they reallocate risk among financial market participants, help to make financial markets more complete. This section outlines the hedging strategies using derivatives with foreign exchange being the only risk assumed.
2.7.1 Forwards
A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. The depreciation of the receivable currency is hedged against by selling a currency forward. If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward. The main advantage of a forward is that it can be tailored to the specific needs of the firm and an exact hedge can be obtained. On the downside, these contracts are not marketable, they can�t be sold to another party when they are no longer required and are binding.
2.7.2 Futures
A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market. Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double coincidence. Futures require a small initial outlay (a proportion of the value of the future) with which significant amounts of money can be gained or lost with the actual forwards price fluctuations. This provides a sort of leverage.
2.7.3 Options
A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend.
2.7.4 Swaps
A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. The advantages of swaps are that firms with limited appetite for exchange rate risk may move to a partially or completely hedged position through the mechanism of foreign currency swaps, while leaving the underlying borrowing intact. Apart from covering the exchange rate risk, swaps also allow firms to hedge the floating interest rate risk.
2.7.5 Foreign Debt
Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile so, to hedge this; he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. The theory assures that the gain realized by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan.
2.8 Choice of hedging instruments
The literature on the choice of hedging instruments is very scant. Among the available studies, Geczy et al. (1997) argues that currency swaps are more cost-effective for hedging foreign debt risk, while forward contracts are more cost-effective for hedging foreign operations risk. This is because foreign currency debt payments are long-term and predictable, which fits the long-term nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term and unpredictable, in line with the short-term nature of forward contracts. A survey done by Marshall (2000) also points out that currency swaps are better for hedging against translation risk, while forwards are better for hedging against transaction risk. This study also provides anecdotal evidence that pricing policy is the most popular means of hedging economic exposures. These results however can differ for different currencies depending in the sensitivity of that currency to various market factors. Regulation in the foreign exchange markets of various countries may also skew such results.
2.8.1 Determinants of Hedging Decisions
The management of foreign exchange risk, as has been established so far, is a fairly complicated process. A firm, exposed to foreign exchange risk, needs to formulate a strategy to manage it, choosing from multiple alternatives. This section explores what factors firms take into consideration when formulating these strategies.
2.8.1.1 Production and Trade
An important issue for multinational firms is the allocation of capital among different countries production and sales and at the same time hedging their exposure to the varying exchange rates. Research in this area suggests that the elements of exchange rate uncertainty and the attitude toward risk are irrelevant to the multinational firm's sales and production decisions (Broll, 1993). Only the revenue function and cost of production are to be assessed, and, the production and trade decisions in multiple countries are independent of the hedging decision. The implication of this independence is that the presence of markets for hedging instruments greatly reduces the complexity involved in a firm�s decision making as it can separate production and sales functions from the finance function. The firm avoids the need to form expectations about future exchange rates and formulation of risk preferences which entails high information costs.
2.8.1.2 Cost of Hedging
Hedging can be done through the derivatives market or through money markets (foreign debt). In either case the cost of hedging should be the difference between value received from a hedged position and the value received if the firm did not hedge. In the presence of efficient markets, the cost of hedging in the forward market is the difference between the future spot rate and current forward rate plus any transactions cost associated with the forward contract. Similarly, the expected costs of hedging in the money market are the transactions cost plus the difference between the interest rate differential and the expected value of the difference between the current and future spot rates. In efficient markets, both types of hedging should produce similar results at the same costs, because interest rates and forward and spot exchange rates are determined simultaneously. The costs of hedging, assuming efficiency in foreign exchange markets result in pure transaction costs. The three main elements of these transaction costs are brokerage or service fees charged by dealers, information costs such as subscription to Reuter reports and news channels and administrative costs of exposure management.
2.8.2 Factors affecting the decision to hedge foreign currency risk
Research in the area of determinants of hedging separates the decision of a firm to hedge from that of how much to hedge. There is conclusive evidence to suggest that firms with larger size, R&D expenditure and exposure to exchange rates through foreign sales and foreign trade are more likely to use derivatives. (Allayanis and Ofek, 2001) First, the following section describes the factors that affect the decision to hedge and then the factors affecting the degree of hedging are considered.
2.8.2.1 Firm size
Firm size acts as a proxy for the cost of hedging or economies of scale. Risk management involves fixed costs of setting up of computer systems and training/hiring of personnel in foreign exchange management. Moreover, large firms might be considered as more creditworthy counterparties for forward or swap transactions, thus further reducing their cost of hedging. The book value of assets is used as a measure of firm size.
2.8.2.2 Leverage
According to the risk management literature, firms with high leverage have greater incentive to engage in hedging because doing so reduces the probability, and thus the expected cost of financial distress. Highly levered firms avoid foreign debt as a means to hedge and use derivatives.
2.8.2.3 Liquidity and profitability
Firms with highly liquid assets or high profitability have less incentive to engage in hedging because they are exposed to a lower probability of financial distress. Liquidity is measured by the quick ratio, i.e. quick assets divided by current liabilities). Profitability is measured as EBIT divided by book assets.
2.8.2.4 Sales growth
Sales growth is a factor determining decision to hedge as opportunities are more likely to be affected by the underinvestment problem. For these firms, hedging will reduce the probability of having to rely on external financing, which is costly for information asymmetry reasons, and thus enable them to enjoy uninterrupted high growth. The measure of sales growth is obtained using the 3-year geometric average of yearly sales growth rates. As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole determinants of the degree of hedging are exposure factors (foreign sales and trade). In other words, given that a firm decides to hedge, the decision of how much to hedge is affected solely by its exposure to foreign currency movements. This discussion highlights how risk management systems have to be altered according to characteristics of the firm, hedging costs, nature of operations, tax considerations, and regulatory requirements.
2.9 Knowledge Gap
Among the many academic publications and articles, there is still a notable gap in this research study that has been undertaken to date in the context of FX exposure which has helped to gather some valuable information. This study therefore serves as a springboard for future researchers to investigate and widen their scope on the effects of FX exposure to the financial performance of a company. The study provides scholars with useful information on how to avert the FX exposure. It is also of use to financial managers who have the responsibility of managing the risk associated with foreign exchange exposure. To this end most research on FX risk have focused on the exposure of multinational companies. This study has found mixed results regarding significant foreign exchange exposures, perhaps, as many multinational companies effectively hedge against many foreign exchange risks using financial and operating procedures. In general, it seems counter-intuitive to most managers that ?domestic? companies that are not engaged in international transactions would be exposed to exchange rate changes. ?Domestic? companies are unlikely to engage in hedging activities and are, thus, more likely to have measurable foreign exchange exposure. Indeed, accounting rules favour derivative-based hedges only against identifiable foreign exchange exposures, thus favouring companies with international transactions and multinational companies. However, there are also good economic conjectural reasons to suspect that domestic companies may be exposed to foreign exchange risks. With the increasing globalization of financial and product markets, domestic firms may face foreign exchange risks through interest rate and financial markets and through product markets as competitors, suppliers, and customers may engage in cross-border transactions and be faced with foreign exchange risks. Given these contrary managerial and economic arguments, the FX exposure of domestic companies is an important empirical question. The studies contend that the measured exposure for domestic corporations is likely to be significant and similar to what has been reported for multinational corporations.
