Financial Hedging Research Articles

Research on Financial Hedging Decision Based on Exchange Rate Risk in Transnational Supply Chain

This paper considers a three-echelon manufacturer-retailer-supplier supply chain, the purpose of which is to investigate the influence of the bilateral exchange rate risks of import and export and the leading company’s financial hedging on the decision-makers of the supply chain. Firstly, it constructs the profit function and the financial hedging decision-making model of each member in the decentralized supply chain. Secondly, it introduces the incentive mechanism of exchange rate risk hedging in the centralized supply chain. Thirdly, from the perspective of wholesale price agreements and revenue-sharing contracts, it discusses the impact of financial hedging behavior and bilateral exchange rate risks on the decision-making process of each member through mathematical modeling. Finally, it explores the relationships of decision variables through simulation analysis. The results illustrate that (i) for decentralized and centralized decision-making, the manufacturer’s expected profit and profit variance decrease with the increase of the fluctuations of import and export exchange rates under the hedging strategy for exchange rate risks; (ii) compared with the decentralized supply chain, the manufacturer’s expected profit in the centralized supply chain decreases slightly under the revenue-sharing contract; (iii) in the centralized supply chain, if the manufacturer’s risk hedging ratio is high, its profit variance is smaller than that of the decentralized supply chain and the expected profits of the retailer and the supplier will increase significantly; and (iv) for the members of the transnational supply chain, centralized decision-making is better than decentralized decision-making.

CAT Bond Pricing in Uncertain Environment

Catastrophe bonds are among the essential instruments in providing a financial hedge for insurance companies and their policyholders. Catastrophic events are rare, and the shortage of data weakens the inference of using probability theory. Uncertainty theory, on the other hand, is a reliable alternative to model these kinds of indeterminacies. We model the problem of pricing catastrophe bonds as an uncertain optimization problem where the maximization of the cedent insurance company’s profit is constrained to the uncertain measure of ruin defined for the investors. Consequently, we balance the concerns of profitability and reasonable protection for the investors and the cedent of the bond, respectively. The solution of the optimization problem is considered as the spread over the LIBOR, which effectively determines the price of the bond. The results depicted the practicality of the modeling, especially the uncertainty theory, in pricing catastrophe bonds. Finally, the basic part of the methodology, on calculating the ruin index, is implemented on a real-world problem, and the results are compared with those obtained using probability theory.

FİNANSAL RİSK YÖNETİMİ VE FİRMA PERFORMANSI: AVRUPA SINIR ÖTESİ BİRLEŞME VE SATINALMALARINDAN BULGULAR

As a result of the increasing volatility in financial markets, the use of financial derivative instruments (forward, futures, option, and swap) has become widespread particularly between large firms around the world. Market risk can be grouped into three categories: exchange rate risk, interest rate risk and commodity price risk. By employing financial derivatives, companies can manage these risks. It is required by International Financial Reporting Standards (IFRS) to reveal their financial positions on financial instruments in their financial reports. The related details in financial reports regarding financial derivatives make it possible to do empirical research on the impact of derivative use on firm value. Along with the mixed results on the relationship among hedging and firm value, empirical research that question the impact of hedging on firm operating activities have been unexpectedly missing. In this study, we aim to examine a significant type of firm operations, cross-border mergers and acquisitions, which is well known for changing a firm’s financial risk exposure. By studying the effect of hedging on firm performance through cross-border M&As, we aim to find out whether and in what way risk management affects firm performance. With a sample of 537 cross-border mergers and acquisitions (M&As) conducted by 14 different developed European companies between 2007 and 2019, we find evidence that acquirers with financial hedging programs have higher cumulative abnormal returns (CARs) than those without such programs around deal announcements. Event study, T-test and Mann-Whitney Test are used as research methods in this study. Additionally, our results show that derivatives users experience longer deal completion times than non-users. Overall, this study provides findings for the European region on the connection between corporate financial hedging and firm performance. Our findings regarding Europe support the previous study in the USA.

