Cash Flow Exposure Research Articles

ESTIMATED IMPACT OF UKRAINE WAR ON EXCHANGE RATE RISK OF MULTINATIONAL ENTERPRISES OPERATING IN EMERGING MARKETS

ABSTRACT Multinational enterprises (MNE) operating in emerging countries are exposed to various types of risk. Exchange rate risk is an important and anticipated part of MNE’s total risk exposure, with a variety of tools available to mitigate that risk. In this study, we focus on transaction exposure of cash flows in eight distinctive emerging market currencies and employ the Modified Value-at-Risk (MVaR) model to estimate the maximum one-period loss during a twelve-month period spanning pre- and during the Ukraine war periods. The predicted losses by MVaR are then compared to the ex-post results, to identify any differences in the pre-and during the Ukraine war periods and to determine the need for adjustments in hedging strategies by MNEs during similar global crises. The motive of this research is to understand the limitations of hedging and what can MNEs do to mitigate transaction exposure risk. The results provide insights into whether MNEs should hedge their currency risk or not. The Ukraine war did impact all firms globally, so this study is relevant and pertinent as firms plan theirs during the war growth. Keywords Exchange rate, transaction risk, value-at-risk, emerging markets, hedging, optimal portfolio

Stock Market's Assessment of Monetary Policy Transmission: The Cash Flow Effect

ABSTRACTWe show that firm liability structure and associated cash flows matter for firm behavior and that financial market participants price stocks accordingly. Stock price reactions to monetary policy announcements depend on the type and maturity of debt issued by the firms and the forward guidance provided by the Fed, both at and away from the zero lower bound. Further, the marginal stock market participant knows the current liability structures of firms and does not rely on rules of thumb. The cash flow exposure at the time of monetary policy actions predicts future investment, assets, and net worth, clearly violating the Modigliani‐Miller theorem.

Currency Hedging: Managing Cash Flow Exposure

Currency Hedging: Managing Cash Flow Exposure

Optimal Dynamic Contracts with Environmental, Social and Governance Criteria

We examine dynamic contracts when output has negative environmental effects and the manager (agent) can invest to build up ESG capital and mitigate the externality. The incentive component of the optimal contract rewards based on cash flow and ESG capital when the principal is risk neutral; and it additionally loads on the production externality when the principal has CARA. Optimal ESG contracts are less sensitive to traditional pay-for-performance measures, and ESG investment is determined by the ratio of capital to cash flow exposure in the contract. We identify conditions under which ESG investment is optimal and improves welfare. We also examine constrained contracts controlling the agency friction associated with ESG investment.

Banks’ exposure to interest rate risk and the transmission of monetary policy

The cash-flow exposure of banks to interest rate risk, or income gap, is a significant determinant of the transmission of monetary policy to bank lending and real activity. When the Fed Funds rate rises, banks with a larger income gap generate stronger earnings and contract their lending by less than other banks. This finding is robust to controlling for factors known to affect the transmission of monetary policy to bank lending. It also holds on loan-level data, even when we control for firm-specific credit demand. When monetary policy tightens, firms borrowing from banks with a larger income gap reduce their investment by less than other firms.

Stock Market's Assessment of Monetary Policy Transmission: The Cash Flow Effect

We show that firm liability structure and associated cash flow matter for firm behavior, and that financial market participants price stocks accordingly. Looking at firm level stock price changes around monetary policy announcements, we find that firms that have more cash flow exposure see their stock prices affected more. The stock price reaction depends on the maturity and type of debt issued by the firm, and the forward guidance provided by the Fed. This effect has remained intact during the ZLB period. Importantly, we show that the effect is not a rule of thumb behavior outcome and that the marginal stock market participant actually studies and reacts to the liability structure of firm balance sheets. The cash flow exposure at the time of monetary policy actions predicts future net worth, investment, and assets, verifying the stock pricing decision and also providing evidence of cash flow effects on firms' real behavior. The results hold for S&P500 firms that are usually thought of not being subject to tight financial constraints.

