Chapter One: Introduction And Background
Multinational companies, exporters, importers, individual investors, and firms with operations overseas are all subject to exchange rate risk. According to these firms, any fluctuation in the exchange rate is a serious risk to be addressed, as it's believed to affect future and current cash flows, value of company assets abroad, competitors' reactions, and the firm market value. Several risk management tools were used by companies to hedge exchange rate exposure. While currency derivatives is still the most common way used for hedging, some firms prefer using operational hedging tools such as foreign earnings or foreign debts as a substitute for foreign currency derivatives. This chapter will be sectioned as follows: Section one will aim to provide an introduction to exchange rate exposure. Section two will give an introduction to derivatives and hedging by illustrating why companies use derivatives and shedding a light on the drawbacks of derivatives use. It will also illustrate the literature point of view about the different types of hedging. Section three will discuss the objectives of the dissertation. Section four will summarize the structure of this paper.
1.2 Exchange Rate Exposure:
The exchange rate is explained as how much one unit of a specific currency is worth in terms of another currency. After the end of the Second World War, the Bretton Wood Agreement (1944) evolved where 44 countries adopted a new international monetary system (IMS) and agreed to fix their exchange rates to the United States Dollar (Hereafter: US $) plus or minus 1%. On the other hand, the US $ was pegged to gold. This system had succeeded in bringing stability to exchange rates over a period of 30 years. However, after the break down of the Bretton Wood System in February 1973, which took place two years after stopping the convertibility of US $ into gold, a new monetary system evolved which was known as the Free Foreign Exchange Market. In this system exchange rates were determined on the basis of offer and demand. The new system has greatly increased the volatility of exchange rates where according to Ching (2007) "it is believed that exchange rates became four times as volatile as interest rates and ten times as volatile as inflation rates."
In a world crowded with multinational companies (MNC) where it is believed that around 60,000 MNCs exist. Companies importing their raw material from one country and marketing their products in another, and with more firms relocating to China, India and Far East countries due to the cheap labor while Europe and US are being the market for these products. Exchange rate exposure is being a major factor in affecting companies' cash flows stability and relatively profits. However, properly hedging the exchange rate exposure companies will maintain their cash flows stability and avoid the exchange rate mitigations. On the other hand, if companies fail in managing its exchange rate exposure, its stock return will be affected and relatively its market value.
The investigations of exchange rate exposure started with Shapiro (1975). He suggested that depreciation in a home currency increases the value of a home currency firm. Shapiro study was followed by Adler & Dumas (1984), who believed that even firms with no operations overseas would still be affected by the exchange rate exposure. Several studies came after that addressing exchange rate exposure on a firm level and industrial level and its effect on a firm value such as Jorion (1990), Bortov & Bodnar (1994), Bodnar & Gentry (1993), Amihud (1994). Although some studies have agreed with one another but there was no one common conclusion derived out of all these studies.
In literature, exchange rate exposure is divided into three categories that vary according to the impact of exchange rate changes on a firm. These types are:
- Accounting Exposure:
Accounting exposure is referred to also as translation exposure. It occurs when firms with subsidiaries overseas need to consolidate their financial statements and foreign currencies have to be converted to local one. However, such translation might affect the parent company net worth or net income thus raising the concerns of exchange rate exposure.
- Economic Exposure:
Economic exposure refers to the effect of exchange rate fluctuations on the firm market value that is measured through discounting its expected future cash flows.
Economic exposure = Transaction + Operating exposures
- Transaction exposure: "It occurs from changes in the value of foreign currency contracts as a result of exchange rate changes" (Thompson). While Operating exposures "arises because exchange rate changes may alter the value of future revenues and costs." (Thompson).
1.3 Derivatives and hedging
Derivatives referred to as off balance sheet instruments are defined as "a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables" (Hull 2005:1). Examples of derivatives can be as simple as a stock, bond, and commodity. Derivatives dealing historically started back in the 19th century for hedging purposes using future trade with commodities. However, some consider derivatives nowadays as speculative instruments that allow big profit opportunity.
Derivatives are of several kinds such as Forwards, Futures, Options, Swaps, Laps, Basket, and Swaptions. However, the most commonly used derivatives are:
- Forwards: A Forward contract is an agreement between two financial institutions or a financial institution and one of its clients to buy or sell a product on a specific future date for a specific price. Forward contracts are traded over the counter and they are widely used by banks.
- Futures: Future contracts are contracts between two parties to buy or sell a specific asset on a specific future date for a specific price. Futures are traded on exchanged and they are for both financial assets and commodities. One of the most famous exchanges for Futures is Chicago Board of Trade and Chicago Mercantile Exchange (CME).
- Options: Option contracts are of two types, Put option and Call option. A Call option is the right but not the obligation to buy an asset at a specific future time for a specific amount of money. A Put option gives its holder, the right but not the obligation to sell the asset for a specific price at some date in the future. Options are traded over the counter and on exchanges.
- SWAPS: SWAPS are defined as the agreement to exchange a stream of future payments. The most common kind of swaps is interest rate swaps.
Derivatives dealers are categorized in three groups, Hedgers, Speculators, and Arbitragers.
- Hedgers: Are those who find shelter in derivatives from the risks that could affect their investments such as interest rate risk, exchange rate risk, and commodity price risk. They invest in both sides to avoid risk.
- Speculators: Speculators are those who also want to have a position in the market, so they use derivatives to bet either on the increase or the decrease of the price; in most cases they affect the share price and the currency exchange rate through their speculations. Speculators profit is gained through the continuous changes in the prices.
- Arbitrageurs: They are an important group in the derivatives market. "Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more markets. They are in the market to take advantage of a discrepancy between prices in two different markets." (Hull 2005:1)
Over the last 20 years, derivatives market have expanded to include more products that serve the needs of investors and firms using them, the expansion was in order to serve the objective of all financial policies that is maximizing shareholders wealth. A recent survey conducted by ISDA (International SWAPS Derivatives Association) in the year 2003, showed that over 92% of the 500 largest corporations throughout the world uses derivatives. This fact evolves the question of what reason drive the company to use derivatives. According to literature and previous studies, the following reasons are the main motives behind the companies' derivatives usage:
- Risk Management: Derivatives are means of financial hedging. They are a risk management tool that firms use to eliminate the uncertainty inherited in the financial markets such as asset risk, interest rate risk, foreign exchange risk, credit risk. In a survey questioning 415 US firms about the reason that lies behind there usage for derivative instruments, Phillips (1995) concluded that 78% of the studied sample makes use of derivative instruments for financial risks management purposes. In studying a UK based sample of FTSE 250 companies, Marshall and Grant (1997) concluded that companies mainly make use of derivatives (swaps, forwards, & options) in order to diminish the cash flow fluctuations. Similarly, in studying a sample of 530 US nonfinancial firms Bodnar et.al (1998) concluded that the core reason behind derivatives usage is keeping the cash flow fluctuations to its minimum. In a recent study, Gibson (2007) concluded "market participants, commercial banks, investment banks, and investors appear to find a variety of credit derivatives products to be useful for their own risk management purposes". Similarly, in a study of 74 Brazilian firms Saito and Schiozer (2005) concluded that managers use derivatives of risk management purposes rather than speculation in order to manage their risk concerns of taxation and accounting issues.
- Value Increasing: Managers tend to use derivatives in order to maximize the firm value through decreasing the volatility of their cash flows that is caused by the changes in exchange rates, interest rates, etc... Clark, Judge and Ngai (2006) studying a sample of 227 Hong Kong and Chinese firms found that hedging creates value for each one of the firms. Similarly, Graham and Rogers (1999) determined that derivatives use increases a firm market value through increasing debt capacity and lowering interest expenses. According to Froot, Scharfstein and Stein (1993) (cited in Nguyen, Faff 2002:8) "hedging through the use of derivatives adds value by insuring that the generation of internal funds is not disrupted by external factors, such as adverse movement in exchange rates, interest rates of commodity prices." According to Froot et al (1993) (citied in Judge 2006: 412) derivatives use "helps ensure the firm has sufficient funds which enable the firm to avoid unnecessary fluctuations in either investment spending or costly external financing and so it increases firm value". Bartram et al. (2006) in studying a sample of 7309 firms across 48 countries concluded limited evidence supporting the fact that foreign currency derivatives use and increase in firm value.