Capacity reservation and sourcing under exchange‐rate uncertainty

AbstractWe study a firm's capacity reservation and sourcing decisions under exchange‐rate and demand uncertainty. The firm initially reserves capacity from one domestic and one international supplier in the presence of exchange‐rate and demand uncertainty. After observing exchange rates, the firm determines the amount of capacity to utilize for sourcing under demand uncertainty. The article makes four contributions. First, it identifies the set of optimal capacity reservation policies for sourcing activities: One onshore, two offshore, and two dual sourcing policies. The first dual sourcing policy is a defensive action where the firm rations limited capacity between the two sources. The second dual sourcing policy is an opportunistic approach as it features excess capacity investment in order to benefit from currency fluctuations. The analysis shows how the optimal sourcing policy changes with increasing degrees of exchange‐rate volatility. Second, while earlier publications classify cost as an order qualifier, we find that characterization of a dominant sourcing strategy is more nuanced under exchange rate uncertainty. In particular, a buyer might not reserve capacity at a supplier who has a lower (expected) cost and choose to work only with a supplier who has a higher unit expected cost. Third, the article shows that risk aversion reduces the likelihood of single sourcing, specifically offshore sourcing, and increases the likelihood of dual sourcing. Fourth, the study demonstrates that financial hedging can eliminate the negative consequences of risk aversion and make the policy findings more pronounced.

Option‐based portfolio risk hedging strategy for gas generator based on mean‐variance utility model

AbstractNatural gas generators are promising devices for reducing greenhouse gas emissions. However, gas generators encounter difficulties in the bid‐to‐sell process based on a relatively high levelised cost of energy for power generation. Therefore, a novel risk hedging strategy is developed based on the mean‐variance portfolio theory to reduce the operational risks of gas generators and enhance their profits. Three types of options are utilised and combined to form a portfolio of financial hedges: the short put option, long put option, and short call option. Two types of energy storage devices are used to facilitate the risk hedging process, namely power‐to‐gas and battery devices. Simulation results demonstrate that the proposed risk hedging model can ensure higher profits for gas generators with reduced risk compared to the traditional risk hedging model and a model using only one type of option. Additionally, the varied risk preferences of gas generators lead to varied portfolio combinations. The more risk averse a gas generator, the more likely the long‐put option will be utilised. In contrast, the less risk averse a gas generator, the more likely that short calls will be utilised.

Testing role of green financing on climate change mitigation: Evidences from G7 and E7 countries.

The study estimates the long-run dynamics of a cleaner environment in promoting the gross domestic product of E7 and G7 countries. The recent study intends to estimate the climate change mitigation factor for a cleaner environment with the GDP of E7 countries and G7 countries from 2010 to 2018. For long-run estimation, second-generation panel data techniques including augmented Dickey-Fuller (ADF), Phillip-Peron technique and fully modified ordinary least square (FMOLS) techniques are applied to draw the long-run inference. The results of the study are robust with VECM technique. The outcomes of the study revealed that climate change mitigation indicators significantly affect the GDP of G7 countries than that of E7 countries. The GDP of both E7 and G7 countries is found depleting due to less clean environment. However, green financing techniques helps to clean the environment and reinforce the confidence of policymakers on the elevation of green economic growth in G7 and E7 countries. Furthermore, study results shown that a 1% rise in green financing index improves the environmental quality by 0.375% in G7 countries, while it purifies 0.3920% environment in E7 countries. There is a need to reduce environmental pollution, shift energy generation sources towards alternative, innovative and green sources.The study also provides different policy implications for the stakeholders guiding to actively promote financial hedging for green financing. So that climate change and envoirnmental pollution reduction could be achieved effectively. The novelty of the study lies in study framework.

Financial Hedging, Corporate Cash Policy, and the Value of Cash

AbstractWe study the implications of financial hedging for corporate cash policy and the value of cash holdings. Using a web crawler program to collect data on the use of financial derivatives between 1993 and 2016, we find that US public firms with financial hedging programs have smaller cash reserves but a higher value of cash than firms without hedging contracts in place. Our empirical results are robust when controlling for potential endogeneity issues, corporate governance, cash regimes and alternative measures of cash holdings. Further, we find that financial hedging not only increases the investment sensitivity to internal cash, but also has a positive effect on investment efficiency. The positive effect of financial hedging on the value of cash is more pronounced for firms with more financial constraints, higher information asymmetry and weaker corporate governance. Collectively, our paper highlights the importance of corporate cash policy as a channel through which financial risk management increases firm value.