Stock Market's Assessment of Monetary Policy Transmission: The Cash Flow Effect

We show that firm liability structure and associated cash flow matter for firm behavior, and that financial market participants price stocks accordingly. Looking at firm level stock price changes around monetary policy announcements, we find that firms that have more cash flow exposure see their stock prices affected more. The stock price reaction depends on the maturity and type of debt issued by the firm, and the forward guidance provided by the Fed. This effect has remained intact during the ZLB period. Importantly, we show that the effect is not a rule of thumb behavior outcome and that the marginal stock market participant actually studies and reacts to the liability structure of firm balance sheets. The cash flow exposure at the time of monetary policy actions predicts future net worth, investment, and assets, verifying the stock pricing decision and also providing evidence of cash flow effects on firms' real behavior. The results hold for S&P500 firms that are usually thought of not being subject to tight financial constraints.

Foreign Market Cash Flow Exposure: A Multi-Country, Firm-Level Study

Prompted by recent financial integration and increasingly regional nature of trade and investment flows, we investigate the existence and characteristics of international market-related cash flow exposures for international and domestic companies. Specifically, we study whether firm-level cash flow exposure varies with a regional or global market index in addition to the usual domestic market index. We investigate how this exposure varies with identifiable firm characteristics such international sales exposure and whether this exposure differs systematically across a variety of different countries. We also investigate whether the same model may be used to measure exposure in crisis and non-crisis periods using the Asian economic and financial crisis as a natural experiment. Our empirical investigation relies on a sample of 1325 companies from eight (non-U.S.) countries for the period July 1996 - June 1998. We find significant evidence of regional cash flow exposure across our sample, and this exposure increases in proportion to firm sales in the region. We also find evidence that even domestic companies are influenced by the stock market in other regions. Finally, we find clear evidence of increased exposure for companies with significant sales in Asia during the crisis in that region.

Asymmetric foreign exchange cash flow exposure: A firm-level analysis

This study analyzes foreign exchange (FX) cash flow and equity exposures of a sample of U.S. multinational firms. Focusing on asymmetry in FX cash flow exposures to direction and magnitude of FX shocks, the study finds that asymmetry is pervasive in several alternative measures of FX cash flow exposure. Also, after decomposing FX equity exposures into discount rate and cash flow components, the study documents significant asymmetries in FX discount rate exposures. The latter finding implies that market-related factors in addition to cash flow–based arguments need to be considered when further exploring FX equity exposure. This study also highlights the importance of model specification: models with asymmetric specifications detect more firms with significant FX exposures.

Modelling foreign exchange rate transaction exposure of UK insurance companies

Purpose The purpose of this paper is to study the sensitivity of foreign exchange exposure through the cash flow estimation method using a sample of 59 UK insurance companies. This approach allows a decomposition of exposures into short- and long-term components. By revealing the nature of their cash flow exposures, companies can evaluate the effectiveness of their hedging programmes and focus their hedging efforts according to the nature of their exposures. Design/methodology/approach Martin and Mauer’s (2003, 2005) three-stage model is used to estimate foreign exchange rate transaction exposures for the sample of 65 UK insurance companies over the period 2004-2013. However, this paper has one important innovation to this method. Instead of the model used in previous papers, the paper uses a model from the actuarial field that was proposed by Blum et al. (2001) for modelling foreign exchange rates with their relevant constituents (inflation and interest rate). Findings The evidence shows that the currency transaction exposure for non-life insurers is greater than that of life insurers. Moreover, the author finds that large insurers exhibit lower frequencies of foreign exchange transaction exposure than small insurers. Originality/value The value of this paper comes from the fact that revealing the nature of cash flow exposures, companies can evaluate the effectiveness of their hedging programmes and focus their hedging efforts according to the nature of their exposures.