- Financial Distress: "Bankruptcy may involve several real costs for the firm, such as the cost of losing stable relationships with suppliers or costs of reorganization" (Spano 2008). Smith and Stulz (1985) discussed that hedging reduces the cost of financial distress by diminishing the probability of acquiring these costs. In a questionnaire survey for understanding the motives that lies behind the UK multinationals usage of derivatives, Joseph & Hewins (1997) concluded that there is weak evidence on the financial distress motive. According to Clark & Judge (2006) "UK Firms risk management decisions are consistent with the extant theory relating to financial distress". Clark, Judge and Ngai (2006) found a very strong relation between hedging decision and the cost of financial distress for a sample of Chinese and Hong Kong firms.
- Tax Advantages: Smith and Stulz (1985) discuss that hedging creates a tax advantage for the firms using derivatives. In explaining Smith and Stulz (1985) point of view regarding tax incentives, Graham and Rogers (1999) stated that firms can use hedging to eliminate the taxable income uncertainty and that hedging allow firms to earn an expected income X with a lowered tax liability. However, Spano (2008) found weak evidence between hedging and tax advantages for U.K firms, however he found some evidence for tax advantages for those firms who hedge against two risks of exchange rate exposure and interest rate risk.
1.3.2 Disadvantages of Derivatives Usage:
Despite the numerous positive impacts discussed above that derivatives might leave on a firm risk, derivatives had been harshly criticized especially after what was observed through the huge derivative losses in the mid 1990's (such as the loss of Orange County, around $ 1 Billion in SWAPS contracts and went bankruptcy). This draws the attention to the drawbacks of derivatives. Previous studies have included the following drawbacks or disadvantages:
- Miss use or Crime: El Masry (2006b) mentioned some of the disasters caused by derivatives that were discussed previously in the work of Kaprinsky (1998) and Singh (1999) ("Sumitomo corporation lost $3500 million in 1996 because of Copper Futures ; Metallgesel Schaft lost $1800 million from oil futures in 1993; Kashima Oil lost $1500 million from FX derivatives in 1994") where El Masry associated these losses not to a problem with derivatives themselves but with the way they were used or misused.
- Additional Costs: These include transaction cost and agency cost. These two are considered additional costs which are associated with the use of currency derivatives, the issue that was discussed previously and covered by Allen & Santomero (1998).
- Credit Risk: "While derivatives cut down on the risks caused by a fluctuating market, they increase credit risk. Even after minimizing the credit risk through collateral, companies will still face some risk from credit protection agencies" (Gordon 2006).
The word hedge is financially defined as "a securities transaction that reduces the risk on an already existing investment position." Dictionary.com, "hedge," in The American Heritage Dictionary of the English Language, Fourth Edition. Source location: Houghton Mifflin Company, 2004. http://dictionary.reference.com/browse/hedge. Available: http://dictionary.reference.com. Accessed: October 09, 2009.
Hedging types vary between natural hedge, operational hedge, and financial hedge. Natural hedging is a hedge without the use of complicated financial instruments. It's the matching between the cash inflows and the cash outflows. A good example of natural hedging is a UK based company importing its goods to the US newly opened a factory in the states, its investment in the US based factory natural hedged its exchange rate exposure between GBP and US $. Operational Hedging is managing the risk and maintaining cash flow variability through company's operations, such as domestic currency invoicing. Financial hedging is defined as hedging through the use of financial instruments such as derivatives.
Firms might hedge risks such as interest rate risk, exchange rate risk, equity, and securities lending. However, although hedging is used by firms to limit their losses, it's important to note that hedging also limit firms potential gains. Companies hedging strategy varies based on its management risk management experience specially that hedging tool sophistication is in a rapid increase, and based on its shareholders approach toward financial price risk. Moreover, it's important to note that two companies within the same industry and facing similar types of risks might still vary in choosing their hedging strategy.
1.3.4 Financial Hedging Versus Operational Hedging:
Talking about exchange rate exposure and its financial hedging tools, it's important to shed the light on other hedging tools that have been studied in previous literature and been applied by firms facing such a risk. Operational hedging strategies are adopted by plenty of firms to cover their exchange rate exposure.
According to Logue (1995) operational hedging is the most effective way for long term managing of exchange rate exposure. Studying the effectiveness of operational hedging on exchange rate exposure of MNCs before and after the Asian financial crisis, Pantzalis et al. (2000) determined a significant negative relation between operational hedging usage and firms' exposure. Similarly, Choi and Jiang (2008) studied a sample of US MNCs and non MNCs, found a significant impact for operational hedging in decreasing firms' exchange rate exposure and increasing firm value. Another study conducted by Pantzalis et al. (2001) using a sample of US MNCs determined that operational hedging proxied through the firm's network of operations can significantly affect its exchange rate exposure. However, according to Chiang & Lin (2004) using a sample of Taiwanese firms for the period of 1998-2002, operational hedging is not an effective way of managing exchange rate exposure for the studied sample.
According to previous literature, a debate has been running about which hedging strategy is more effective in managing firms' exchange rate exposure and avoiding the variability in its cash flows. It has been also a point of question whether operational hedging acts as a substitute or complement for financial hedging. According to Nam et al. (2005) study of 424 US firms for the period of 1996-2000, financial and operational hedging were both determined to be completing each other with both being effective in decreasing MNCs exchange rate exposure and increasing their firm value. Similarly, studying a sample of 208 US multinationals for the period of 1994 - 1998, Simkins et al. (2001) concluded a complementary relation between financial and operational hedging strategies. Their study suggested a negative relation between FCD usage and exchange rate exposure. It also concluded that operating networks dispersion associate in reducing firms' exchange rate exposure. Hankins (2007) examined in her paper firms risk management strategies. She found a significant negative relation between operational and financial hedging. Based on her analysis, Hankins concluded that firms' usage of FCD decrease for one or two years following an acquisition (i.e. acquisition is considered as an operational hedging activity according to Hankins study). Studying the corporate risk management of MNCs, Chowdhry and Howe (1999) concluded a complement relation between financial and operational hedging for an optimal financial hedging policy. Similarly, Al-Shboul (2007) studied the financial and operational hedging for a sample of 181 Australian firms by applying Jorion (1991) model for detecting firms' exchange rate exposure. He found strong evidence that the usage of both hedging strategies together significantly decrease firms' exchange rate exposure, suggesting a complementary relationship between the two. Moreover, in their study Allayaniss & Ofek (2001) concluded that firms use both types of hedges in hedging their exchange rate exposure. Similarly, Wong (2005) determined a compliment relation between financial and operational hedging for firms to reach optimal output. However, according to Wong (2005) operational hedging is determined as more effective than the financial one, and adapting both types of hedging is too costly for firms. Differently, Allanayiss, Weston, and Ihrig (2001) findings implied that financial hedging is the most effective among the two strategies, while adopting both strategies is the best. However, according to Lim and Wang (2001), who studied financial and operational hedging (determined through diversification), concluded that the two complete each other and suggested that "using financial hedging instruments can increase the benefit obtained from diversification since financial hedging and corporate diversification are effective for different types of risks". According to Bartram et al. (2009) operational and financial hedging each decrease firms' exposure to exchange rate by 10% - 15%, while both applied together reduces the exposure by 40%.
Finally, in a study about firms' managing exchange rate uncertainty conducted by Deloitte (2006) , an audit firm ranked 3rd globally between the big four audit companies, recommended the following: "Financial hedging strategies are suitable for mitigating small and short term currency fluctuations. But to circumvent the effects of large, long term shifts in the dollar's value, companies are well advised to adopt operational hedging strategies". This finding is consistent with Chowdhry and Howe (1999) and Davis and Militello (1995) conclusions.
1.4 Dissertation Objectives:
The dissertation in hand aims to investigate the relationship between derivative use and exchange rate exposure; it also seeks to test the exchange rate exposure for the United Kingdom (UK) general retailers' industry firms. Research in the area of derivatives is new, where in the UK it's only since the year 1998 where companies started being obliged under the FRS (13) to include corporate hedging activities in financial statements footnotes. However, some firms still take advantage of the FRS (25) accounting standards exemption and do not include this information in their annual reports. While in the US, the SFAS 105 issued in the year 1994 made it mandatory for the firms to include off balance sheet activities in their annual reports. Since that time academics started to research more the derivatives use by firms and try to understand the reasons why derivatives are being used. However, it's worth mentioning that before the accounting regulations force companies to include such data in their annual reports, researchers was trying to do that through sending surveys to companies in a way to know whether they use derivatives or not.
