Currency hedging at firm level

Currency hedging is taking a position and using derivatives to acquire either an asset, cash flow, or contract to offset the unexpected change in its existing position value (Eiteman et al, 2009). Hull (2009) found that most hedging theory is based on the assumption that shareholders have as much information about the risk faced by their firm as does the company's management. Rene and Stulz (1996) investigate 530 companies defined that hedging is a practice that risk manager's prediction of future market to influence the hedged exposure percentage. Brown (2001) after investigating HDG Inc., found three motivating factors for firm to hedge. Firstly, smoothing earnings, which can effectively reduce the taxes. Next, based on the hedge rate, it will be easier for managers to facilitate internal contracting. Finally, benefits from acquiring competitive pricing in the market. Houston and Muller (1988) found that firms hedge more with growth in foreign operations. Moreover, Geczy, Minton, and Schrand (1997) examined Fortune 500 companies' currency hedging activities, found that firms combined with high growth opportunities and low financing ability have strong preference of currency derivatives. This result is consistent with Froot, Scharfstein, and Stein's (1993) hedging theory.

Usually, the firms use derivatives to eliminate the foreign exchange exposure, such as transaction exposure, operating exposure, and translation exposure (Eiteman et al, 2009). About the first form, corporate managers mainly use traditional risk management products like derivatives to deal with it. Concerning the operating exposure, the firm always denominates part of its capital in overseas, and makes the movement of the firm's cost and revenue in tandem, which will eliminate the currency risk. This approach also called natural hedging. Copeland and Joshi (1996) found the evidence by investigating nearly 200 firms, state that natural hedging will be a superior and easier approach than focusing on hedging firm's cash flow.

Specifically, Brown (2001) examined FX hedging activities of structuring the derivatives portfolio, suggest that for illiquid currency, forward will be a better choice than options; For hedging behavior, statistical analysis which use recent hedging and managerial historical data can used to direct it; For hedging policies, exposure and FX rate volatility can determine it. Further, Williamson (1988) found that concerning exchange rate exposure, the competition and the ratio of overseas sales to total sales are also the key determinants, and the prediction of further competitiveness of respective industry should base on the further work on FX exposure.

Regarding the relationship between the portfolio hedging and the currency hedging, Fama and French (2004) state that based on the Capital Asset Pricing Model (CAPM), the risk the firm faced can be clarified into systematic risk and unsystematic risk, if we diversifying our portfolio in the multinational market level (Brown and Reilly, 2009), the unsystematic risk which also the most of currency risk can be hedged. Suppose an investor holds two stocks IBM and Lenovo, when Renminbi depreciated, the fall in IBM's share price will be offset by the gain in the Lenovo's share price. Thus by using portfolio hedging, the currency risk can also be offset. According to Modigliani-Miller, hedging cannot change the firm's and shareholders' values unless they lower the taxes of the firm (Miller, 1988), because the hedging merely changes the unsystematic risk of company's cash flow, while the required return is based on the systematic risk. Thus firm's value cannot increase by hedging due to the investor still use the required return to discount the same cash flow (Eiteman et al, 2009). Moreover, Eiteman, Moffett and Stonehill found that the currency risk management may reduce the value of firms' cash flow, because risk management itself cannot increases any intrinsic value, whereas it normally consume some of the shareholder's resource.

Further, Copeland and Joshi (1996) after an examination of the difference between optimal hedge and unhedge among 200 large companies state that the former merely reduced less than 10% of cash flow volatility, but has not significantly eliminated the total cash flow volatility. And it is also very likely for non-financial firms to overhedge at two or three times than the optimal hedge position. Even the firms could make an optimal hedge today, no one can guarantee tomorrow's hedge still optimal (Adam and Fernando, 2006).

