Long-term Foreign Currency Research Articles

Does derivative usage boost firm value in an economy with controls? Evidence from India

AbstractThe role of derivatives on firm valuation has recently become a subject of intense debate for emerging markets where there is greater asset price volatility, illiquidity, and the absence of common regulations and accounting standards. Given the lack of data availability, disclosure inconsistency and distinctive regulatory requirements for Indian firms, we assess the impact of corporate hedging via derivative use on the performance of BSE-100 non-financial firms over the period 2010–2017. Our results from keywords-based hand-collected derivative usage data show that all types of derivatives, except rate derivatives, have a significant and positive impact on firm value through channels of reduced earnings volatility and increased leverage with tax benefits. Firms with greater leverage tend to benefit from the use of rate derivatives. Still, among those highly leveraged firms, the ones who experience high earnings volatility are unable to benefit from rate derivatives. Besides, hedge accounting benefits firms in dealing with earnings volatility when they have higher derivatives exposure. As capital controls on international flows can limit the use of derivatives, we show that firms with currency risk exposure in terms of long-term foreign currency debt do benefit from rate derivatives. Our results are also robust with a matched sample for derivative users and non-users. Overall, we conclude that easing regulatory controls on derivatives dealings can be beneficial for firms in growing emerging economies.

The Role of Financial Instruments in Corporate Exchange Rate Risk Management

As international investment increases with the process of economic globalization, managing exchange rate risk efficiently has become one of the most significant strategies for companies to reduce risk and make more profits. Due to the need to consider numerous internal and external factors, risk management is a sophisticated decision that executives need to make effectively. On the basis of accentuating the magnitude of hedging exchange rate risk for corporations and combining previous research findings and theoretical analysis, this research introduces some pragmatic approaches for firms to choose and utilize suitable financial instruments in hedging exchange rate risk, such as the rational use of financial instruments to hedge risks, the use of short-term and long-term foreign currency derivatives to reduce exchange rate risks, and the impact of board structure on hedging activities. The content of the analysis can provide companies with a deeper understanding of the ways to select and utilize the most appropriate financial instruments for risk management, thus improving corporate efficiency and achieving corporate objectives. The study would act as an available tool for corporations to improve efficiency and achieve their goals.

An analysis of Granger causality between sovereign credit rating and economic growth in Sub-Saharan Africa

Interest in the relationship between credit rating and economic growth is growing as emerging economies increasingly integrate into international financial markets. Without credit ratings, developing economies would not have been able to successfully issue their sovereign bonds to support economic growth. Therefore, this paper examines a causality relationship between Standard & Poor’s long-term foreign currency sovereign credit ratings and economic growth in 19 Sub-Saharan countries over the period from 2003 to 2018. The results of the Granger causality tests show a unidirectional causality from sovereign credit ratings to economic growth, not vice versa. This implies that economic growth is not significant in determining sovereign credit ratings. It can thus be concluded from these findings that sovereign credit ratings are proactive actions by rating agencies that are relevant in determining future economic growth. Thus, investors benefit from utilizing credit ratings to prevent inherent information asymmetry in fundamental economic factors. Therefore, it is important for policy makers to pay attention to sovereign credit ratings when formulating macroeconomic policies.

A comparative study of economic growth as a key determinant of sovereign credit ratings in Africa