Most of the derivatives researches to date were based on US multinationals, some on the Asian companies (Japan) and few on UK firms. This reason gives more importance for this study to work as an additional evidence for the derivatives research outside the US and based on a UK industry where results and circumstances might be different from those of the US. According to Bartram et al (2006) "The US may not be the best laboratory for examining derivatives usage. Since it is among the most financially stable countries in the world, financial risk management with derivatives may be less critical for US firms". (Bartram et al 2006:5)
From the other hand, personally, this study is of various importances as it contributes a lot to my knowledge repertoire and personal development. Moreover, it serves as a profound base for my future plans in being engaged in careers related to equity derivatives and financial risk management.
This paper is expected to answer the following questions:
- What is the exchange rate exposure?
- What is the effect of derivatives use on the exchange rate exposure?
1.5 Dissertation Structure:
This paper is structured as follows: Chapter one already discussed the exchange rate exposure, derivatives instruments and reasons why they are used by firms with shedding a light on the drawbacks of derivative use. It also gave an overview of hedging with discussing some of the previous empirical studies regarding the usage of operational and financial hedging. Chapter one consisted of the two research questions that worked as a motive for investigating this topic. Chapter two gives the reader information about most of the previous empirical studies related to the topic and the conclusions they drew. Chapter two will serve as a good base to compare the findings of this study with those of previous researchers. Chapter three will discuss the methodological approach used in this study. It will also provide a description for the sample used for this study, the variables used and the reasons why they were chosen, as well as the resources been used during this study. Chapter four will describe the results of the regression and cross-sectional analysis; it will also discuss the analysis results in light with the previous literature findings. Section five will summarize the work done, conclude, and recommend for future researches.
Chapter Two Literature Review
Risk management is a term that has widely spread among corporations over the past decade. Its importance has evolved progressively over the span of those years until it has contributed to nowadays corporations an essential pillar for risk limitations and management. Risk management has also gained more significance with more corporations expanding and seeking business overseas besides the huge increase in the number of multinationals worldwide, exchange rate exposure. Along with that, hedging through derivatives has been an area of interest for plenty of researchers interested in financial risk management specially after "SFAS 105 required firms to report information on financial instruments with off balance sheet risk such as futures, options, and swaps" (Allayannis & Ofek 2001) where the access for the information became much easier than before.
This part of the paper intends to highlight over relevant previous studies in order to review derivatives' use and exchange rate exposure. This chapter will be divided into three sections. Section one will discuss the studies related to exchange rate exposure and its effect on a firm market value. Section two will discuss the studies related to the relation between derivatives use and exchange rate exposure. Section three will focus on the studies related to derivative use and its effect on a firm market value.
2.2 Empirical Studies on Exchange Rate Exposure:
Globalization has affected every single aspect of life. By invading the whole world, globalization has made countries open to one another in terms of trading and exchanging technologies, commodities and all sorts of products; moreover, it has caused firms to indulge more in the import-export process and foreign sales activities. The changes caused by globalization make a reasonable explanation for the question marks behind firms being vulnerable to several risks including, but not limited to, exchange rate fluctuations as well as commodity price fluctuation. To elaborate on this, a simple example from Airbus company can be referred to. According to the Airbus company chairman, the company's costs are mainly denominated in Euro while a large percentage of its revenues is in United States ( US) $ indicating a 1 billion Euro loss in the case of 10 cent Euro appreciation against US $. In literature, foreign exchange exposure (referred to also as economic exposure) is defined as the effect of unexpected changes in exchange rates on the value of firms. According to the classical exchange rate exposure theory, a firm in its home country will benefit from the depreciation of its country currency, in contrast to foreign firms that will be harmed from such depreciation. This effect of course concerns managers, investors and analysts. The reason which pushed many researchers to investigate firm's exchange rate exposure till our present day.
As a matter of fact, the majority of the studies concerned about the exchange rate exposure have been interested in studying the US firms and US multinationals. For instance, Jorion (1990) investigating a sample of 287 U.S multinationals concluded that only 5% of the studied firms are significantly affected by exchange rate exposure on a 5% level. The week exposure level found in Jorion (1990) results was consistent with those of Amihud (1994), Bartov & Bodnar (1994). Studying the exchange rate exposure for U.S, Canada, & Japan on an industrial level Bodnar & Gentry (1993), concluded that 20-35% of industries are exposed to significant exchange rate fluctuations in each of the three countries. Allayannis and Ofek (2001) interpret these results as the possibility that US multinationals fully cover their exchange rate exposure through hedging activities. Studying the exchange rate exposure of US MNCs Hanshin and Soenen (1999) realized that small MNCs are more exposed to exchange rate than large ones. They also concluded that hedging is not effective in eliminating this risk and that small MNCs benefit from a depreciation of the US $ in the international market. However, Choi and Prasad (1995) in studying a sample of 409 U.S multinationals concluded "a significant exchange rate exposure to trade weighted value of the U.S dollar for just 14.9% and 10% of U.S multinationals at the 10% level" (Cited in Bartram and Bodnar 2005). Allayannis and Ihrig (2000) using a sample of 82 U.S manufacturing industries over the period of 1979 and 1995, concluded that only 4 out of 18 industries have a positive exchange rate exposure. Kim and Choi (2002) studied the exchange rate exposure for a sample of US firms that have reported Asian sales over the period of 1997 - 2002. They found that 30% of the studied companies', their values are significantly affected by the lagged changes in the real exchange rate.
Talking about Asia, in studying the exchange rate exposure for Taiwan exporting firms, Chiao (2002) concluded that Taiwan firms were jointly exposed to exchange rate fluctuations over a period of three transitional periods of Taiwan's economy. Moreover, according to He and Ng (1998) study of the exchange rate exposure for a sample of 171 Japanese firms "at least 25% of the 171 firms have a significant positive exchange rate exposure". In contrast to He and Ng (1998) results; a study analyzing the exposure of 1110 Japanese firms listed on the PACAP over the period of 1975 to 1992, Chow and Chen (1998) determined that around 80% of these firms had a negative exchange rate exposure. Qing (2007), studied a sample of large Japanese multinationals listed on the Directory Of Multinationals. He applied Jorion (1990) model and concluded a significant exchange rate exposure in 42.5% of the firms by applying weekly data, and a 31.3% exchange rate exposure by applying monthly data. Parsley and Popper (2003) studied a sample of East and South Asian firms, concluded that most of the studied firms have a significant positive exchange rate exposure to US $, Yen, and sometimes Euro. Aybar and Thirunavukkarasu (2005) studied a sample of 106 emerging markets MNCs. They found that 60% of the companies analyzed have a positive exchange rate exposure. They also concluded that emerging markets MNCs firm value increases with the appreciation of the local currency.
In Europe, some studies have been concerned in both the industrial as well as the firm level. However, only few researchers have been interested in studying the exchange rate exposure post and pre Euro to determine the Euro effect on exchange rate exposure. El Masry (2006a), in studying the exchange rate exposure for UK non financial firms on an industrial level, found that several UK industries such as (Transport, Retail, Construction, Food, Oil, Gas and Telecommunications) have a positive exchange rate exposure while diversified industries such as Aerospace and defense are not subject to any exchange rate risk. Another study conducted by Jong, Lingternik and Macrae (2002) using a sample of Dutch firms over the period of 1994-1998 realized that over 50% of the firms are positively exposed to exchange rate risk. Similarly, Solano (2000) studied the exchange rate exposure for 71 non financial firms listed on the Spanish Stock Exchange Market between the periods of 1992-1997; his results indicated "the existence of economic exposure in about 20% of companies and that export and import are decisive factors in the level of economic exposure to exchange rate risk." Domniguez & Tesar (2001) studied the relationship between stock returns and exchange rate exposure for a sample of firms from eight countries including the UK. According to their study, a significant impact was detected for exchange rate exposure on the firms share value.
Along with the Euro evaluation, many studies emerged to study the exchange rate exposure being a single European currency. Studying a sample of French firms, Nguyen, Faff and Marshall (2004) concluded that "the Euro led to a reduction in both the number of firms that have significant exchange rate exposure and absolute size of the exposure" (Nguyen, Faff, and Marshall 2004). Interestingly, the result showed a sort of reliability by remaining consistent with Bartram and Karolyi studies whose conclusion revealed the same results (2002). However, on the other hand and in a more recent study addressing the exchange rate exposure on a firm level for the Euro zone, using a sample of 1147 European firms in 7 Euro zone and 4 non Euro zone European countries, Huston and O'driscoll (2009) realized that after Euro, the exchange rate exposure has increased for both Euro zone and non Euro zone firms, while the exposure increases in those Euro zone firms was more significant that the non Euro zone firms.
