A primer on the exposure of non-ﬁnancial

8/6/2019 A primer on the exposure of non-financial

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J. of Multi. Fin. Manag. 15 (2005) 394413

A primer on the exposure of non-financialcorporations to foreign exchange rate risk

Sohnke M. Bartram a,, Gunter Dufey b, Michael R. Frenkel c

aLancaster University, Management School, Department of Accounting and Finance, Lancaster LA1 4YX, UK

b Nanyang Business School, NTU Singapore and Ross School of Business, The University of Michigan,

Ann Arbor, MI 48109-1234, USAc WHU Koblenz, Department of Economics, Burgplatz 2, D-65179 Vallendar, Germany

Received 15 August 2004; accepted 3 April 2005

Available online 7 July 2005

Abstract

In the presence of deviations from parity conditions such as purchasing power parity and the

international Fisher effect, non-financial corporations are confronted with risks stemming from the

impact of unexpected exchange rate changes on the value of the firm, especially in the short- and the

medium-term. The motivation for this paper stems from the authors dissonance with both the existing

academic literature and observed corporate practice, where too much emphasis is placed on either

financial assets or hedging instruments, or forecasting rates in the latter case. This paper analyzes

the economic exposure of non-financial firms, focusing on cash flows. In this context, issues such as

the dimension of pass-through time and other complexities of exposures are explicitly addressed and

such considerations in turn are linked to hedging decisions. The role of the competitive environment

is stressed and related to analytical concepts such as currency of denomination and currency of

determination. Finally, the complexity of the trade-off between financial and operative hedges is

emphasized. The overall objective is to pull together diverse strands of the existing academic literature

into a clear conceptual framework with the ultimate aim of improving managerial decision-making. 2005 Elsevier B.V. All rights reserved.

JEL classification: G3; F4; F3

Keywords: Foreign exchange rates; Exposure; Corporate finance; Risk management; Hedging; Derivatives

Corresponding author. Tel.: +44 1524 592 083; fax: +44 1425 952 10 70.

E-mail addresses: [email protected] (S.M. Bartram), [email protected] (G. Dufey),

[email protected] (M.R. Frenkel).

URL: http://www.lancs.ac.uk/staff/bartras1.

1042-444X/$ see front matter 2005 Elsevier B.V. All rights reserved.

doi:10.1016/j.mulfin.2005.04.001


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S.M. Bartram et al. / J. of Multi. Fin. Manag. 15 (2005) 394413 395

1. Introduction

Foreign exchange rate changes represent an important source of risk for non-financial

corporations. Spectacular losses or even bankruptcies over the last decade and longerhave drastically demonstrated the consequences of unprofessional management of these

risks.1 With the emergence of large currency blocs with their own, internally focused

macro-economic policies, together with the parallel rise in the international involvement

of firms (usually referred to as globalization), and the opening of markets through more

liberal trade policies and the technology-driven reduction in transportation costs, the num-

ber of firms impacted directly or indirectly by exchange rate changes has dramatically

grown.

Corporate foreign exchange risks began to attract widespread attention during the 1970s

when the Bretton Woods system of fixed exchange rates unraveled. The subsequent rise in

volatility of exchange rates and interest rates fostered a burst of financial innovation, exem-

plified by the proliferation of derivative instruments and their increasing use by corporations

in all industry sectors (see e.g., Bartram et al., 2004; Bodnar et al., 1998). Derivatives can

be quite efficient hedging instruments for corporate risk management. Nevertheless, they

can be quite complex as well, with strong leverage effects. Consequently, the use of these

instruments carries with it high risks both for the unsophisticated user, as well as for

executives tempted by gambling with their shareholders money. In contrast, when properly

used for hedging, derivatives or various other financial transactions can reduce those risks of

non-financial firms for which they are not rewarded in the market. Since the term hedging

is widely misused in practice, a clear conceptual foundation is key to management actionconsistent with the objective of firm value maximization.

Hedging requires first and foremost an understanding of the underlying risk position: it

means creating a position to offset an exposure. A hedge can be implemented either in the

cash market or with derivatives. In contrast, speculation means taking actions in view of an

explicit or implicit forecast that deviates from that of the market (as revealed, for example,

by forward rates or interest differentials in functioning markets). In other words, a good test

of whether an action involves hedging or speculation is the presence or absence of a causal

relationship to the underlying exposure of the firm. This consideration focuses the agenda

firmly on the definition and estimation of the exposure of firm value due to unexpected

exchange rate changes. Here is where problems begin: the literature offers three definitionsof exposure, namely accounting, transaction and economic (or cashflow), but only the

latter is consistent with financial theory.