PurposeThis study is a comparative analysis of the magnitude of economic growth as a key determinant of long-term foreign currency sovereign credit ratings in 30 countries in Africa, Europe, Asia and Latin America from 2010 to 2018.Design/methodology/approachThe analysis applies the fixed effects (FE) and random effects (RE) panel least squares (PLS) models.FindingsThe authors find that the magnitude economic coefficients are marginally small for African countries compared to other developing countries in Asia, Europe and Latin America. Results of the probit and logit binary estimation models show positive coefficients for economic growth sub-factors for non-African countries (developing and developed) compared to negative coefficients for African countries.Practical implicationsThese findings mean that, an increase in economic growth in Africa does not significantly increase the likelihood that sovereign credit ratings will be upgraded. This implies that there is lack of uniformity in the application of the economic growth determinant despite the claims of a consistent framework by rating agencies. Thus, macroeconomic factors are relatively less important in determining country's risk profile in Africa than in other developing and developed countries.Originality/valueFirst, studies that investigate the accuracy of sovereign credit rating indicators and risk factors in Africa are rare. This study is a key literature at the time when the majority of African countries are exploring the window of sovereign bonds as an alternative funding model to the traditional concessionary borrowings from multilateral institutions. On the other hand, the persistent poor rating is driving the cost of sovereign bonds to unreasonably high levels, invariably threatening their hopes of diversifying funding options. Second, there is criticism that the rating assessments of the credit rating agencies are biased in favour of developed countries and there is a gap in literature on studies that explore the whether the credit rating agencies are biased against African countries. This paper thus explores the rationale behind the African Union Decision Assembly/AU/Dec.631 (XXVIII) adopted by the 28th Ordinary Session of the African Union held in Addis Ababa, Ethiopia in January 2017 (African Union, 2017), directing its specialized governance agency, the African Peer Review Mechanism (APRM), to provide support to its Member States in the field of international credit rating agencies. The Assembly of African Heads of State and Government highlight that African countries are facing the challenges of credit downgrades despite an average positive economic growth. Lastly, the paper makes contribution to the argument that the majority of African countries are unfairly rated by international credit rating agencies, raising a discussion of the possibility of establishing a Pan-African credit rating institution.

Do Long-Term Foreign Currency Sovereign Credit Ratings Positively Affect Bond and Equity Market Efficiency in Africa

This study investigates the weak-form efficiency of long-term foreign currency denominated bonds and stocks in incorporating long-term foreign currency sovereign credit rating announcements in 19 African countries over the period of 1994 to 2014. The results of Ljung-Box Q autocorrelation, runs and variance ratio tests find that sovereign credit ratings do not significantly impact bond market efficiency. In contrast, stock markets show evidence of weak form efficiency implying that long-term sovereign credit ratings positively affect equities market efficiency in Africa.

Do long-term foreign currency sovereign credit ratings positively affect bond and equity market efficiency in Africa

Do long-term foreign currency sovereign credit ratings positively affect bond and equity market efficiency in Africa

The impact of sovereign credit rating changes on government bond yields in South Africa

This study applies an event study analysis on Standard & Poor's (S&P), Fitch and Moody's sovereign credit ratings for South Africa over the period 2007 to 2018 to investigate the impact of long-term foreign currency sovereign credit ratings changes on 30-year sovereign bond yield. Results of the analysis find a generally significant increase in bond yields before, during and after credit rating downgrades and negative outlook events. However, there was no statistically significant impact on bond yields associated with upgrades and positive outlook events. It is thus concluded that investors in South Africa's long-term bonds are more sensitive to negative credit rating events, which are mainly driven by structural problems in the economy. This paper recommends monetary and fiscal authorities to address the concerns raised by rating agencies in review reports leading to negative outlook and downgrades before they become more apparent to trigger negative rating actions.

Sovereign Credit Rating Announcement Effects on Foreign Currency Denominated Bond and Equity Markets in Africa

ABSTRACTThis study investigates the net effect of sovereign credit rating announcements on long-term foreign currency denominated bonds and stock markets in 19 African countries over the period of 1994 to 2014. Using a combination of Granger Causality tests and Dynamic Conditional Correlation (DCC) models, the results show that there is a positive relationship between Africa’s stock and bond markets, and weak positive associations between sovereign credit ratings and bond and stock markets. These results imply that both stocks and bonds react negatively (positive) to sovereign credit downgrade (upgrade) announcements. The study further finds that sovereign rating changes affect bond prices more than stock prices because of the volatility in the magnitude of a sovereign downgrade on the default risk premium and bond yields in African markets.