As mentioned previously, exchange rate exposure is a real risk that contributes a real fear for managers, investors and analysts. In fact, it is believed that such exposure causes a fluctuation in the firms' future cash flows and relatively the future value of the firm. In studying the effect of exchange rate exposure on firms value, Doukas, Hall, and Lang (2001) analyzed a sample of 1079 firms traded on Tokyo Stock Exchange (TSE) over the period of 20 years (1975- 1995). Their study concluded a significant relation between exchange rate fluctuations and firms' value. Similarly, Amihud (1994) using a quarterly data of 32 U.S exporting firms concluded a lagged effect of exchange rate exposure on a firm value. Also, Choi and Prasad (1995) studying a sample of 409 U.S multinationals over the period of 1978- 1989 concluded that firms value is significantly affected by both real and nominal exchange rates.
Opponents; however, disagree with the idea that exchange rate exposure have a real significant impact on a firm value. For example, Hudgen & Turner (1995) argued that real exchange rate cannot be included as a pricing factor because it fails to meet the normal significant tests. Using a unique sample database from 18 different countries over 25 years, Doidge, Griffim and Williamson (2002) determined that several firms are subject to exchange rate exposure to an extent that can't be linked to chance and that a big portion of firms' value fluctuation can't be explained as due to exchange rate fluctuation. These results were consistent with Jorion (1990) and Amihud (1994) findings. However, those results were argued by Qing (2007) stating that " the lack of significant evidence of exchange rate exposure documented in previous literature is due to the reason that the selection of exchange rate index doesn't appropriately capture the firm's sensitivity to exchange rate changes" (Qing 2007).
2.3 Empirical Studies on Derivatives Use & Exchange Rate Exposure:
"To mitigate exchange rate uncertainty, it has been claimed that hedging, not only financial hedging, but also operational hedging can protect companies from unexpected movements of exchange rates" (Allayannis, Ihrig, and Weston 2001 ).
As the literature previously discussed, exchange rate exposure is a main risk that firms usually fear due to its effect in declining its future cash flows. Financial hedging, hedging through derivatives, is one way of risk management tools used by firms to decrease their exchange rate exposure, due to the believed negative relation between those off balance sheet contracts and exchange rate exposure. Plenty of studies were conducted to determine the effect of derivatives on exchange rate exposure especially after the SFAS 105, where the information of derivative use became available for researchers in companies annual reports.
Allayannis & Ofek (2001), using a sample of S&P 500 non financial firms, studied the firms behavior toward the use of FCD (Foreign Currency Derivatives), whether it's for hedging or speculative purposes. Their findings suggested a negative relation between exchange rate exposure and FCD implying that firms use FCD in order to hedge their risk rathen than speculate in the financial market. Similarly, El Masry (2006b) in surveying the derivative use of 407 UK non financial firms concluded that derivatives are most commonly used by firms trying to manage their exchange rate exposure risk, which suggest the negative effect between exchange rate exposure and derivative use. In a study of UK multinationals, Joseph (2000) concluded that all firms in his sample were using derivatives to hedge exchange rate exposure. However, studying a sample of all listed companies on the Taiwan stock exchange over the period of 2001 - 2005, Lin, Wu, and Ho (2007) concluded that all analyzed firms usage of derivatives was for speculative purposes rather than hedging their exchange rate exposure.
In studying the effect of derivative usage on exchange rate risk; Cheon, Duchac, & Goldberg (1996) found a significant relation between the increase in use of derivatives and the decrease of risk. Similarly, studying a sample of Swedish firms, Nydahl (2001) concluded a negative relation between exchange rate exposure and derivatives use. Using FCD as a proxy for financial hedging, Chen Qing (2007) concluded that FCD are capable of effectively reducing the level of exchange rate exposure for a sample of 75 large Japanese multinationals. Hagelin and Pramborg (2002) studying a sample of Swedish firms to determine the effect of hedging on exchange rate exposure; they concluded that financial hedging (FCD and/or foreign denominated debt) was effective in reducing the exchange rate exposure for those firms using it. Anand & Kaushik (2008) studied the motives that lie behind the use of FCD in corporate India, using a sample of 620 companies that are greatly exposed to exchange rate risk (transaction exposure in 74.5% of companies, translation exposure in 58.3% of firms, and economic exposure of 54.3% of firms), Anand & kaushik determined that 96.1% of managers in the studied firms use FCD for hedging the exchange rate exposure and to improve the firms value. Similarly, in studying a sample of Australian firms, Nguyen & Faff (2002) investigated the role of FCD in alleviating foreign exchange rate exposure, they concluded that Australian firms are extensively exposed to exchange rate fluctuations and that firms use FCD in order to hedge this risk and maximize the firm value; they also concluded that FCD are more effective in reducing short term foreign exchange exposures compared to longer term once. In a recent study examining 176 France largest nonfinancial firms Clark & Mefteh (2009) concluded a strong negative relation between foreign currency derivative use and firms' exchange rate exposure. Studying the exchange rate exposure of a sample of Brazilian firms, Jose (2008) found that companies' exchange rate exposure declined after their use of derivatives and foreign debt. Bartram, Brown & Minton (2009) studied the exchange rate exposure of global firms, their findings suggested that operational hedging can decrease the exchange rate exposure of a global firm by a range of 10% - 15%. However, financial hedging through foreign currency derivatives together with foreign debt can decrease firms' exchange rate exposure up to 40%. Using a sample of Taiwanese nonfinancial firms; Chiang & Lin (2004) concluded that foreign currency derivatives are an effective way of hedging exchange rate exposure.
On the other hand, few contradictory conclusions to those mentioned above were found in literature. Examples of those might include Lingerink & Macrae (2002), studying a sample of Dutch firms concluded no significant effect of derivative use on exchange rate exposure. Also, Allayannis, Brown, and Klapper (2001) studied the behavior of East Asia firms during the Asian financial crisis, they found that FCD failed to protect the firms using it from exchange rate exposure, and that firms that were using FCD before the crisis performed as poorly as those who didn't. Studying a sample of 471 non financial European firms, Muller & Verschoor (2005) concluded a weak effect of the foreign currency derivatives usage and companies' exchange rate exposure. Studying a sample of US 94 non-financial MNCs, Anderson & Makar concluded that changes in derivative usage between the periods of 1996-1998 and 1998-2000 are due to ineffective hedging of the exchange rate exposure.
2.4 Empirical Studies on Derivative Use & Firm Value:
Despite the fact that classic Modigliani and Miller (hereafter: M&M) paradigm suggests "that hedging is irrelevant to the firm and can be done by shareholders on their own by holding well diversified portfolios" (Allayannis & Weston 2001), literature have always linked derivative use to firm value. Recent studies have had an opposing point of view of M&M and have come to conclusions supporting the view that hedging is a value increasing strategy for firms.
According to Smith and Stulz (1985) hedging can be motivated through incentives and that firms that hedge for a market value maximization can achieve that through benefiting from three different incentives which he categorize as tax incentives, cost of financial distress, and managerial risk aversion. Similarly, Graham & Rogers (2002) concluded that hedging rewards a firm with a tax incentive that on average can increase a firm value by 1.1%; beside the other hedging benefits of increased debt capacity and cost of financial distress. In studying a sample of gold mining industry and in consistency with the managerial risk aversion mentioned previously in Smith & Stulz (1985), Tuffano (1996) determined a positive relation between the use of commodity derivatives and the value of stocks held by managers and directors. According to Hagelin et.al study of Swedish firms they found that managers while studying hedging activities, they hedge to protect their personal remuneration rather than shareholders benefit.