Short-Run and Long-Run Consumption Risks, Dividend Processes and Asset Returns

We examine the implications of short-run and long-run consumption risks on the momentum and long-term contrarian profits and the value premium in a unified economic framework. By introducing time-varying firm cash flow exposures to the short-run and long-run shocks in consumption growth, we find the otherwise standard intertemporal asset pricing model goes a long way toward generating the momentum and long-term contrarian profits and the value premium. The model also reproduces the size effect, the pairwise correlations between the profitabilities of these investment strategies, and the performance of the standard CAPM and the consumption CAPM in explaining these well-documented return behaviors.

Short-Run and Long-Run Consumption Risks, Dividend Processes, and Asset Returns

We examine the implications of short-run and long-run consumption risks on the momentum and long-term contrarian profits and the value premium in a unified economic framework. By introducing time-varying firm cash flow exposures to the short-run and long-run shocks in consumption growth, we find the otherwise standard intertemporal asset pricing model goes a long way toward generating the momentum and long-term contrarian profits and the value premium. The model also reproduces the size effect, the pairwise correlations between the profitabilities of these investment strategies, and the performance of the standard CAPM and the consumption CAPM in explaining these well-documented return behaviors.

Term Structure of Uncertainty in the Macroeconomy

Dynamic economic models make predictions about impulse responses that characterize how macroeconomic processes respond to alternative shocks over different horizons. From the perspective of asset pricing, impulse responses quantify the exposure of macroeconomic processes and other cash flows to macroeconomic shocks. Financial markets provide compensations to investors who are exposed to these shocks. Adopting an asset pricing vantage point, we describe and apply methods for computing exposures to macroeconomic shocks and the implied compensations represented as elasticities over alternative payoff horizons. The outcome is a term structure of macroeconomic uncertainty.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Asymmetric Foreign Exchange Cash Flow Exposure: A Firm-Level Analysis

This study analyzes foreign exchange (FX) cash flow and equity exposures of a sample of U.S. multinational firms. Focusing on asymmetry in FX cash flow exposures to direction and magnitude of FX shocks, the study finds that asymmetry is pervasive in several alternative measures of FX cash flow exposure. Also, after decomposing FX equity exposures into discount rate and cash flow components, the study documents significant asymmetries in FX discount rate exposures. The latter finding implies that market-related factors in addition to cash flow–based arguments need to be considered when further exploring FX equity exposure. This study also highlights the importance of model specification: models with asymmetric specifications detect more firms with significant FX exposures.

Direct versus indirect regression estimates of foreign exchange cash flow exposure

To estimate foreign exchange (FX) cash flow exposure, one may choose between direct and indirect regression approaches, where the direct approach uses accounting-based cash flow data and the indirect approach uses equity returns as a cash flow proxy. The indirect approach typically includes one or more additional independent variables to control for the impact of FX changes on the required rate of return. Frequently, the control variable is an equity index. We propose that using a bond return control variable instead of equity returns addresses several theoretical problems inherent in the indirect estimation approach. In our empirical analysis we find that using the bond-based control variable results in FX cash flow exposure estimates that are more highly correlated with direct measures than using an equity index as a control variable.

Pricing Uncollateralized Swaps

An uncollateralized swap hedged back-to-back by a CCP swap is used to introduce FVA. The open IR01 of FVA, however, is a sure sign of risk not being fully hedged, a theoretical no-arbitrage pricing concern, and a bait to lure market risk capital, a practical business concern. By dynamically trading the CCP swap, with the liability-side counterparty provides counterparty exposure hedge and swap funding, we find that the uncollateralized swap can be fully replicated, leaving out no IR01 leakage. The fair value of the swap is obtained by applying to swap's net cash flows a discount rate switching to counterparty's bond curve if the swap is a local asset or one's own curve if a liability, and the total valuation adjustment is the present value of cost of funding the risk-free price discounted at the same switching rate. FVA is redefined as a liquidity or funding basis component of total valuation adjustment, coherent with CVA, the default risk component. A Longstaff-Schwartz style least-square regression and simulation is introduced to compute the recursive fair value and adjustments. A separately developed finite difference scheme is used to test and find regression necessary to decouple the discount rate switch. Preliminary results show the impact of counterparty risk to swap hedge ratios, swap bid/ask spreads, and valuation adjustments, and considerable errors of calculating CVA by discounting cash flow or potential future exposure.