The use of alternative measures such as accounting or transaction exposure is largely

prompted by management incentive issues (e.g., bonuses are paid on the basis of reported

1 To illustrate, exchange rate losses on its European sales were identified as the largest factor in a 16 billion

Yen operating loss of the Japanese carmaker Mazda in 2001. In the same year, Toyota reported a 2.5 billion

Yen operating loss in Europe, indicating that the current Euro exchange rate against both the Yen and Sterling

meant Toyotas European operations would not return to profitability in the near term. Similarly, the profits of theEuropean aerospace and defense group EADS were wiped out in the year 2000 by a Euro 1.4 billion currency hit.

And Uniwear, a Belgian group that specializes in hosiery, announced that its 39.5% plunge in profits in 1998 (to

20 billion Belgian Franc) was mainly due to losses on Sterling and Dollar exchange rates.


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396 S.M. Bartram et al. / J. of Multi. Fin. Manag. 15 (2005) 394413

earnings) associated with the reliance on accrual accounting based on historical cost. For the

last 30 years, these issues have been addressed in many diverse publications, but the various

facets of economic exposure are distributed throughout a vast literature. The purpose of this

paper is to pull together all relevant strands of the literature and to present a comprehensiveanalysis of economic foreign exchange rate exposure, including an explicit consideration

of the time dimension that is relevant in this context. Last but not the least, we provide some

cogent and consistent implications for corporate hedging policies, including fundamental

considerations regarding the choice of hedging instruments.

To this end, the remainder of the paper is organized as follows. Section 2 briefly reviews

the definition of exchange rate exposure. Section 3 examines exchange rate effects on non-

financial firms competing in export or import markets. Section 4 focuses on additional

aspects of foreign exchange rate exposure resulting from basically indirect effects of unan-

ticipated foreign exchange rate changes on the profitability of firms. From the analysis of

the various dimensions of exposure, Section 4 derives implications for managerial action

such as debt denomination and duration structuring, the use of derivatives and other hedging

activities. Finally, Section 5 presents the conclusion of the analysis.

2. Concepts of foreign exchange rate exposure

Foreign exchange rate riskin general is related to unexpected changes in foreign exchange

rates. It can be quantified with the statistical measure of variance or standard deviation. More

specifically, foreign exchange rate risk exists because international parity conditions suchas Purchasing Power Parity and the International Fisher Effect hold at best in the long run.

Consequently, there is no immediate adjustment among exchange rates, interest rates and

prices for goods and services. The concept of foreign exchange rate exposure describes the

impact of foreign exchange rate changes on corporations. More precisely, economic foreign

exchange rate exposure represents the sensitivity of firm value in national currency with

regard to unexpected foreign exchange rate changes (Adler and Dumas, 1984). Transaction

exposure defines the effect of exchange rate risk on individually contracted transactions and

can thus be perceived as a part, or component, of the economic exposure. This is in contrast

to the concept of accounting exposure, which refers to the impact of exchange rate risk on

accounting measures.Conventional wisdom of exposure and hedging typically relates to the management of

investment portfolios, especially with regard to fixed-income securities and, by extension,

to commercial receivables. For financial assets, the foreign exchange rate exposure can be

determined and quantified without great difficulties, since the amount, currency and term of

payments of securities, accounts receivables, or payables are typically contractually fixed

(equities represent an exception here). Consequently, financial assets with a few exceptions

are subject to foreign exchange risk only if some of its cash flows are denominated in

foreign currency. Due to the deterministic character of the cash flows, hedging the asset

against unexpected foreign exchange rate changes can be accomplished with relative ease

in the forward market. A typical example is the hedging of a foreign currency receivable byselling an equivalent amount of foreign currency for forward delivery, i.e., establishing a

short position in that currency to offset changes in the value of future cash flows. Essentially,


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the forward hedge converts a foreign currency asset, or liability, into an asset denominated

in domestic currency.

