Currency Hedging Research Articles

The Effect of Foreign Currency Hedging on External Financing

Existing theory offers two divergent views on the effect of hedging on external financing. One view is that hedging allows a firm to reduce its reliance on external finance when capital market imperfections make external finance more costly than internally generated funds. A contrasting view is that by reducing information asymmetries and/or volatility, hedging reduces external financing costs and hence motivates firms to increase their reliance on external financing. In this paper, I provide empirical evidence on the effect of foreign currency hedging on external financing. My results suggest foreign currency hedgers raise more external financing than nonhedgers. In addition, although financially constrained hedgers raise less external financing than financially unconstrained hedgers, financially constrained hedgers raise more external financing than financially constrained nonhedgers. Further, I find that the difference in external financing between hedgers and nonhedgers is driven by both debt and equity financing.

Currency Hedging - A Free Lunch?

Currency Hedging - A Free Lunch?

Global Currency Hedging

Over the period 1975 to 2005, the US dollar (particularly in relation to the Canadian dollar) and the euro and Swiss franc (particularly in the second half of the period) have moved against world equity markets. Thus these currencies should be attractive to risk-minimizing global equity investors despite their low average returns. The risk-minimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the US dollar. There is little evidence that risk-minimizing investors should adjust their currency positions in response to movements in interest differentials.

The Effect of Foreign Currency Hedging on External Financing

The Effect of Foreign Currency Hedging on External Financing

Foreign Currency Hedging and Firm Value: A Dynamic Panel Approach

Foreign Currency Hedging and Firm Value: A Dynamic Panel Approach

The Term Structure of Currency Hedge Ratios

Many firms face product price risk in foreign currency, uncertain costs in home currency and exchange rate risk. If prices and exchange rates in different countries interact, natural hedges of foreign exchange risk might result. If the effectiveness of such hedges depends on the hedge horizon, they might affect a firm's usage of foreign exchange derivatives and lead to a term structure of optimal hedge ratios. We analyze this issue by deriving the variance minimizing hedge position in currency forward contracts of an exporting firm that is exposed to different risks. In an empirical study, we quantify the term structure of hedge ratios for a ' typical ' German firm that is exporting either to the United States, the United Kingdom or Japan. Based on cointegrated vector autoregressive models of prices, interest rates and exchange rates, we show that the hedge ratio decreases substantially with the hedge horizon, reaching values of one half or less for a ten-years horizon. Our findings can (partly) explain the severe underhedging of long-term exchange rate exposures that is frequently observed and have important implications for the design of risk management strategies.

Foreign Currency Hedging and Firm Value: A Dynamic Panel Approach

Foreign Currency Hedging and Firm Value: A Dynamic Panel Approach

Foreign Currency Hedging and Firm Value: A Dynamic Panel Approach

The Modigliani and Miller (1958) irrelevance proposition suggests that in perfect capital markets a firm’s hedging policy does not affect its value, since shareholders can undo any hedging activities implemented by the firm. Recent theories, however, argue that when capital markets are imperfect, hedging can increase a firm’s value by influencing its expected taxes, expected financial distress costs and investment decisions.1 More recently, researchers have examined the effect of hedging with derivatives on firm value. For example, Allayannis and Weston (2001) find that in a broad sample of firms, the value of firms that hedge foreign currency risk is, on average, 4.87 percent higher than non-hedgers, and Carter, Rogers and Simkins (2006) find that fuel hedging increases firm value by 5 to 10 percent for a sample of US airlines.

The Effect of Foreign Currency Hedging on the Probability of Financial Distress

This paper investigates the effect of foreign currency hedging with derivatives on the probability of financial distress. I use Merton's (1974) option pricing model to compute firms' distance to default as a proxy for their probability of financial distress. Using an instrumental variables approach to control for endogenous hedging and leverage, I find that the extent of foreign currency hedging is associated with a greater distance to default, and hence a lower probability of financial distress. Whereas previous research finds that the probability of financial distress is a determinant of a firm's hedging policy, this paper provides direct evidence supporting the hypothesis that the extent of hedging reduces a firm's probability of financial distress.