Financial hedging and operational flexibility as instruments to manage exchange‐rate uncertainty in multinational corporations

AbstractResearch SummaryLiterature that compares the advantages of financial hedging and operational flexibility as instruments to manage exchange‐rate uncertainty presents inconsistent results. This study addresses such inconsistencies in two ways. First, it clarifies that the effects of financial hedging and operational flexibility are asymmetric. Financial hedging helps an MNC to reduce a negative effect of exchange‐rate uncertainty on firm value, whereas operational flexibility allows an MNC to enhance a positive effect of exchange‐rate uncertainty on firm value. Second, the study demonstrates that these effects are contextual to the MNC's subsidiary network. Depending on whether exchange‐rate correlation in the subsidiary network is positive or negative, either financial hedging or operational flexibility is more effective than the other. Regressions on a sample of U.S. manufacturing firms support the predictions.Managerial SummaryMultinational corporations face exchange‐rate fluctuations in their subsidiary networks as a source of substantial uncertainty. MNCs can manage this uncertainty using financial hedging and operational flexibility. However, the literature is inconclusive on whether MNCs can use both instruments in equal measure. This study clarifies that financial hedging allows MNCs to limit negative consequences of exchange‐rate uncertainty on their stock‐market valuations. Operational flexibility, by contrast, gives MNCs the opportunity to exploit exchange‐rate uncertainty and thereby to enhance their firm value. In addition, the study proposes that the effectiveness of financial hedging and operational flexibility depends on the individual MNC's subsidiary network configuration. Based on these findings, MNCs can identify the effective instrument for managing exchange‐rate uncertainty.

Mandatory governance reform and corporate risk management

Using the Sarbanes-Oxley Act of 2002 as a quasi-natural experiment to identify the impact of corporate governance reform on foreign exchange risk hedging, we find that the substantial improvements in governance standards increased derivatives hedging and reduced foreign exchange exposure. The results are robust whether we consider initial reform gap or actual implementation, focus on legally required governance measures or include voluntary concomitant reforms. The economic magnitude of the effect is large. Our findings are corroborated by cross-sectional evidence, showing that firms with larger foreign markets exposure and a larger distortion in CEO incentives react more strongly to the reform. Financial hedges are implemented rapidly whereas exposure measures that encompass operational hedges take more time to adjust.

Supporting Operations with Financial Hedging: Cash Hedging Vs. Cost Hedging in an Automotive Industry

Financial hedging of raw material prices and exchange rates has become an integral part of many manufacturers' operating practices. Previous empirical research suggests that a desire to avoid financial distress and the affiliated curtailment in operations is one of the strongest hedge motivations. Taking the hedging motivation as given, we examine the effectiveness of two data‐driven hedging policies at mitigating financial distress in the car manufacturing industry. The first policy is the “cost hedging” policy, under which the carmaker hedges raw material and production input purchases. This policy appears to be in wide use in practice. The car manufacturer needs to trade in aluminum, steel, zinc, and plastic to achieve the cost hedge. The second policy is a “cash hedging” policy under which the firm hedges its net cash flow. To determine a cash hedging policy, the firm solves a stochastic program that minimizes its hedge cost subject to cash flow constraints. The program solution suggests that the firm needs to trade S&P500, aluminum, and zinc to implement the hedge. Our results reveal that the most critical drivers of hedging decisions appear to be demand shifts, especially demand elasticity shifts. The least important drivers are car design updates, which change the car's raw material requirements. This finding sheds light on why cost hedging, which focuses on hedging raw materials, is less effective than the cash hedging technique, which hedges both costs and demand.