The analysis of foreign exchange rate exposures for a corporation on the basis of indi-

vidual assets and liabilities is, however, incomplete, since portfolio effects can be realizedif different assets and/or liabilities are denominated in currencies that are not perfectly cor-

related. This is particularly true for financial institutions, which have almost exclusively

financial assets on their balance sheet, but also for the large group of non-financial firms

for whom it is not untypical to have some of their receivables, payables, debt and other

financial positions in different currencies. When assets and liabilities are denominated in

the same (foreign) currency and have the same duration of cash flows, matching or netting

of cash flows is possible (Pringle, 1991). Moreover, there is also a statistical relationship

between assets and liabilities in different currencies due to the correlations between differ-

ent exchange rates. As a consequence, diversification effects result as changes of cash flows

in one currency are partially offset by changes of cash flows in other currencies, and one

has the possibility of reducing (but not eliminating) risk through cross hedging for the

combined position by utilizing a matrix of expected correlations among currencies based

largely on past experience.

Even when focusing on these net effects, the analysis of foreign exchange rate exposure

presented so far remains at the level of transaction exposure. A transaction exposure is

relatively easy to identify and to hedge, but it represents only a part of the relevant eco-

nomic foreign exchange rate exposure of the firm. While exchange rate movements affect

contractually fixed transactions directly, there are additional effects on future cash flows

related to the competitive position of the firm, which can manifest themselves in price aswell as quantity effects. Consequently, only an integrated analysis of the foreign exchange

rate exposure of financial assets and real assets provides the basis for a complete profile of

the economic foreign exchange rate exposure of the entire firm (Adler and Dumas, 1980).

3. Analysis of economic foreign exchange rate exposures

3.1. Exposure analysis for exporters and import-competing firms

For non-financial institutions, financial assets with contractually fixed cash flows and(more) readily available market prices only play a minor role. By contrast, current values

of real assets such as machinery and production facilities are important for them, but at the

same time more difficult to determine, since the future cash flows from these assets are not

contractually fixed and may be affected by currency movements. Thus, they can be often

estimated only with a great deal of uncertainty.

By definition, the economic foreign exchange rate exposure of real assets consists of

the effect of foreign exchange rate movements on the associated future cash inflows and

outflows. However, in contrast to financial assets, cash flows of real assets are uncertain

even without currency risk, since the quantities as well as future prices of inputs and outputs

are not known with certainty. As a result, the analysis of the economic foreign exchangerate exposure has to consider the short- and long-term impact of exchange rate movements

with regard to prices and quantities (Adler, 1994; Dufey and Giddy, 1978). Since suppliers,


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Fig. 1. Devaluation effect on exporter with perfect competition.

customers and competitors are affected by foreign exchange risk as well and possibly

attempt to pass the consequences on to other market participants (pass-through), competitive

conditions play a crucial role in determining economic foreign exchange rate exposure.

The general principles of economic foreign exchange rate exposure of non-financial firms

can be illustrated in a simplified analysis of an exporter (with cash sales to avoid the foreign

currency receivables digression) based on comparative statics. At the outset of the analysis,

it is assumed that the exporter only uses domestic inputs to produce one good, which is

sold exclusively in a foreign market with perfect competition (Levi, 1994). As markets arecompetitive and individual market participants are price takers in the short run, their only

decision variable consists of the quantity of production and sales. Profits are maximized

where marginal costs, MC, which define the supply curve S, equal marginal revenues MR

(Fig. 1). Applying the small country argument to the relevant market, the demand curve

(and, thus, the marginal revenue curve) is horizontal. For simplicity, it is further assumed

that the quantities of production and sales are identical, i.e., there are no inventories. Further,

the common assumption of increasing marginal cost is made.

The profit of the exporter that originates from the sales of a quantity X1 at price PDC1 (in

domestic currency DC) is:2

G1 = (MR1 MC1)X1 = (PDC1 MC1)X1. (1)

The sales price in domestic currency can be expressed as the product of the price in foreign

currency PFC and the exchange rate S (in domestic currency per unit of foreign currency):

PDC1 = S1PFC1 . (2)

Assuming that the small country assumption applies to all domestic exports, exchange

rate changes do not change the sales price in foreign currency. Therefore, a depreciation of

2 The sales price is equal to marginal revenue with perfect competition, i.e. the demand curve D is horizontal.

It is assumed that there are no fixed costs.