According to Allayannis and Weston (2001) study of a sample of 720 large non financial firms, firms that apply a hedging strategy experience an increase in their firm value while those who used to hedge and decide to stop their hedging strategy experience a decrease in their firm value. Similarly, Carter et. al (2006) using a US airline industry sample in studying the jet fuel hedging, concluded that jet fuel hedging is positively related to U.S airline firm value. They concluded that hedging increases firm value between 12% - 16%. Another recent study conducted by Clark, Judge, and Belghitar (2008) considering a sample of UK firms in studying the value effects of foreign currency and interest rate hedging for UK firms, they concluded larger value effect s for hedging in increasing a UK firm value compared to a US one, the thing that he associated with higher expected financial distress costs for UK firms compared to those of U.S. In an international study of 7309 international firms Bartram et al (2006) "finds that hedging is associated with higher firm value only for certain risk such as interest rate risk". In a recent study, Bartram, Brown & Conrad (2009) analyzing a large sample of companies from 47 different countries, they concluded that derivatives use increase firm value and eliminate each of systematic risk and total risk. Studying a sample of Swedish companies, Hagelin et al determined that companies that use foreign currency derivatives have a higher premium than those of non users; according to their study derivative use significantly increase firm value. A similar result was conducted; using a sample of Brazilian firms for the period of 1996 - 2005, Rossi & Laham (2008) determined a positive relation between FCD usage and firms' value. In studying a sample of Swedish firms, Hagelin (2003) concluded that firms use foreign currency derivatives in order to hedge their transaction exposure and increase their firm value. He found no significant impact between hedging translation exposure and adding value to the firm.
However, some studies have agreed with M&M and determined that derivative use have no effect or a very little significant effect on a firm market value. Jin and Jorion (2004) using the Q ratio in studying 119 U.S oil and gas producers found no difference between hedgers and non hedgers. However, these results was argued by many studies that followed Jin and Jorion (2004), while according to Simkins (2006) Jorion results were a consequence of his own sample. In questioning the results of Graham and Rogers (2002), "that derivative induced debt capacity increases firm value by 1.1% on average" (cited in Jin & Jorion 2004), Guay and Kothari (2003) studied a sample of 234 large non financial corporations. They determined that the effect of exchange rate exposure on a firm cash flow is insignificant so how come the use of derivatives would be that significant to affect a firm value? A recent study by Lookman (2004) using a sample of oil and gas E&P (exploration and production) firms argued that most of the previous papers that proved hedging increases a firm value have hedged a secondary risk, which means hedging a primary risk should make a more significant increase in a firm value. However, after his testing he concluded that " firms that their primary risk trade at a discount compared to their un-hedged counter parts, while firms that hedge a secondary risk trade at a significant premium " (Lookman 2004). In studying a sample of Australian firms, Reynolds (2003) found that hedging through derivatives does not increase the firm value as no difference in value was found between firms that uses derivatives and those who doesn't.
One recent study conducted by Ben Khidari and Folus (2009) studying a sample of French firms and questioning the ability of hedging in increasing firm value. Interestingly, their findings were against literature and previous researchers since they concluded that derivative users had a lower firm value than those of non-users. Their study suggested a new probability in the literature of hedging.
Given these contrasting theoretical implications, the relation between hedging and firm value will remain as an open question for present and future researchers to prove.
Chapter Three: Research Methodology
This chapter will discuss the methodological approach used to answer the research questions. The methodological approach used by Allayannis & Ofek (2001), who investigated the effect of foreign currency derivatives on firms' exchange rate exposure will be closely followed. This chapter is sectioned as follows: Section one will consist of the sample description of the companies used in the analysis. Section two will discuss the hypothesis of this study. Section three will define the models that will be used in the testing for getting the empirical results. Section four will define the variables of the analysis. Section five will consist of the sources been used in retrieving the data.
3.2 Sample Description:
The initial sample consisted of the companies recognized under the UK general retailers industry sector (60 companies), however 20 companies was excluded from the beginning of the study due to the unavailability of their historic data in the DataStream Database and 40 companies was taken for this study whose historical data were available in the Data Stream Database from the period of 05/1/2000 till 31/12/2008. This sample was chosen for two reasons. First, the retail industry was determined to have a positive exchange rate exposure by El Masry (2006a), so it was interesting to study the exposure on a firm level and determine whether derivatives are being effective in decreasing firms' exposure. Second the sample consists of large firms which are more likely exposed to exchange rate exposures due to their export/import activities such as WH Smith, Next, and Marks & Spencer. The sample consists of companies that use foreign currency derivatives, 47.5% of the studied companies use foreign currency derivatives which are considered as a moderate percentage in comparison with previous studies, such as EL Masry (2006b) 67 % of the studied sample used derivatives, Allayannis and Weston (2001) 40% of the companies were derivative users. Since these companies are from retail industry sector and considered as non financial firms then there use of derivatives is for hedging purposes rather than for financial purposes as they are not considered as market makers. In order to form a better understanding of the UK retail industry market, I have divided this section into two. Section one will give an over view of the UK economy. Section two will give an over view of the UK Retail industry sector.
3.2.1 UK Economy Overview:
The UK population is around 61 million inhabitants distributed over England, Scotland, and Wales. The UK is one of the most globalised countries in the world. Follwing Germany and France the UK economy is considered the third largest economy in Europe. The UK got the third highest purchasing power parity in Europe after Russia and Germany. As of September 2009 the UK gross domestic product is 317.4 billion with a decrease of 5.5 billion of that in 2008 due to the economic crisis that hit the UK during the beginning of this year; the unemployment rate is 7.9% with a 2% increase of that of the previous year; the trade balance is a deficit of -2.4 billion due to the large amount of products the UK import and due to the fact that the UK economy is considered as a service oriented economy. The UK balance of payment as of June 2009 is a deficit of 8.5 billion of which 3.2 is in Euro and 5.4 of non Euro. Figure 1. shows a graph of the GDP quarterly growth for the period of 2004-2009.
(Source: http://www.statistics.gov.uk/cci/nugget.asp?id=192 )
One of the biggest contributions to the UK GDP is that of the natural gas manufacturing due to the fact that the UK is considered as one of the largest producer and exporter of gas in Europe. Being one of the most stable countries politically and an attraction point for tourists from all over the world, the UK was the second largest recipient of foreign direct investment (FDI) in the year 2007. The UK is ranked by the world trade organization in the year 2009 as the second largest importer and the third largest exporter of commercial services, and the eight largest exporter and fifth largest importer of merchandise. The UK is a member in the European Union (EU) and the G8. As for industry sectors, the service sector is the most dominant sector in the UK economy followed by the health sector and the retail sector respectively.
3.2.2 UK Retail Industry Overview:
The UK Retail industry sector is the third largest sector after the business services and health sectors. Retailing is a major contributor for the UK economy; it employs over three million people (11% of the total UK workforce). The UK retail industry sector contributes around 8% of the national GDP. Analysts predict that by the beginning of 2013, the retail industry sector will increase by 15% in size.
This sector has a turnover of 260 billion GBP a year on around 300,000 businesses. Sizes of companies vary greatly within this sector, where it includes some of the giant companies in the UK (such as Tesco & Sainsbury's) that employs thousands of workers in line with local corner shops that are mainly considered as a one person enterprise. The competition within the sector is increasing rapidly since the UK allows easy entry for overseas retailers. However, UK retailers are also seeking new markets through expanding overseas. Some of the major giants in this sector are M&S, Next, HMV, Tesco, Sainsbury's.
FTSE 350 General Retailers: The FTSE 350 general retailers is sub index derived from the FTSE 350 market index. The index was developed in the year 1985 with a base value of 1000. It currently includes 18 companies that are all included among the sample used for this study. The graph presented in figure 2 shows the performance of the FTSE 350 General Retailers market index over the period of March 2008 till September 2009.
According to Froot, Schrafstein and Stein (1993) financial theory, firms decide to utilize the use of derivatives in order to increase the firm market value. And according to Allayannis & Ofek (2001) firms use derivatives in order to decrease the exchange rate exposure and thus increase the firm value through stabilizing their future earnings fluctuations. Based on the previous observations of Froot, Schrafstein & Stein (1993) and Allayannis & Ofek (2001), I derived the two main hypotheses to be tested in this dissertation, they are generated as follows:
Hypothesis 1: There is a negative relation between exchange rate exposure and derivatives use.
Hypotheses 2: There is a positive relation between hedging and firm value.
The analysis methodology will follow the methodological approach used by Allayannis & Ofek (2001), Dumas (1978), Adler & Dumas (1984) and Hodder (1982), where they "define economic exposure to exchange rate movements as the regression coefficient of the value of the firm on the exchange rate across states of nature. Indeed in Adler & Dumas stock prices and exchange rates are both endogenous variables and determined simultaneously. However, for an individual firm, we can safely assume that exchange rates are exogenous" (Cited in Allayannis & Ofek 2001).
