Exchange-Rate Hedging: Financial versus Operational Strategies

Abstract

Exchange-rate exposure is an important source of risk for multinational corporations. To mitigate the impact of exchange-rate fluctuations, it has been claimed that multinational corporations can employ risk-management strategies not only through financial derivatives, but also through operational hedges. For example, Schering-Plough in its 1995 annual report (p. 25) argues in support of exclusive use of operational hedges: “To date, management has not deemed it cost-effective to engage in a formula-based program of hedging the profitability of these operations using derivative financial instruments. Some of the reasons for this conclusion are: The Company operates in a large number of foreign countries; the currencies of these countries generally do not move in the same direction at the same time.” Conversely, many corporations with large worldwide networks, such as IBM or Coca Cola, make extensive use of derivative financial instruments. This paper investigates both financial and operational exchange-rate risk-management strategies of multinational firms. While several studies have examined either firms’ financial hedging or firms’ operational hedging activities, no study thus far has examined financial and operational hedging simultaneously for a large cross section of firms. To the extent that the decision to use financial hedging strategies is related to (and affected by) the operational strategies that a firm employs, it is important to examine how each strategy contributes to the overall goal of mitigating risk and improving shareholder value. Using a sample of U.S. multinational nonfinancial firms during 1996–1998, we find that operational hedging is not an effective substitute for financial risk management. However, we find that the more geographically dispersed a firm is, the more likely it is to use financial hedges. The end result on firm value is that operational hedging strategies benefit shareholders only when used in combination with financial hedging strategies.