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the domestic currency (anincrease in the exchange rate) from S1 to S2 leads to a proportionate

increase in PDC, as the sales price in the foreign currency does not change:

PDC2 = S2PFC1 > PDC1 = S1PFC1 . (3)

At the same time, foreign sales prices at different points in time are assumed to be determined

by the foreign inflation ratePF:

PFC2 = PFC1 (1 + P

F). (4)

This implies that all suppliers increase their prices in foreign currency according to

the foreign inflation rate. Inflationary effects abroad have the same effects on PDC as a

depreciation of the domestic currency:

PDC2 = S2PFC1 (1 + PF). (5)

Combining (2) and (5) yields:

PDC2

PDC1

=S2

S1(1+ PF). (6)

Consequently, price increases in the world market as well as a depreciation of the domes-

tic currency will result in increasing marginal revenues. However, this may translate only

partially into higher profits due to possible simultaneous domestic inflation. Thus, in the

end, the change in the real exchange rate determines the overall effect on profits and, thus,exposure to foreign exchange rate risk of exporters. Assuming that there is no domestic

inflation so that input prices of exporters remain unchanged, marginal costs do not change

and the exporter increases production to the profit-maximizing quantityX2 (Fig. 1). A depre-

ciation of the domestic currency thus leads to an increase in sales revenue and profits as

well as to higher production, confirming the results ofShapiro (1975).

As there are no barriers to market entry in the case of perfect competition, higher profits

not only induce higher output by producers but could also attract new competitors in the

long run, who wish to benefit from more advantageous market conditions. This would shift

the supply curve outward, so that the output effect is larger.

In addition to the effects described so far, Fig. 2 illustrates the implications of higherinput prices induced directly or indirectly by a depreciation of the domestic currency. After

a depreciation, prices in domestic currency increase for imported (consumer) goods and

the opportunity costs (of sales abroad) increase for tradable domestic inputs. As a result,

domestic cost of living, wages and prices for domestic inputs may also rise; so that the

depreciation indirectly induces higher production costs even if the exporter has no direct

foreign inputs. Higher costs correspond to an upward shift of the marginal cost curve, from

MC1 to MC2 (Fig. 2). As a result, exports and profits are lower, a result that is independent

of the possibilities of an adjustment of prices as mentioned above. If domestic inflation,

which is reflected in the increase in cost

MC2

MC1= (1 + PD), (7)


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Fig. 2. Long-term effect of depreciation on exporter.

is lower than the combined effect of the exchange rate increase and foreign inflation (6),

the domestic firm still benefits, since a real depreciation occurs and profits in real terms

increase:

PDC2

PDC1

MC2

MC1=

S2

S1(1 + PF) (1 + PD)

= S(1+ PF) (PD PF)

S (PD PF).

(8)

As (8) shows, a positive net effect on the profits of exporters results from a real depreci-

ation. If purchasing power parity holds initially, net effects occur should the exchange rate

deviate from purchasing power parity in the new equilibrium. This illustrates again that the

economic currency risk depends entirely on changes in the real exchange rate.

In the case of monopolistic competition, the demand curve is downward-sloping, as is

marginal revenue (Fig. 3). For simplicity, we assume that marginal costs are constant. If

the domestic currency depreciates, each point on the demand curve shifts upward by the

rate of foreign currency appreciation and the new sales price for the export quantity X is

determined as

PDC2 = S2P

FC2 = S2(1 + P

F)PFC1 . (9)

Since this is a proportional price change, the absolute price increase is larger for high

prices than for low ones. As in the case of perfect competition, the depreciation ceteris

paribus leads to higher export quantities. Put differently, the same number of exported

products generates larger revenues in domestic currency. Consequently, the depreciation

leads to an increase in the profit-maximizing export quantity from X1 to X2, which is

determined by the intersection of the marginal cost curve and the marginal revenue curve

(this effect is smaller for increasing marginal cost than for constant marginal cost). Due tothe finite elasticity of the demand curve, the sales price increases less than it does under

perfect competition.


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Fig. 3. Impact of depreciation on exporter with imperfect competition.

If the exporting firm is a subsidiary of a foreign company, the impact of exchange rate

changes has to be analyzed in the local currency of the parent and not in the currency of the

subsidiary. The effects on the profits of the subsidiary measured in foreign currency, i.e., the

local currency of the parent, are illustrated in Fig. 4. As in the analysis shown in Fig. 3, we

again assume monopolistic competition, constant marginal costs and independence of input

prices from foreign prices. A change in the exchange rate now has no effect on the demand

curve and the marginal revenue curve. The subsidiarys cost of production, however, accrues

in its domestic currency. Consequently, a depreciation of the currency or the subsidiary

reduces these costs from the perspective of the parent. Therefore, the marginal cost curve

shifts downward by the rate of the depreciation of the currency of the subsidiary. As in

the earlier analysis, the optimal export quantity of the exporter increases from X1 to X2.