3.4.1. Time Series Analysis:
Based on the previous definition and in line with the previous researchers, the same approach will be used in this dissertation to estimate a firm's exchange rate exposure using the following model:
Model (1): Rit = oi + 1Rmt + 2 FXit + it, t = 1,..T
Rit is the rate of return on the ith firm's common stock in period t
Rmt is the rate of return on the market portfolio in period t
FXit is the rate of return on a movement in exchange rates, measured in GBP per unit of foreign currencies (Euro & USD) in period t.
A regression will be run using companies stock return as a dependent variable and the rate of return on market portfolio, and the rate of return on a movement in exchange rates (US & Euro) as independent variables.
3.4.2 Cross Section Analysis:
After estimating the exchange rate exposure using Model (1), a test will be run on each company separately to detect the effect of derivative usage on the exchange rate exposure; since it's believed that firms use currency derivatives to decrease their exchange rate exposure so we shall expect the exposure to decrease after running this test using the following model:
Model (2): ?XR = a+ fx1 + fx2 + fx3 + fx4 + fx5 + XRD + = 1, N
?XR is the exchange rate exposure estimated in model number one.
fx1 is the firms size.
fx2 is the firm growth opportunity.
fx3 is the firms leverage.
fx4 is the firms liquidity.
fx5 is the firm payout ratio.
XRD is the foreign currency derivatives usage.
The results obtained in the cross sectional analysis will be discussed in the empirical results discussion section, in chapter four, in order to obtain the relationship between firms derivative usage and their exchange rate exposure.
Following the approaches of previous studies in the area of derivatives and exchange rate exposure, this study controls for companies specific variables such as the companies' stock return, size, growth opportunity, leverage, liquidity, dividend, UK to US $ exchange rate, and UK to Euro exchange rate. This section will include a definition of each variable, the source and the form it was retrieved from, and the importance of each of the variables in the study (i.e. why it was used).
Size: The size is measured as the logarithm of companies' total assets. It was retrieved in monthly form for the period of 05/1/2000 - 31/12/2008 using the Data Stream Database. Companies size is believed for some researchers to matter in its decision to use derivatives, were larger companies are believed to tend to use derivatives more than small companies. For example according to Allayannis & Weston (2001) "large firms are more likely to use derivatives than smaller firms for example because of the existence of large fixed start-up costs of hedging". Also, according to Berkman, et al. (2002) size is one of the two main variables for derivatives use in the Australian industrial and mining firms. According to Qing (2007) study of a sample of Japanese multinationals, firm size and exposure through foreign sales were the sole factor behind a firm decision to hedge. However, on the other hand some researchers find no relation between hedging and firms size which leave the relation ambiguous, for example in his study of UK non financial firms determinants of foreign currency hedging, Judge (2007) illustrates that small firms have greater incentive to hedge since external financing would be so expensive due to the high transaction costs, the reason which drives smaller firms to tend more toward hedging.
Growth Opportunity: The growth opportunity is measured through the price to book value ratio; it was retrieved in monthly form for the period of 05/01/2000 to 31/12/2008 using the Data Stream Database. Previous studies suggest that firms with high growth opportunities are more likely to hedge and use derivatives. Lin & Smith (2007) concluded a positive relation between firms' growth and hedging. Their findings suggest that high growth firms tend to hedge in order to increase their investment. Similarly, Geczy, Minton & Schrand (1997) concluded that firms with bigger growth opportunities and tighter financial constraints are more likely to use currency derivatives. There results were consistent with Shapiro & Titman (1986), Lessard (1990), & Froot, Schrafstein & Stein (1993) that firms to hedge through derivatives in order to maintain their cash flow stability and avoid fluctuations that might affect their decisions in investing into valuable growth opportunities. However, in studying why and how UK firms hedge, Judge (2006) concluded no relation between a firm growth opportunity and its derivative use.
Leverage: Leverage in this paper is determined through companies' debt ratio (Total Debt / Total Assets), it was retrieved through the Data Stream Database in monthly form for the period of 05/01/2000 - 31/12/2008. The relation between leverage and derivative use is debatable. Although high leverage indicates a bigger risk of bankruptcy and financial distress, the reason which usually push high leverage companies for using derivatives, however according to Howton & Perfect (1998) in studying currency and interest rate derivatives use in US firms using a sample of 451 fortune 500 / S&P 500 firms and randomly selected 461 firms they concluded that firms decision to use currency derivatives was directly related to cash flows while unrelated to leverage. Dolde (1995) concluded a significant positive relation between hedging and firm leverage. He interpreted his findings by suggesting that hedging and leverage are interrelated due to their common effect on financial distress and agency costs.
Liquidity: Liquidity is measured through the companies' quick ratio (Current Assets - Inventories / Current Liabilities), companies quick ratio is retrieved through the Data Stream Database in a monthly form for the period of 05/01/2000 - 31/12/2008. Liquidity is considered as a substitute for hedging. According to Nguyen & Faff (2002) study of Australian firms, they found that "the exposure of longer horizons between 12 and 24 months is positively related to a firm liquidity supporting the view that liquidity is a substitute for hedging". Judge (2006) studying a sample of FT500 largest UK firms for the year of 1995 concluded a negative relation between liquidity and hedging indication that they are substitutes. However, Judge (2003) studying the foreign currency derivatives of top 500 UK firms ranked by market value for the year of 1995, concluded that liquidity is an incentive for hedging.
Dividend: The dividend is used as an indicator of the profitability of the companies and its measured through the companies payout ratio (Dividend per share/ Earning per share), the payout ratio is retrieved through the Data Stream Database in monthly form for the period of 05/01/2000 - 31/12/2008. According to Nguyen & Faff (2002) a company would use foreign currency derivatives more extensively if it pays higher dividends. Similarly, Berkman & Bradbury (1996) in studying a sample of 116 firms, concluded that a low dividend payout ratio reduce the need to use derivatives.
Exchange Rate: The nominal exchange rate history for UK to US $ and UK to Euro were retrieved through DataStream Database in weekly form for the period of 05/01/2000 - 31/12/2008. The % change was then calculated and used for the analysis. These two currencies were chosen specifically due to the fact that most of the firms use derivatives that are denominated either in US $ or Euro.
Stock Return: The return is used as a proxy for the firms' market value. It was retrieved in weekly from 05/01/2000 - 31/12/2008, using the Data Stream Database, then it was used to calculate the percentage change of each company stock return between two consecutive weeks. The stock return was commonly used by previous researchers for testing the effect of hedging and exchange rate exposure on a firm market value; some of these studies are Allayannis & Ofek (2001), El Masry (2006b).
3.6 Sources of Data:
During this part I will list the resources that have been utilized as sources of data and information while writing this thesis. They are as follows:
Internet: The internet was an extremely useful source of information for every part of this dissertation. Online libraries was the most useful among all for giving me access to previous researchers papers on topics such as derivatives, exchange rate exposure, and hedging. Also, the internet was the main source for viewing companies annual reports were information about companies derivative usage had to be retrieved.
Data Stream Database: The Data Stream International Database, under the license of the University of Plymouth, was used to retrieve the historical information related to the companies (Stock Return index, Quick Ratio, Trade Weighted Exchange Rate, Payout Ratio, Debt Ratio, Price to book value ratio, Total Assets). The Data Stream Database was extremely helpful in spite of the limited license that the university holds for the program; specially that retrieving such data from other software's such as Bloomberg had failed due to their complexity and data unavailability.
Annual Reports: As mentioned previously that companies in the UK were obliged to include corporate hedging activities in financial statements footnotes since the year 1998 under the FRS (13). For this reason, obtaining information on the companies' derivatives usage, companies annual reports were browsed through the companies' websites or in the case of the unavailability through the services provided by Financial Times website, annualreportsforplcs.co.uk website, and northcote.co.uk.
Chapter Four: Empirical Results
This part of the dissertation will test the relation between exchange rate exposure and firms stock return. It will also determine the effect of hedging through derivatives on the firms' exchange rate exposure and firm value. This chapter is sectioned as follows: Section one consists of the descriptive statistics for the data applied in model (1). Section two consists of the regression analysis results between firms' stock return as a dependent variable and exchange rates and market return as independent variables. Section three consists of the descriptive statistics for the data used in model (2). Section four consists of the cross sectional analysis to determine the effect of hedging on the exchange rate exposure and firm value. Section five discusses the results of the testing in light of the research hypotheses and previous literature.
4.2 Descriptive Analysis:
Tabel 1 represents the descriptive statistical data for the main independent variables used in equation (1) mentioned previously in the methodological part of the dissertation. The data was retrieved through the DataStream Database for the period of 05/01/2000 - 31/12/2008. The weekly percentage change was calculated for each of the variables and entered into the SPSS statistical software to generate this statistical information. The main independent variables consist of the FTSE 350 General Retailers market index, the UK to US $ exchange rate, and the UK to Euro exchange rate.