Family Firms, Agency Costs and Risk Aversion - Empirical Evidence from Diversification and Hedging Decisions

We analyse whether family firms differ from non-family firms in terms of business segment and geographical diversification or the application of currency hedging instruments. This analysis is based on a unique dataset of 339 publicly listed companies (1,561 firm years) in the German Prime Standard from 2002 to 2006. While there is widespread empirical evidence on differences between family and non-family firms in terms of corporate performance, comparatively little is known about the impact of family firm dimensions on firm behaviour. We try to fill this research gap with a single country study focusing on Germany, an economy where family-control traditionally plays a predominant role in corporate governance. We find that family firms are less diversified in unrelated business segments. However, there are no differences between family firms and non-family firms in terms of overall and related business segment diversification. For geographical diversification, we do not find convincing evidence for any differences. Finally, our analysis indicates that family firms are less likely to use currency hedging instruments. In a second step, we go beyond existing research and distinguish between two separate dimensions of family firms: family management and family ownership. Empirical results indicate that those two dimensions have conflictive effects on firm behaviour. Family management, i.e. the involvement of the founding family into firm management, reduces agency costs and thus leads to lower levels of business segment diversification and less currency hedging. In contrast family ownership leads to risk aversion and more business segment diversification. Overall, the family management aspect is more likely to dominate the family ownership aspect.

Applying Regret Theory to Investment Choices: Currency Hedging Decisions

We apply regret theory, an axiomatic behavioral theory, to derive closed-form solutions to optimal currency hedging choices. Investors experience regret of not having chosen the ex-post optimal hedging decision. Hence, investors anticipate their future experience of regret and incorporate it in their objective function. We derive a model of financial decision-making with two components of risk: traditional risk (volatility) and regret risk. We find results that are in sharp contrast with traditional expected utility, loss aversion, or disappointment aversion theories. We discuss the empirical implications of our model and its ability to explain observed hedging behavior.

Applying regret theory to investment choices: Currency hedging decisions

We apply regret theory, an axiomatic behavioral theory, to derive closed-form solutions to optimal currency hedging choices. Investors experience regret of not having chosen the ex post optimal hedging decision. Hence, investors anticipate their future experience of regret and incorporate it in their objective function. We derive a model of financial decision-making with two components of risk: traditional risk (volatility) and regret risk. We find results that are in sharp contrast with traditional expected utility, loss aversion, or disappointment aversion theories. We discuss the empirical implications of our model and its ability to explain observed hedging behavior.

The Term Structure of Currency Hedge Ratios

Many firms face product price risk in foreign currency, uncertain costs in home currency and exchange rate risk. If prices and exchange rates in different countries interact, natural hedges of foreign exchange risk might result. If the effectiveness of such hedges depends on the hedge horizon, they might affect a firm's usage of foreign exchange derivatives at different horizons and lead to a term structure of optimal hedge ratios. We analyze this issue by deriving the variance minimizing hedge position in currency forward contracts within a basic model of an exporting firm that is exposed to different risks. In an empirical study, we quantify the term structure of hedge ratios for a typical German firm that is exporting either to the United States, the United Kingdom or Japan, using a cointegrated vector autoregressive models of prices, interest rates and exchange rates. Our main empirical result shows that the term structure of hedge ratios is clearly decreasing for all currencies considered, going down to a half or less for a hedge horizon of ten years. We have found that one explanation is that revenue risk increases more strongly with the hedge horizon than does exchange rate risk. The main reason, however, lies in the correlation structure between different risks that varies with the hedge horizon due to cointegration relations; i.e., we observe natural hedges at long horizons. As a consequence, hedging effectiveness decreases much less with the hedge horizon than hedge ratios. For long horizons, there can also be substantial differences between currencies. For instance, the ten-years hedge ratio for the British Pound still amounts to 53% in comparison to 34% for the US Dollar. In contrast, the difference for shorter horizons of up to two years is very small. In conclusion, our findings can (partly) explain the severe underhedging of long-term exchange rate exposures that is frequently observed and have important implications for the design of risk management strategies.

Export and Strategic Currency Hedging

This paper examines an international Cournot duopoly wherein a home firm and a foreign firm compete in the home market under exchange rate uncertainty. The foreign exporting firm, being risk averse, has incentives to hedge its exchange rate risk exposure. In a two-stage setting, we show that hedging via an unbiased currency futures market acts as a strategic device. In particular, under either constant or decreasing absolute risk aversion, an increase in the hedging volume of the foreign firm promotes its exports and deters the home firm’s output. In contrast to the well-known full-hedging result in a perfectly competitive environment, we find that the foreign firm over-hedges for strategic reasons. Furthermore, the separation result from the hedging literature under perfect competition no longer holds in our duopoly framework, i.e., equilibrium output levels depend on the risk attitude of the foreign firm as well as the probability distribution of the spot exchange rate.

