The Foreign Exchange Exposure of Domestic Companies in Eurozone: Case of the Baltic States

Abstract

JEL Classification: G32, F31 Introduction In an increasingly globalizing world, companies in small open economies such as Baltic are not isolated from the effects of international economic cycles, currency movements, and global competition. Since mid-2008, foreign exchange markets have become more volatile due to the financial crisis in 2008 and the currency wars. Between mid-2012 and mid-2014, the euro increased in value by 10% compared to other currencies, but this trend has reversed over the last six months, and the effective exchange rate has fallen by 5.2%. Between spring 2014 and late January 2015, the euro depreciated by almost 20% against the US dollar and by about 10% against the British pound, driven by increasingly diverging monetary policy stances and growth dynamics. Generally, risk contribution from unhedged currency exposures could be higher than it used to be in the past. For this reason foreign exchange risk management may be more of a priority than ever. Nowadays companies face the challenge of evaluating the potential loss of transactions, especially in light of the recent financial crisis that showed what can happen as a result of poor risk management policy. Value -at-Risk (VaR) holds a special place in the risk management--it is used almost everywhere. VaR is particularly important because it is used to calculate the market risk component of regulatory capital under the Basel Committee and it is one of the most applied risk measure in investment portfolio theory, financial control and financial reporting as well. In this paper we have applied VaR methods for non-financial companies' foreign exchange exposure measurement. As a misleading VaR estimate can lead to bad judgement on foreign exchange exposure and, consequently, to bad risk management, there is a need for an examination of VaR applications in the context of Baltic non-financial companies. The measure of foreign exchange exposure lies in the variety of difficulties. First of all, there is no single unambiguous method of risk assessment, as different methods may produce different results. Secondly, each method has its own faults. The object of this research is foreign exchange risk measurement and management for the Baltic States companies. The purpose of this research is by analysing different issues relating to the measurement and management of foreign exchange exposure to propose Baltic companies better ways to manage their outstanding currency positions. To achieve the purpose the following tasks were conducted: 1. Analysis of the theoretical aspects of the measuring and managing currency exposure. 2. Analysis of Baltic companies' financial reports data to clarify risk management activities. 3. Clarifying firms' attitudes towards foreign exchange risk management in the Baltic States. 4. Estimating different VaR methods to measure foreign exchange exposure. 5. Development of recommendation how Baltic companies should manage their outstanding currency positions. The research methodology used in this paper is generally accepted qualitative and quantitative methods of economic research, including Value-at-Risk (VaR) methods to measure risks for different horizons and by testing different observation periods of open positions. The paper starts with a literature review in order to highlight the difficulties faced by non-financial companies in identifying, measuring and managing foreign exchange risk. The analysis conducted in this paper is based on companies' financial reports' data and statistics, and certain empirical studies. The data set is based on firms that were publicly listed on NASDAQ OMX Baltic Stock Exchange lists. Baltic Regulated market is the primary market of the NASDAQ OMX Baltic exchanges, which is regulated under EU directives and is under the supervision of the national FSA. The listing requirements are based on European standards and EU directives, and intended for companies that are well established. …