The effects of sovereign credit rating spillovers on neighbouring countries’ financial markets

ABSTRACTThis study investigates the spillover effects of long-term foreign currency sovereign credit rating announcements on foreign currency-denominated bonds and stock markets in 19 African countries during the period of 1994–2014. Using a combination of Granger causality tests and impulse response function, the results show that there is marginal regional sovereign rating spillover impacts that are quickly absorbed into capital markets trading long-term securities. The analysis further shows marginal spillover effects that persist over longer time periods in sovereign ratings of other countries in the same region from a sovereign rating change in one country. These results imply that the regional bilateral linkages between countries serve as channels of capital and sovereign credit rating information flow. Thus, it is imperative for regional countries to pursue prudent developmental macroeconomic policies to avoid negative ratings that will have regional spillover effects.

Do sovereign rating announcements affect emerging market exchange rate correlations? A multivariate DCC-GARCH approach

ABSTRACTThis article investigates the effects of sovereign credit rating announcements on time-varying exchange rate return correlations for a sample of 11 emerging market countries over the period 2002–2015. The data set covers daily exchange rates and long-term foreign currency sovereign ratings, outlooks and watch list. The pairwise time-varying correlations are derived by corrected Dynamic Conditional Correlation (cDCC) modelling which is a member of multivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models family. Furthermore, to capture the global factor effect, a dynamic-weighted index is created by using dynamic principal component (DPC) analysis. Findings suggest that some of the emerging market exchange rate co-movements are affected by rating announcements. Upgrades of Moody’s and downgrades of Fitch lead to spillovers. Main source of these spillovers are sovereign credit rating changes of European countries, especially Czech Republic and Turkey. Countries with high amount of external debt, large current account deficit and speculative grade are more prone to be influenced by announcements on a foreign country’s long-term sovereign rating.

Impact of sovereign rating changes on stock market co-movements: the case of Latin America

ABSTRACTWe aim to determine if long-term foreign currency sovereign rating assessments (from S&P, Moody’s and Fitch) for the advanced emerging Latin American countries (Brazil, Mexico and Chile) have any significant effect on the correlation between their stock market returns in the last decade. With that purpose in mind, we obtain the time-varying correlation by cDCC modeling using ARX-APARCH filtered returns. The analysis shows that the rating changes do not have a significant effect on the correlations in general. After testing for robustness, we reveal that an upgrade to an investment grade level for a country is more likely to positively diversify it from others in the region instead of creating a common positive regional investment environment. Results have important implications for investors and policymakers.

Sovereign credit ratings, capital flows and financial sector development in emerging markets

How does the sovereign credit ratings history provided by independent ratings agencies affect domestic financial sector development and international capital inflows to emerging countries? We address this question utilizing a comprehensive dataset of sovereign credit ratings from Standard and Poor's from 1995–2003 for a cross-section of 51 emerging markets. Within a panel data estimation framework, we examine financial sector development and the influence of sovereign credit ratings provision, controlling for various economic and corporate governance factors identified in the financial development literature. We find strong evidence that our sovereign credit rating measures do affect financial intermediary sector developments and capital flows. We find that i) long-term foreign currency sovereign credit ratings are important for encouraging financial intermediary development and for attracting capital flows. ii) Long-term local currency ratings stimulate domestic market growth but discourage international capital flows. iii) Short-term ratings (both foreign and local currency denominated) retard all forms of financial developments and capital flows. There are important implications in this research for policy makers to encourage the provision of longer-term credit ratings to promote financial development in emerging economies.