A dynamic stochastic programming model for international portfolio management

We develop a multi-stage stochastic programming model for international portfolio management in a dynamic setting. We model uncertainty in asset prices and exchange rates in terms of scenario trees that reflect the empirical distributions implied by market data. The model takes a holistic view of the problem. It considers portfolio rebalancing decisions over multiple periods in accordance with the contingencies of the scenario tree. The solution jointly determines capital allocations to international markets, the selection of assets within each market, and appropriate currency hedging levels. We investigate the performance of alternative hedging strategies through extensive numerical tests with real market data. We show that appropriate selection of currency forward contracts materially reduces risk in international portfolios. We further find that multi-stage models consistently outperform single-stage models. Our results demonstrate that the stochastic programming framework provides a flexible and effective decision support tool for international portfolio management.

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Foreign Currency Hedging and Firm Value: A Dynamic Panel Approach

Foreign Currency Hedging and Firm Value: A Dynamic Panel Approach

Active Currency Hedging Strategies for Global Equity Portfolios

His article examines, for 21 developed countries, whether active currency hedging strategies can outperform currency benchmarks: 100% unhedged, 50%/50%, and 100% hedged. We consider four active currency strategies: 1) the “selective” strategy that consists in hedging when the forward rate is at a premium, 2) the “large premia” strategy that consists in hedging only when the premium is large, 3) the momentum strategy, and 4) the mean-reverting strategy. Results for the 1992–2004 period show that, overall, the selective strategy outperforms the other strategies at 12- and 1-month horizons. Results for sub-periods show that no strategy continuously dominates. <b>TOPICS:</b>Global, developed, currency

Behavioral currency hedging for international portfolios

The purpose of this paper is to incorporate behavioral issues as it relates to the active currency hedging of international portfolios in the context of traditional expected utility maximization approach. The uniqueness of the approach is that separate risk aversion parameters are introduced for asset and currency markets. The paper is similar in spirit to Black (Black, F. 1989, Universal hedging, Financial Analysts Journal (July–August), 16–22.), who argued that a portion of foreign equity investments should be permanently unhedged, which is basically postulating that one should take a buy-and-hold position in currency with a fraction of the capital. The behavioral twist included in the traditional expected utility maximization approach results in lower hedge ratios, ceteris paribus, partly due to the asymmetric nature of the compensation structure of currency managers. Since the asymmetric nature of incentive schemes of asset and currency managers dictates how one optimizes the investment portfolio of a pension or endowment fund, the unusual behavior of a given institutional fund manager should not be called “irrational,” only because the optimal currency hedging level deviates from the one derived under rational expectations. This only justifies the use of different hedging strategies by various institutional investors. We describe in detail how the level of hedging should be revised downwards because of behavioral factors. Conclusions are in the context of what people would predict to see in the market, if certain investors behave in an “irrational” way.

Foreign investment with inflation-linked securities: A natural hedge under Fisher theory?

All foreign holders of U.S. dollars currencies face significant risk of unfavorable currency exchange movements, proportional to the amounts they hold. Some of these risks can be hedged to an extent, but the costs of doing so can be significant, and errors in execution or maintenance of the hedges can cause serious capital losses. Today the vast holdings of China and others creates currency risk on an unprecedented scale. China alone now has a total in excess of a trillion (1 × 10 12) U.S. dollars, which makes traditional approaches to hedging problematic at best. 1 1 At this writing, China has a reported $1.07 trillion in reserves: Batson, Andrew (2007), “China May Get More Daring with Its $1.07 Trillion Stash”, The Wall Street Journal, February 15, 2007, C1. A year earlier it was reported that “[China] will soon release statistics showing it has passed Japan as the biggest holder of foreign currency the world has ever seen. Its reserves already exceed $800 billion and are on track to reach $1 trillion by the end of the year, up from just under $4 billion in 1989.” Keith Bradsher, The New York Times, Sunday, February 26, 2006. http://www.nytimes.com/2006/02/26/weekinreview/26bradsher.html?_r=1&pagewanted=all&oref=slogin. This paper analyzes the potential hedging effectiveness of investing foreign dollar holdings in U.S. inflation-indexed securities under Fisher's Identity. To the extent that Fisher's Identity and its derivative theories hold, foreign investors can effectively protect the purchasing power of their dollar balances, and earn an assured rate of return. Investment in inflation-indexed securities does not incur the additional expenses that swaps and currency hedges do.