However, the price expressed in the currency of the parent company declines. Nevertheless,

sales revenue will increase because demand is price-elastic around the optimum. The costs

Fig. 4. Foreign currency analysis of depreciation effect on exporter.


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Fig. 5. Depreciation effect on domestic producer with perfect competition.

of production increase as well, but to a lesser degree than sales rise. As a consequence, the

resulting net effect is an increase in profits in the currency of the parent company.

The analysis so far has demonstrated that foreign exchange rate risk will, in the short run,

affect the revenue side of the business of an exporting firm and will also directly or indirectly

affect its cost structure over time. Some domestic firms may, however, engage only to a small

extent if at all in international trade. Nevertheless, even companies with purely domestic

operations, with no exports or imports, nor foreign currency debt, etc., which consequentlyface neither accounting nor transaction exposure, may have economic foreign exchange rate

exposure. This can happen in case international market leaders located abroad are able to

contest the local market with imports (import competition) (Hodder, 1982; Marston, 2001;

OBrien, 1994; Aggarwal, 1981).

If domestic prices are influenced by the value of foreign currencies because of import

competition, exchange rate changes will affect revenue and profits of domestic producers

despite their focus on the domestic market. Depending on the direction of the exchange rate

change, prices may rise or firms may be forced to lower their prices. Fig. 5 shows the effect

of a depreciation of the domestic currency on the business of an import-competing domestic

firm with perfect competition.D denotes domestic demand for the good under consideration.S1W depicts the world market price that is given for the individual import-competing firm.

For simplicity, we assume that there is only one domestic import-competing firm. The

marginal costs of the firm (MC1) determine the supply curve of the domestic producer (S1D)

and, thereby, the level of domestic demand satisfied by domestic production. A depreciation

of the domestic currency increases the world market price expressed in domestic currency

units from P1 to P2 so that the world market supply curve shifts upward to S2W. With

increasing marginal costs, this leads to an increase in the number of units sold in the domestic

market fromX1 toX2. Here we assume that the depreciation reduces but does not completely

eliminate imports in the market under consideration. As the marginal cost function does

not change in response to the depreciation in the short run, the increase in marginal costs isonly caused by higher output. As a consequence, profits are unambiguously higher for the

domestic firm after the currency depreciation. Similarly, an appreciation forces domestic


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Fig. 6. Depreciation effect on domestic producer with imperfect competition.

firms to lower their price. As a result, domestic producers suffer a profit loss following the

appreciation.

Over time, exchange rate changes may affect the costs of the firm. For example, a

depreciation of the domestic currency leads to more expensive imports, which can induce

higher domestic production costs through higher prices for imported inputs or through

higher wages induced by higher costs of living. As a consequence, the supply curve of

the domestic producer (S2D = MC2) shifts upward, once again causing his competitiveness

vis-a-vis imported products to deteriorate and, thus, reducing his market share (Fig. 5).

Finally, we examine the situation in which a domestic producer is a monopolist for his

products although there are similar products available in the world market. The producer

is then operating in monopolistic competition and domestic buyers consider world market

products as imperfect substitutes. For simplicity, we assume that the producers marginal

costs are constant. This situation is illustrated in Fig. 6. A depreciation of the domestic

currency increases the price of substitutes from abroad so that the demand curve and the

marginal revenue curve shift upwards to D2 and MR2, respectively. Revenue increases by

more than in the case of perfect competition, because not only the sales quantity rises

(X2 >X1), but also the sales price (P2 > P1). At constant marginal cost of production, thedomestic producer ends up with higher profits. However, as discussed before, over time the

domestic marginal cost of production may increase (MC1 shifts to MC2), leading to a higher

price (PL), lower sales, market share and profits. As the analysis demonstrates, there is an

economic foreign exchange rate exposure even for domestic producers who do not engage

in international trade originating from import competition. Note, that this effect may occur

not only in the presence of foreign import competition, but also in the case of a threat of

foreign penetration of the domestic market.

3.2. Exposure analysis for importers

The effect of foreign exchange rate changes on exporters and on importers is essentially

the opposite for each. While a depreciation of the domestic currency improves the business


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Fig. 7. Impact of depreciation on importer with imperfect competition.

of exporters, it has a negative impact on the profits of importing firms. Here, we focus on

traders who can import any quantities of goods in the world market at a given price and

can sell these goods in domestic markets under conditions of monopolistic competition.