A Fabricated Ceiling? The Information Contribution of Bond Ratings

We test whether security prices react to an independent, unanticipated and simultaneous change in the bond rating procedure. It has been problematic in the literature to ascertain whether a borrower's bond price reacts because of a rating change or whether a rating change coincides with a fundamental (or market-perceived) change in the borrower's risk. Moody's unanticipated announcement on June 7, 2001 provides an ideal natural experiment to test for the independent information effect of rating changes. On that date, Moody's eliminated its sovereign ceiling rule allowing a company rating to exceed that of its home country. It placed the long-term foreign currency bonds of 38 companies from 13 different emerging markets, mostly Latin American, on review for an upgrade. We find that the yield spreads of the affected companies fell in a cross-section comparison with control companies on June 8, 2001. However this effect is no longer significant when allowing for a time dimension and not just a limited cross-section comparison on the event date. There is no evidence that companies that a priori would be expected to be more constrained by the sovereign ceiling react more strongly to the announcement. Finally, there is no stock price reaction, even in a cross-section comparison on the event date. That we find little or no security price reaction to Moody's elimination of the sovereign ceiling is a significant result. The sovereign ceiling rule is important to the extent that rating agencies provide information value in pricing emerging market debt. If the independent elimination of the ceiling rule did not contribute new information, then the rule itself may not have been important. There is only one paper that has investigated a change in rating procedures exclusively reflecting rating information. Kliger and Sarig (JOF 2000) assessed the information value provided by Moody's refinement of issued ratings in April 1982. Our paper contributes to this literature on credit ratings as well as to the greater literature on emerging market bonds, which have become the principal source of emerging market finance.

Do Changes in Sovereign Credit Ratings Contribute to Financial Contagion in Emerging Market Crises?

Credit rating changes for long-term foreign currency debt may act as a wake-up call with up-grades and downgrades in one country affecting other financial markets within and across national borders. Such a potential (contagious) rating effect is likely to be stronger in emerging market economies, where institutional investors' problems of asymmetric information are more present. This empirical study complements earlier research by explicitly examining cross-security and cross-country contagious rating effects of credit rating agencies' sovereign risk assessments. In particular, the specific impact of sovereign rating changes during the financial turmoil in emerging markets in the latter half of the 1990s has been examined. The results indicate that sovereign rating changes in a ground-zero country have a (statistically) significant impact on the financial markets of other emerging market economies although the spillover effects tend to be regional.

Misspecification and the pricing and hedging of long-term foreign currency options

This study examines the effects of stochastic volatility upon the pricing and hedging of long-term foreign currency options. The traditional method of pricing such options uses a constant volatility option model with an implicit volatility derived from a short-term traded option. We show that the traditional method leads to small pricing errors for short- and medium-term options, but does a poor job in pricing long-term options. The traditional method also does a poor job for all maturities in determining the derivatives of the option's value with respect to the exchange rate (delta) and the volatility (vega). The errors in calculating these derivatives, which are used in forming the replicating portfolio, lead to large and costly errors in error hedging.

Discussion: The Exposure of Long-Term Foreign Currency Bonds

The unique characteristic of a foreign asset is that the real purchasing power of the cash flows from the asset depends on the exchange rate prevailing on the conversion date. A naive view is that this dependence exposes foreign assets to exchange risk proportional to the volatility of the exchange rate and, other things equal, makes foreign assets much riskier than domestic ones. Anothe extreme is that for nonmonetary foreign assets, purchasing power parity (PPP) causes exchange rates to move inversely todifferential inflation rates, thereby eliminating exchange risk. Aliber and others maintain that a similar argument applies to foreign monetary assets. The international Fisher effect (IFE) causes the exante equilibrium return on all default-free monetary assets, measured in the domestic currency, to be the same regardless of the currency denomination of the instrument. The fact is, however, that PPP and IFE cannot be expected to hold instantaneously throughout time, but only on average over time. Consequently, although foreign assets may promise the same expected return as domestic assets, they will have a higher variance of return as seen by domestic investors. To justify the holding of foreign assets by a domestic investor, one must introduce portfolio considerations, the possibility of consumption expenditures denominated in the foreign currency, heterogeneous expectations, or market imperfections.

The Exposure of Long-Term Foreign Currency Bonds

A currency is not risky because devaluation is highly likely. If the devaluation were certain, there would be no risk at all. A weak currency can be less risky than a strong currency. A strong currency does not become risky because it has been used to denominate a firm's debt.