However, in the real world, without hedging, contrary to the Modigliani-Miller theory, the unsystematic risk may reduce shareholder's value (Eiteman et al, 2009), because while hedging reduces the currency risk of firms further cash flow, it also reduced the likelihood of firm's cash flow falling below the minimum level, consistent with Nance, Smith and Smithson (1993) finance theory. There are several severe factors can cause financial distress problems to the firm, then result costly process, such as accountants, lawyers, "fire-selling" assets. The higher the risk of the firm has, the higher the compensation is for the risk manager, thus reducing the risk level can effectively save money for the firm. This suggests that at the corporate level the shareholder's value can be benefited by hedging (Eiteman et al, 2009). Allayannis and Weston (2001) examined 720 large nonfinancial companies during the period from 1990 to 1995, discovered robust evidence showing that the firm using Foreign Currency Derivatives has a higher value than firms that remain unhedged by 4.87%.

Regarding Hedging's disadvantages to the shareholders, "agency problems" is quite common in recent years. Essentially, corporate managers have incentives to make their firms to grow excess the optimal size. Because the higher growth of the firm, the more power under the manager's control, and also the higher compensation to the manager, due to the amount of the compensation to the manager is positively relate to the firm's growth (Murphy and Kevin, 1985). Nowadays, compares with reward managers by bonus year to year, companies prefer reward them through promotion (Baker and George, 1986), but toward firm's supply, this also caused strong organizational bias. Next disadvantage is the difficulty for shareholders to outguess their risk manager tries to make money by speculation or reduce risk by hedging. Finally, it becomes increasingly difficult for firms to get expertise and internal controls to eliminate the potential risk arise from derivatives trading.

Remember in January 1985, Deutsche Lufthansa AG, the largest airline in Germany, has signed a contract of $500 million with Boeing of buying 20 Boeing 737 jets, and these 20 Boeing 737 airplanes will be delivered in one year. At that time, spot exchange rate is DM3.2/$, that is DM1.6 million contract worth, and The U.S dollar already appreciated for several years against deutschemark. Many currency analyst and advisor stated the dollar is overvalued, as well as Heinz Ruhnau, the chairman of Lufthansa, believed that the dollar would depreciated against DM and fall soon. However, because the contract size is too large, remain a unhedge position means left huge risk to his firm. The current forward rate of 360 day was DM3.2/$, same as spot rate, since same interest rate of Eurodollar and Euro Deutschemark. Finally, Heinz Ruhnau make a compromise, he covered $250 million of contract at forward rate of DM3.2/$, and leave the rest with unhedged.

In the end, as Heinz Ruhnau expected, the dollar fall sharply to DM2.3/$ by January 1986 and the total amount of money paid to Boeing reduced to DM1.375 billion:

One-half with forward contract: $250,000,000×DM3.2/$=DM800, 000,000.

One-half with unhedged: $250,000,000×DM2.3/$=DM575, 000,000.

Here the problem is that Lufthansa still need to consider the amount of forward cost, DM225, 000,000. So totally it is significantly higher than fully unhedged. As a result, Heinz Ruhnau was been heavily criticized by his organization.

Ruhnau's hedging strategy is basically reasonable, the one-half of contract covered by forward is used to protect firm against adverse significant change of exchange rate, and the rest used to make profit if dollar move in his favor, but there are four mistakes inside it: Firstly, Ruhnau purchasing Boeing aircraft at the wrong time, when all of the currency analyst and advisor even himself believed the U.S dollar is overvalued, and will fall soon, he should be more patient for the price change in dollar before he sign the contract; Secondly, Ruhnau should hedge half of the exposure when he expected dollar to fall; Thirdly, compare with the forward, we suggest purchasing put option with underlying of U.S dollar, because lower of the dollar price, the higher profit Ruhnau obtains from it.

In conclusion, though currency hedging has several disadvantages like agency problems, arguments for outguessing risk managers' behavior between speculation or hedging, and its expense to shareholders' resource. It still highly necessary for firms, especially for companies doing multinational business, though hedging itself cannot produce any intrinsic value, but it can eliminates FX risk in firms' operation, which effectively secured shareholder's value. Next, currency hedging can alleviate firm's financing pressure, which is crucially useful for firms founded in developing country that still weak in capital raising. Thus, based on the relevant academic evidence and our deduction, currency hedging add shareholder values at firm level.

Reference:

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