Demand Response as a Real-Time, Physical Hedge for Retail Electricity Providers: The Electric Reliability Council of Texas Market Case Study

Residential demand response (DR) programs are generally administered through an electricity distribution utility, or an electric grid operator. These programs typically reduce electricity consumption by inducing behavioral changes in the occupants of participating households. We propose implementing a wholesale-price-sensitive residential DR program through the retail electricity provider (REP), who has more naturally aligned incentives to avoid high wholesale electricity prices and maintain customer satisfaction, as compared to distribution utilities, grid operators, and the average residential consumer. Retail electricity providers who serve residential consumers are exposed to substantial price risk as they generally have a portion of their portfolio exposed to variable real-time wholesale electricity prices, despite charging their residential customers a fixed retail electricity price. Using Monte Carlo simulations, we demonstrate that demand response, executed through internet-connected thermostats, to shift real-time residential HVAC load in response to real-time prices, can be used as an effective physical hedge, which is both less costly and more effective than relying solely on financial hedging mechanisms. We find that on average a REP can avoid USD 62.07 annually per household using a load-shifting program. Given that REPs operate in a low margin industry, an annual avoided cost of this magnitude is not trivial.

Risk Trading in Energy Communities

Local energy communities are proposed as a regulatory framework to enable the market participation of end-consumers. However, volatile local market-clearing prices, and consequently, volatile cost give rise to local market participants with generally heterogeneous risk attitudes. To prevent the increased operational cost of communities due to conservative trading decisions in the forward stage, e.g., a day-ahead market, we propose risk trading in energy communities via financial hedging products, the so-called Arrow-Debreu securities. The conditional value-at-risk serves as our risk measure for players to study different degrees of market completeness for risk. We define a risk-averse Nash game with risk trading and solve the Nash equilibrium problem for an incomplete market for risk as a mixed complementarity problem. We show that such a Nash equilibrium problem reduces to a single optimization problem if the market is complete for risk. Numerical findings indicate that a significant community cost saving can be realized when players engage in risk trading and sufficient financial hedging products are available. Moreover, risk trading efficiently protects less risk-averse players from highly risk-averse decision-making of rival players.

Financial hedging and corporate investment

Building on the well-documented relationship between corporate financial hedging and firms' borrowing costs, this study examines the impact of utilizing financial derivative instruments on corporate investment. We document that engaging in financial hedging enables firms to pursue more inorganic growth opportunities in the form of M&As. Acquiring firms with financial hedging programs have a lower borrowing cost and are more likely to pay for their deals with cash and use external borrowing. While financial hedging serves as a vehicle for firms to bring their inorganic investment plans to fruition by facilitating their financing, it also leads to inferior investment choices when conflicts of interest among managers and shareholders are more likely to arise. Our study shows for the first time that the financial flexibility emanating from corporate financial hedging can give rise to agency costs by instigating entrenched managers to overinvest.

Apakah Financial Dan Operational Hedging Efektif Mengurangi Eksposur Nilai Tukar?

n the midst of regulators' efforts to deepen the market by encouraging foreign exchange derivative transactions, this study aims to observe the effect of these derivative instruments from company perspective in reducing exchange rate exposures. In addition to hedge using derivative instruments (financial hedging), this study also observed hedging performed through firm’s operational activity (operational hedging) with control variables of export sales and foreign debt. The research object is manufacturing companies listed in IDX (Indonesia Stock Exchange) during 2010-2018 using panel data regression as data analysis method. Empirical results show that financial hedging reduce exchange rate exposures faced by companies while operational hedging has no effect. Export sales provide positive exchange rate exposures and foreign debt provide negative exchange rate exposures.

Efficiency or resiliency? Corporate choice between financial and operational hedging

We propose that firms face two potential defaults: Financial default on their debt obli- gations and operational default such as a failure to deliver on obligations to customers. Hence, financially constrained firms substitute between saving cash for financial hedg- ing to mitigate financial default risk, and spending on operational hedging, which mitigates operational default risk. Whereas corporate financial hedging increases in leverage, operational hedging declines in leverage. This results in a positive relation- ship between operational spread (markup) and financial leverage or credit risk, which is stronger for financially constrained firms.We present empirical evidence supporting this relationship.