This implies that domestic markets can be separated from the world market. Of course, we

could alternatively assume that these firms are foreign producers with constant marginal

production costs who sell their products in what we refer to as the domestic market. Thus,

they are exporters of the foreign country.

Assuming that the domestic currency depreciates, importing firms are negatively affected

because imported goods become more expensive. In Fig. 7, we show this as an upward shift

of the marginal cost curve from MC1 to MC2. Note, that the same effect would result from

foreign inflation. As a result, the depreciation leads to a price increase in domestic currency

units and to a decline in import volumes. The import value will decline due to price-elastic

demand around the optimum.

With imperfect competition (i.e., a not completely elastic demand curve), the increase

in cost resulting from the depreciation reduces the quantity of imported goods (M2 P1), total

revenues of the importer decrease due to price-elastic demand around the optimum. Total

costs of the importer will decline as well, but to a smaller extent than the decrease in sales,

so that the depreciation of the domestic currency leads to a net decline in monopolistic

profits.

The analysis from the perspective of a foreign exporter or the parent company of the

importer both focusing on the effects in foreign currency units is very similar. As shown

in Fig. 8, marginal costs are unchanged, as the change in the exchange rate has no impact

on foreign currency costs. However, the sales price in foreign currency is lower after a

depreciation, and so is the profit-maximizing import quantity. Since a smaller number ofgoods are sold at a lower price, total revenues decrease. As they decrease more than total

costs, profits of the foreign parent company decline.


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Fig. 8. Foreign currency analysis of depreciation effect on importer.

3.3. Dimensions of complex economic foreign exchange rate exposure

An important aspect relevant for the analysis of the economic foreign exchange rate

exposure is the distinction between the currency of denomination and the currency of

determination (OBrien, 1994; Flood and Lessard, 1986; Dufey, 1972). The currency of

denomination of a transaction is the currency in which the payments of contractually fixed

agreements are specified (e.g., the currency specified in a purchase contract). By contrast,the currency of determination indicates which currency is most important in determining

the price in the world market. For example, lead is traded and paid in pound sterling at the

LME, but the price is determined by the U.S. Dollar, as the United States is a substantial

source of supply in addition to representing a large part of total demand. The currency of

determination is thus specified by the international competitiveness of corporations, which

results from comparative advantages in terms of technology, efficiency and effectiveness of

production, cost structures, etc.

To illustrate the previous point, consider the automotive industry. In this market, the

U.S. Dollar and the Japanese Yen can be regarded as currencies of determination. Because

of the significant size of the national car markets and the associated cash flows in theirnational markets, the value of these currencies also plays an important role for car prices

in international trade. Specifically, international competition forces car manufacturers in

other countries to follow price changes of producers from countries of the currencies of

determination in order to keep their market shares (Williamson, 2001).

The size of the exposure is closely related to its time horizon. In the short run, the

opportunity for firms to change their exposure is very limited. Changing cost structures

by altering sources of supply or the location of production is not possible within this time

frame. As a consequence, the asset exposures can be expected to be larger in the short-term

than in the long-term, where operative flexibility may be used to change the asset exposure

through the purchase, sale or relocation of assets. To illustrate, considerations concerningthe foreign exchange rate exposure of a firm may be a motivation to engage in foreign direct

investment, to create excess capacities or to invest in machinery with multi-functionality.


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Fig. 9. Transaction exposure of exporter with fixed sales.

However, to build in such flexibility will be costly. Conclusions with regards to the exposure

after hedging may be different, though, as financial hedging is readily available to provide

short-term protection. Another facet of the time dimension is the speed of the adjustment

processes of prices and quantities following a change in the exchange rate. The exposure is

determined by the ability to pass the (negative) consequences of exchange rate movements

on to other market participants and by the pace with which equilibria between exchange

rates, interest rates, and prices for goods and services are re-established (Bodnar et al., 2002;

Flood and Lessard, 1986).In reality, existing long-term purchase agreements between companies as well as techno-

logical facts often cause a time lag for exchange rate changes to induce the described effects

on prices and quantities. Moreover, the points in time for delivery, billing, and payment typi-

cally differ, giving rise to accounting and transaction exposures for accounts receivables and

accounts payables. As a result, firms often try to reduce their foreign exchange rate exposure

through the choice of the invoicing currency and the hedging of transaction exposures with

forwards or futures.