According to the FTSE 350 GR market index values ranged between a minimum of -0.204 and a maximum of 0.145, with a mean close to 0 (exactly -0.000728) and the highest standard deviation among the group with a value equals to 0.03 indicating a bigger spread of FTSE 350 GR data than the other variables data. The UK to US $ exchange rate weekly change history for the studied period shows a minimum of -0.046 and a maximum of 0.068, a mean and a standard deviation of 0.0002 and 0.126 respectively. The last main independent variable, the UK to Euro exchange rate, had the lowest standard deviation between the group with the value of 0.103, the highest mean of 0.0009, and a range of values that spreads between a minimum of -0.030 and a maximum of 0.055.
Skewness defined as "the measure of the asymmetry of the probability distribution of a real value random variable" (Wapedia 2009). According to the analyzed independent variables, FTSE 350 GR market index distribution was left skewed (i.e. negative skewness) indicating that the distribution had few low values. However, according to each of the two exchange rates (UK to US $ and UK to Euro), the distribution was right skewed (i.e. positive skewness) indicating that the distribution includes few high values. Kurtosis defined as the measure of peakdness and taildness of a statistical distribution. All three independent variables distributions had a positive kurtosis also called as (Leptokurtic) indicating a peaked distribution.
The correlation between each of the three variables (FTSE 350 GR, UK to US$, UK to Euro) is presented in table 2 below. No significant correlation was found between any of the three variables were correlation values ranged between a minimum of -0.006 and a maximum of 0.212. These results are good indicators that the analysis will not face the multi colinearity problem, which takes place when two or more variables are related, and doesn't contribute to a good regression model.
4.3 Regression Analysis for All Companies Stock Return:
An average of all companies stock returns have been calculated in order to test the relationship between companies stock return (dependent variable) and all other independent variables (UK to US $ exchange rate, UK to Euro exchange rate, FTSE 350 General Retailers). The analysis will be based on the following model that is discussed more in details in the methodology part:
a. Predictors: (Constant), UK TO EURO, FTSE 350 GEN RETAILERS , UK TO US $
The model summary presented in table 3 shows a moderate coefficient of determination of 51% indicating that 51% of the company's stock return is identified by the applied independent variables. The model suggests that other variables than the ones used in the analysis can explain 49% of companies' stock return.
a. Predictors: (Constant), UK TO EURO, FTSE 350 GEN RETAILERS , UK TO US $
b. Dependent Variable: average
The analysis of variance table (ANOVA) shows a mean square of 0.043 and an F ratio of 163.858 and an F-significance of 0.000 (significant at 99% significance level) indicating that the results are true and not due to chance and applicable not only for the studied sample.
In studying which variables significantly affect the firm's stock return. The results presented in Table 5 reflect that the return on the market portfolio represented by the FTSE 350 GR significantly impacts the firms' stock return at the 99% significance level. The analysis shows that the UK to Euro exchange rate have a significant effect on the firms' stock return. However, no significant impact was detected for UK to US $ exchange rate.
a. Dependent Variable: Companies Stock Return
4.4 Time Series Analysis:
In order to test the exchange rate exposure of each company, a regression has been run for each company individually using its stock return as a dependent variable while FTSE 350 GR, UK to US $, and UK to Euro exchange rates as independent variables. The data used for this analysis is presented in Appendix (1).
The regression done provided the following conclusions:
Within the analyzed sample of the 40 UK retail industry companies, eight companies (20%) were determined to be insignificant (below the 90% significance level). Four companies (10%) were determined as significant at the 95% significance level, while 28 companies (70%) were significant at the highest significance level of 99%.
Using the FTSE 350 GR as a proxy for market risk, five firms (12.5%) out of the forty companies had no significant exposure to the market risk while thirty five companies (87.5%) have a significant exposure to market risk, including one company with a negative significant exposure.
Exchange Rate Exposure:
Companies were tested against two exchange rate exposures, UK to US $ and UK to Euro. Three companies (7.5%) had a significant negative exchange rate exposure to US $ - 2 firms at 95% significance level, 1 firm at 90% significance level. However, also three companies (7.5%) were positively exposed to US $ exchange rate - 2 firms at 99% significance level, 1 firm at 90% significance level, making a total of 6 firms (15%) exposed to UK to US $ exchange rate fluctuations.
Moreover, according to the UK to Euro exchange rate, 10 firms (25%) are exposed to this exchange rate, were 6 firms have a significant negative exposure - 2 firms at 99% significance level, 3 firms at 95% significance level, and 1 firm at 90% significance level. While 4 firms have a significant positive exposure - 3 firms at 95% significant level, 1 firm at 99% significance level. However, two companies (5%) had a double exposure (i.e. exposed to both Euro and US $). In general 14 companies (35%) are exposed to exchange rate whether it's US$ or Euro. Table 6 presents a summary of the regression analysis results.
4.5 Descriptive Analysis for Model (2):
Table 7 shows descriptive statistics for the values of the independent variables used in Model (2). The average of each ratio per company was calculated and used for the regression. A derivative dummy equal to one have been used to proxy the companies who used foreign currency derivatives during the period studied and a dummy equal to zero if the company was a non derivatives user.
The statistical data for the analyzed 40 companies shows that the mean of UK TO US $ exchange rate exposure is 0.011 with the minimum being -0.689 and a maximum of 0.741 indicating an overall increase. The variance is 0.062 while the skewness is positive indicating the direction of the variation is skewed to the right. However, according to the UK TO EURO exchange rate exposure the mean is -0.132 (with the minimum being -1.407 and a maximum of 0.636) indicating an overall decrease. The variance is 0.154. The skewness is negative indicating the direction of the variation is skewed to the left. Both exchange rate exposures have similar positive kurtosis showing relatively peaked distributions. The positive values indicate the possibility of leptokurtic distributions that is too tall. The means of Price to Book Value, Total Assets (Log), Quick Ratio, Payout Ratio are all positive of 1.226, 15.94, 0.932 and 35.5 respectively. The large variances for Price to Book Value and Payout Ratio are indicative that the data have some extreme values for these variables. Quick Ratio has a positive skewness of 4.56 showing skewness to the right and kurtosis shows very peaked distribution. The skewness of Price to Book Value, Total Assets, and Payout Ratio are all negative indicating skewness to the left. Except for Payout ratio all other variables show peaked distributions.
According to Table 8 that shows the correlations between the independent variable used in Model (2), a positive correlation of 0.676 at the 99% level of significance between Total Assets and Payout Ratio was found indicating that these two variables are moderately correlated in a positive manner meaning that as Total Assets increase so does the Payout Ratios. This is the highest correlation amongst all the variables analyzed. A moderate negative correlation of -0.554 between UK TO US $ and UK TO EURO was found also at the 99% level of significance. There are some low positive correlations of 0.359 and 0.342 between Derivative Usage and Total Assets and Payout ratio at the 95% level of significance. All other correlations are not statistically significant.
4.6 Cross Sectional Analysis
This part of analysis will be divided into 2 sections; the first section will discuss the effect of the variables (i.e. Total Assets, Price To Book Value, Quick Ratio, Payout Ratio) used in equation (2) together with the foreign currency derivatives on the companies UK to US $ exchange rate exposure, while section two will discuss their effect on the UK to Euro exchange rate exposure. The regressions have been run using exchange rate exposures separately as a dependant variable and other companies' ratios and foreign currency derivatives as independent variables. The analysis is based on the following model:
Table 9 shows that the coefficient of determination (Adjusted R) is 15% which means that only 15% of the dependant variable (UK to US $) is explained by the model, which is considered as a relatively low percentage, leaving 85% of different factors that UK to US $ exchange rate exposure would be determined by. The ANOVA presented in table 5 is showing an F of 8.581 and an F significance of .000 (i.e. significant at 99% level), indicating that the results are applicable for different samples and not exclusive for the studied sample. Table 6 presents the variable used in the analysis and illustrates which variables predict the exchange rate exposure. According to the regression, the following variables can be used to predict the US $ exchange rate exposure: Total Assets at the highest level of significance of 99%, Price to Book Value at 95% significance level, and foreign currency derivatives at 99% significance level.
a. Predictors: (Constant), Derivative Usage, Quick Ratio, Price to Book Value, Payout Ratio, Total Assets
Table 12 shows that according to the UK to Euro exchange rate exposure the coefficient of determination (Adj. R2) is 7.5% implying that 7.5% of the dependent variable is explained by the model, the ANOVA presented in table 8 shows that F is equal to 8.581 while F significance is significant at 90% significance level indicating that the model is significant.