Dynamic Risk Management: Investment, Capital Structure, and Hedging in the Presence of Financial Frictions

AbstractThis article develops a dynamic risk management model to determine a firm's optimal risk management strategy. This strategy has two elements. First, for low‐leverage values, the firm fully hedges its operating cash flow exposure, due to the convexity of its cost of capital. When leverage exceeds a very high threshold, the firm gambles for resurrection and stops hedging. Second, the firm manages its capital structure through dividend distributions and investment. When leverage is low, the firm replaces depreciated assets, fully invests in opportunities if they arise, and distribute dividends, all of these together to achieve its optimal capital structure. As leverage increases, the firm stops paying dividends, while fully investing. After a certain leverage, the firm also reduces investment until it stops investing completely. The model predictions are consistent with empirical observations.

Direct versus Indirect Estimation of Foreign Exchange Cash Flow Exposure

To estimate foreign exchange (FX) cash flow exposure, one may choose between direct and indirect regression approaches, where the direct approach uses accounting-based cash flow data and the indirect approach uses equity returns as a cash flow proxy. The indirect approach typically includes one or more additional independent variables to control for the impact of FX changes on the required rate of return. Frequently, the control variable is an equity index. We argue that a bond return is a better control variable than an equity index. For a sample of U.S. firms, we find empirical support for this idea.

Dynamic Risk Management: Investment, Capital Structure, and Hedging in the Presence of Financial Frictions

This paper develops a dynamic risk management model to determine a firm's optimal risk management strategy. This strategy has two elements: First, for low leverage values, the firm fully hedges its operating cash flow exposure, due to the convexity of its cost of capital. When leverage exceeds a very high threshold, the firm gambles for resurrection and stops hedging Second, the firm manages its capital structure through dividend distributions and investment. When leverage is low, the firm replaces depreciated assets, fully invests in opportunities if they arise, and distribute dividends; all of these together to achieve its optimal capital structure. As leverage increases, the firm stops paying dividends, while fully investing. After a certain leverage, the firm also reduces investment, until it stops investing completely. The model predictions are consistent with empirical observations.

The Market Reaction Associated With SFAS No.8 And SFAS No.52: Did Investors Recognize Differential Economic Content Of Translation Gains And Losses?

<p class="MsoNormal" style="text-align: justify; margin: 0in 0in 0pt;"><span style="font-size: 10pt;"><span style="font-family: Times New Roman;">This study uses the SFAS No.52 functional currency designation as a proxy for the varying economic content of Temporal Method translation gains and losses to refine tests of the market reaction to SFAS No.8 and subsequent foreign currency translation policy events.<span style="mso-spacerun: yes;">  </span>We observe that dollar functional currency MNEs having by definition a relatively greater degree of short-term cash flow exposure are more negatively impacted by accounting policy events beginning with the SFAS No.8 Exposure Draft and extending through the SFAS No.52 Exposure Draft than are local currency functional currency firms having by definition a relatively lesser degree of short-term currency exposure.<span style="mso-spacerun: yes;">  </span>Our results are consistent with intuition suggesting that local currency functional currency firms are negatively impacted only by the adverse earnings implications of largely unrealized translation gains and losses induced by SFAS No.8;<span style="mso-spacerun: yes;">  </span>a condition subsequently alleviated by SFAS No.52.<span style="mso-spacerun: yes;">  </span>Dollar functional currency firms, on the other hand, are negatively impacted by the earnings effects of floating exchange rates on near-term entity cash flows and the largely realized translation gains or losses taken to income under SFAS No.8;<span style="mso-spacerun: yes;">  </span>a condition unchanged by SFAS No.52.<span style="mso-spacerun: yes;">  </span>We conclude that investors did discern the differential degree of MNEs currency exposure relative to the Temporal Method, and that the SFAS No.52 functional currency designation was a relatively important source of information concerning the assessment of the exchange rate exposure of the U.S.-based MNEs.</span></span></p>