If the revenues of an exporter are fixed in the domestic currency in the short run because

sales quantities and prices are fixed either by setting prices in the domestic currency or by

hedging foreign currency prices through foreign exchange forwards/futures then only the

cost side of the exporter can possibly be influenced by exchange rate changes. As explained

above, a depreciation of the domestic currency can lead to cost increases if tradable factors

of production become more expensive or if an increase of production costs results from

increased domestic inflation as a result of the depreciation (Fig. 9). Consequently, profits

are reduced in the short run unless the cost of the input factors is hedged against currency

risk as well (Levi, 1996).3 The analysis of this situation in foreign currency (perspective

of a foreign parent) results in lower profits as well (in the short run), since the revenues

in foreign currency decrease for the same hedging/invoicing strategy and they decrease

more than the costs fall if the depreciation causes higher costs in the domestic currency.

3 However, hedging inflation risk is difficult in general.


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The previous considerations show that foreign exchange rate risk management by hedg-

ing individual transactions in the forward market (possibly on a revolving basis) or by

choosing the invoicing currency guarantees only a short-term reduction or delay of the

exposure. That is, foreign exchange risk for existing contracts can be hedged, but transac-tion hedging provides no protection against future changes of competitiveness induced by

(unexpected) exchange rate changes. For those changes, the implementation of a long-term

strategy or a long-term hedge is necessary. However, the extent and magnitude to which

such future effects on cash flows are relevant in the analysis and hedging of risk, depends on

the relevant discount rate. Since cash flows that are very far in the future are less important

for firm value, defined as the present value of all future cash flows, it appears sensible to

define a time horizon up to which cash flows are planned and considered in the analysis

(Oxelheim and Wihlborg, 1991).

The economic foreign exchange rate exposure of multinational firms typically has many

more dimensions and facets than that analyzed for the exporters and importers above, since

it is determined by many different factors. For example, as pointed out by OBrien (1994),

an exposure often exists for several products (multi-product exposure), several markets

(multi-market exposure) and with regard to several currencies (multi-currency exposure).

Apart from exports and imports of input and output components, the foreign exchange

rate exposure is often related to the financial structure of different (foreign) subsidiaries

with their parent company, which in turn is influenced by the repatriation of profits, e.g.,

via dividends, patents fees or royalties, transfer prices, etc. (Smithson, 2000). Through the

impact on the operating cash flow, the investment decisions of the firm are affected as well

(Campa and Goldberg, 1999).Consequently, it is often assumed that the foreign exchange rate exposure of multina-

tionals is larger than that of firms with primarily domestic activities. In this context, the

percentage of foreign sales or foreign assets is perceived as an indicator of the foreign

exchange rate exposure. However, companies with sizable international business in dif-

ferent countries and different currencies are often diversified across various currencies so

that they possess natural hedges (i.e., not only revenues but also costs depend on the

exchange rate) and that they can react at lower cost to exchange rate movements because

of their foreign subsidiaries (e.g., shifting of production, operative flexibility). In addition,

as discussed earlier, any firm or subsidiary can be exposed to exchange rate risk without

its operation necessarily being reflected in international trade, as long as it is faced withcompetition from abroad (Hodder, 1982).

If companies in the same industry are relatively homogeneous with regard to their busi-

ness activity, the industry sector might give a general indication about the extent of foreign

exchange rate exposure. Thus, export-oriented industries and sectors with import com-

petition can be expected to exhibit a positive exposure. By contrast, for industry classes

with high import content, a negative relationship between corporate performance mea-

sures and exchange rate changes can be expected. The economic foreign exchange rate

exposure is eventually determined by factors such as the international, industry- or even

firm-specific competitive structures, the degree of product diversification, the competitive

position, the extent of geographic diversification, and the relevant product and factor mar-kets (Allayannis and Ihrig, 2001; Marston, 2001; Johnson, 1996; Pringle, 1995; Moffett and

Karlsen, 1994; Lessard, 1991; Pringle, 1991; Luehrman, 1990; Abuaf and Schoess, 1988;


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Flood and Lessard, 1986; Dickins, 1988; Lessard and Lightstone, 1986).

To summarize, the following aspects are crucial for identifying, analyzing, and quanti-

fying the economic foreign exchange rate exposure of non-financial corporations:

a long-term, forward-looking perspective;

the clear focus on cash flows;

taking into account price and quantity effects of exchange rate changes;

the consideration of operative flexibility of the firm (adjustment of prices, changes of

market for inputs and outputs);

the focus on the currencies of denomination and determination.

4. Implications for corporate hedging decisions

With regard to the implementation of risk management strategies, financial as well as

operative hedging tools appear reasonable to cope with foreign exchange rate exposures.