Knowledge discovery with Deep RL for selecting financial hedges (AAAI 2021 KDF Presentation slides)

Knowledge discovery with Deep RL for selecting financial hedges (AAAI 2021 KDF Presentation slides)

Persistence as an Optimal Hedging Strategy

Bacteria invest in a slow-growing subpopulation, called persisters, to ensure survival in the face of uncertainty. This hedging strategy is remarkably similar to financial hedging, where diversifying an investment portfolio protects against economic uncertainty. We provide a new, to our knowledge, theoretical foundation for understanding cellular hedging by unifying the study of biological population dynamics and the mathematics of financial risk management through optimal control theory. Motivated by the widely accepted role of volatility in the emergence of persistence, we consider several models of environmental volatility described by continuous-time stochastic processes. This allows us to study an emergent cellular hedging strategy that maximizes the expected per capita growth rate of the population. Analytical and simulation results probe the optimal persister strategy, revealing results that are consistent with experimental observations and suggest new opportunities for experimental investigation and design. Overall, we provide a new, to our knowledge, way of conceptualizing and modeling cellular decision making in volatile environments by explicitly unifying theory from mathematical biology and finance.

Effect of Financial Hedging on Capital Investments of Non-Financial Firms

Effect of Financial Hedging on Capital Investments of Non-Financial Firms

Family Business and Transaction Exposure

This study provides additional evidence and insight into theories on transaction exposure as it empirically examines the magnitude of transaction exposure in Kuwait, a developing country. Specifically, it investigates factors that might influence Kuwaiti firms’ responses to their transaction exposure and how being a family business or part of a family business group could play a mediating role in this response. Through conducting a questionnaire survey with the largest 147 industrial and commercial Kuwait firms, the results of a multinomial logistic regression indicate that theories on financial hedging seem to be inapplicable in the Kuwaiti case. However, these theories provide only partial explanations for management behavior in response to the transaction exposure of Kuwaiti companies. Findings show that a firm being part of a family business group is significantly correlated with its level of hedging, suggesting that firms that are members of a family group of businesses are expected to hedge at a higher level. This points to other theories, such as institutional theory, as playing greater roles in explaining the transaction exposure behaviors of firms in developing countries, and also suggests that family-controlled businesses are expected to engage in more innovative financial strategies and hedge at a higher level. The research findings imply that Kuwaiti firms need to be more aware of their transaction exposure and pay more attention to the related issues. Training programs in risk-management strategies should be provided to decision makers to help them evaluate the hedging strategies they employ. This study shows how different behaviors toward risk exist between firms that operate in developed and developing countries, including the effect of being part of a family business resulting in firms engaging in more innovative financial strategies when dealing with risk.

Supporting Operations with Financial Hedging: Cash Hedging Versus Cost Hedging in an Automotive Industry

Financial hedging of raw material prices and exchange rates has become an integral part of many manufacturers’ operating practices. Previous empirical research suggests that a desire to avoid financial distress and the affiliated curtailment in operations is one of the strongest hedge motivations. Taking the hedging motivation as given, we test two data-driven hedging policies to see how effective they are at mitigating financial distress in the car manufacturing industry. The first policy is the cost hedging policy, under which the carmaker hedges raw material and production input purchases. This policy appears to be widely in use. The car manufacturer needs to trade in aluminum, steel, zinc, and plastic to achieve the cost hedge. The second policy is a cash hedging policy under which the firm hedges its net cash flow. The firm solves a stochastic program with a min hedge cost objective and cash flow constraints to construct the cash hedge. Its solution suggests that the firm needs to trade S&P500, aluminum, and zinc to implement the hedge. Our results further reveal the relative importance of different market factors on the automaker’s hedging policy. The most critical drivers of hedging decisions appear to be demand shifts, especially demand elasticity shifts. The least important drivers are car design updates, which change the car’s raw material requirements. This finding sheds light on why cost hedging, which focuses on hedging raw materials, is less effective than the cash hedging technique, which hedges both costs and demand.