Table 14 shows that three independent variables can be used to predict the UK to Euro exchange rate exposure: Price to Book Value, which is also significant in predicting US $ exposure, is significant at 95% level; Total Assets, also significant in US $ exposure prediction, is significant at 99% level and finally foreign currency derivatives at 99% significance level.
4.7 Empirical Results Discussion:
The regression analysis between all firms stock return as a dependent variable and UK to US $ exchange rate, rate of return on market portfolio, and UK to Euro exchange rate as independent variables shows an expected positive relation between firms stock return and rate of return on market portfolio. It also shows a significant negative relation between firms stock return used as a proxy for firm value and UK to Euro exchange rate. These results indicate that as the UK to Euro exchange rate exposure increases, firms' stock return and thus firm market value decreases. This finding is consistent with the previous literature of Choi and Prasad (1995), Amihud (1994), and Dukas, Hall, and Lang (2001) that concluded that exchange rate exposure decreases a firm market value through affecting its cash flows. However, the insignificant impact of UK to US $ exchange rate on firms stock return can be explained as that the studied firms are more subject to operations with Euro zone countries rather than the United States and other Dollar countries.
According to previous literature, firm size is one of the factors that affect the firm decision in hedging activities. During this study, the logarithm of firms' total assets was used to control for firms size. In line with the findings of Allayannis and Weston (2001), Chen and Qing (2007), and Berkman et. al (2002) this study shows a significant positive correlation between firm size and derivatives use. The positive correlation indicates that as the firm size increases, derivatives use increase among the studied firms. Based on these results, one can conclude that firms decision on how much to hedge with derivatives can be to certain limit affected by the firm size.
Another significant positive correlation was determined between firms payout ratio used as a proxy for firms liquidity and derivative usage by firms. This positive correlation contradicts the finding of Nguyen and Faff (2002) study of Australian firms. This result refutes the conclusion of Nguyen and Faff (2002) that liquidity is a substitute for hedging. However, it indicates that firms' liquidity work as a complement for hedging and the more liquid the firm is the more they hedge through derivatives.
This paper specifically concentrated on two possible hypotheses to be evaluated and measured. The study tested the reliability of the following:
Hypotheses 1: There is a negative relation between exchange rate exposure and derivative use.
Hypotheses 2: There is a positive relation between hedging and firm value.
According to what previous reviews and literature has conducted, foreign currency derivatives have been considered to be used as a way of hedging in order to decrease exchange rate exposure and hence increase firm value. However, according to this study results a positive relation was determined between exchange rate exposure and foreign currency derivatives usage, indicating that derivatives increase the exchange rate exposure of the firms that hedge. The results also imply a negative relation between derivative use and firm value. Based on this result, the study rejects its main hypothesis. These results contradict with the findings of Allayannis & Ofek (2001) that concluded a strong negative relation between exchange rate exposure & firm value. It also disagree with the findings of previous studies that concluded that derivatives have no effect on exchange rate exposure and firm value (example: Allayannis, Brown, and Klapper (2001), Jong, Lingerink, and Macrae (2002), Faff and Marshall (2005)). However, this study supports the findings of Ben Khedri and Folus (2009) that derivatives might affect firm value negatively and not positively.
The study results suggests that firms might be using ways other than foreign currency derivatives (i.e. operational hedging) to hedge their exchange rate exposure, such as:
Diversification: The term is financially defined as "dividing investment funds among a variety of securities with different risk, reward, and correlation statistics so as to minimize the unsystematic risk." Such assumption is consistent with Markwitz diversification principal which proves that international diversification may be beneficial in terms of exchange rate exposure reduction (Y.K 1991: 162). It is also consistent with the finding of El Masry (2006b), in questioning the reason behind companies not using derivatives, "that exposures are more effectively managed by other means such as risk diversification or risk shifting arrangements." (El Masry 2006b).
Domestic Currency Invoicing: Domestic currency invoicing is a term that contributes to another way that would be used by exporting firms to hedge their exchange rate exposure and transfer the exposure to the importing firm. This assumption would be consistent with the findings of Bjrn Dohring (2008) in studying the effect of domestic currency invoicing on the Euro area firms exchange rate exposure. His findings stated that 50% of the euro-area exports are invoiced in the domestic currency and they effectively shift the exchange rate exposure from the exporting firm to the importing one.
However, it is important to note that despite of the fact that the results for the sample used in this study are not consistent with previous literature but as Bartram et. al (2006) concluded that "the findings of empirical studies remain controversial because the conclusions are largely sample specific."
Leading and Lagging income and expenditures: It is considered as an internal way of hedging. It's based on the firm expectations toward the exchange rate, whether it will fall or rise. Based on such prediction, a firm will be able to decide whether to pay their expenditures or receive their income in advance (Lead), or to postpone the payment or the income for a later date (lag).
Netting Receipts and payments: This way of hedging is considered as an internal hedging tool. It is based on the idea of coordinating between a firm payments and income in a foreign currency. This coordination between the two can compensate any losses in the payment through gains in the receipt.
5. Summary, Conclusion, Limitations & Recommendations:
Exchange rate exposure, hedging, and their effect on firm value have been an area of interest for many researchers interested in the risk management field to date. This paper studied the exchange rate exposure and derivative usage of 40 UK general retailers whose data was found through the DataStream Database over the period of 05/01/2000 - 31/12/2008. The study aimed to answer the following two research questions:
- What is the exchange rate exposure?
- What is the effect of derivative use on the firms' exchange rate exposure?
Throughout this paper previous literature related to exchange rate exposure and hedging have been reviewed to act as a profound base for results comparison and hypothesis formation. This study followed the methodological approach used by Allayannis and Ofek (2001) in testing the firms' exchange rate exposure against US $ and Euro. The regression analysis showed that 15% of the studied firms are significantly exposed to US $ exchange rate, while 25% of the sample are significantly exposed to the Euro exchange rate. Moreover, the study concluded a significant negative impact for the UK to Euro exchange rate exposure over the firms' stock return. This conclusion is consistent with findings of previous literature.
Another regression was run to test the impact of derivative usage on firms' exchange rate exposure by applying a model that control for the following variables: firm size, growth opportunity, leverage, liquidity, and dividends. In consistency with previous literature on the exchange rate exposure, a significant positive correlation was found between firms' size and derivative use indicating that the bigger firms tend to hedge more than smaller ones. Unlike previous findings, the study concluded a positive correlation between liquidity and derivative use while no other variables were determined to affect the firms' use of derivatives.
The empirical results also showed a positive relation between exchange rate exposure and foreign currency derivatives use, and a negative relation between derivatives use and firm value. However, due to certain limitations, analysis showed that for the studied sample foreign currency derivatives might not be the ideal way of hedging and companies might be using other means of hedging such as operational hedging. The limitations were seriously hindering the ability to companies' data were from a sample of 70 companies available in the Datastream Database for UK general retailers, 30 had to be excluded from the beginning due to the incomplete data. The validity of responses, for example, might be called into question because of the unrepresentative sample taken into consideration. However, it's important to note that although the study results might not be reliable with respect to previous findings, they are characterized to be sample specific.
This study also suggests a new probability of relationship between exchange rate exposure and derivatives usage and firm value to be taken into consideration by investors and firms. It also works as an additional evidence for investors on the negative relation between exchange rate exposure and firms' stock return. The importance of this paper is that it serves to be an additional evidence for the derivatives and exchange rate exposure study field in the UK and aims to expand the previous literature which was mainly focused on US multinationals.
Exchange rate exposure will remain as a main problem that firms will always be facing. Such a risk will definitely drive the curiosity of more researchers to investigate forward and help find possible solutions for covering it. One possible recommendation for future researchers would be, considering the evidences and results provided throughout this research paper, a similar study for a larger sample of UK retail companies is highly recommended. If conducted, such a study in the future might help get a more reliable conclusion where larger samples as well as more variables are to be considered and added respectively. This latter will explain in depth the dependent variables (i.e. companies stock return & Exchange rate exposure). Finally, I hope that this study will form a good start for future studies in different countries and under different market conditions for the topic of exchange rate exposure, derivatives, and firm value.