Symmetric exposures can be hedged with cash transactions, including debt denomination,

or with derivatives, having straight line-payoff functions such as forwards, futures or swaps.

However, corporate exposures may not be linear or symmetric (Bartram, 2004). Asymmet-

ric foreign exchange rate exposures originate, for instance, when multiple currency price

lists are used, by which effectively a currency option is granted to the customer (Kanas,

1996a,b; Giddy and Dufey, 1995). Furthermore, real or financial options at the firm level

can cause non-linear exposures as well (Ware and Winter, 1988), and firms may adjust their

pricing in different ways as a reaction to currency appreciations and depreciations (Knetter,1994). Having recognized that exposures may frequently be non-linear, simple currency

options will rarely fit: exposures often reflect complex, compound options that may not

be available in the market (Giddy and Dufey, 1995). Apart from using derivatives, hedging

can be implemented by choosing the currency of denomination of short-term and long-term

debt and other cash transactions.4 Vice versa, the extensive use of currency options may

simply reflect that management is trying (or feels compelled) to arbitrage compensation

systems based on (deficient) accounting information the bottom line rather than cash

flow driven value maximization.

Internal methods of risk management such as making payments earlier or later (e.g.

for accounts payables), the matching/netting of cash flows in foreign currency or the use

of transfer pricing are, however, often rather ineffective instruments to manage foreign

exchange rate risk, as they reduce only the gross exposure of subsidiaries, but not the

exposure at the level of the consolidated parent company (Oxelheim and Wihlborg, 1997;

Eiteman et al., 2004). What counts is the change in the denomination of liabilities from

unrelated providers of funds that may result from such internal movements of funds.

In addition to derivatives and cash transactions, operative instruments can be employed

especially for the management of long-term exposures through the natural hedges of

production facilities abroad and the operative flexibility of excess capacities (Aggarwal and

4 The hedging effect of foreign currency debt is analyzed in OBrien (1994); examples are presented in Shapiro

(1999).


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Soenen, 1989; Lessard and Lightstone, 1986; Srinivasulu, 1981). Non-financial firms can

benefit from natural hedge positions if cost and revenue cash flows occur in such a way that

largely compensate currency positions, which depend on the same determinants (Shapiro,

1999; Chowdhry and Howe, 1999; Logue, 1995; Moffett and Karlsen, 1994).A general challenge of hedging exposures consists of the fact that the exposure is con-

stantly changing over time, reflecting changes in corporate assets and activities as well as

developments in the competitive environment. As a result, the hedge ratio is time-dependent,

and hedging needs adjustment whenever exposures change (Stulz, 2003). However, this

tends not to be a day-to-day occurrence and, thus, too frequent adjusting of financial posi-

tions tends to beprima facie evidence for financial management trying to beat the market.

Conceptually, it is useful to distinguish between the exposure of the operative assets

(gross exposure) of a corporation, and the exposure of the equity position (residual or

net exposure). The latter reflects not only the impact of foreign exchange rate risk on the

(operative) assets, but also the effects of the financial structure of the firm taking into

account the denomination and duration of its liabilities. Non-financial firms clearly derive

their competitive advantage from the effective and efficient use of operative assets, which

are primarily their real assets both tangible and intangible, but also include some financial

assets such as cash balances, receivables, and payables necessary to operate efficiently. The

core competency of non-financial firms in the market place for non-financial goods and

services allows them to make better predictions about the developments in these markets

and, thus, to generate profits from carrying the operative risks associated with their business

assets. As a consequence, they can increase firm value by taking on business risk that is

associated with these assets, as capital markets reward higher risks with higher returns.In contrast, non-financial firms cannot be expected to persistently make better predictions

on foreign exchange rates than professional traders in banks and other financial institutions

who provide transaction and pricing services for financial assets to their clients as their

core business. As a result, they will typically not be able to increase the value of the firm

by betting on particular exchange rate movements. To the contrary, theoretical arguments

largely supported by empirical evidence indicate that taking financial risk will generally be

a value-destroying strategy for firms outside the financial sector (Bartram, 2000).

Nevertheless, as always there are exceptions: In situations in which the access to seg-

mented financial markets is conditioned on having operative assets, financial transactions

can provide the firm with (additional) sources for value creation. Such is typically thecase in situations where corporate financial management is not competing in its pricing

efforts with professional traders in financial institutions with sophisticated information and

risk management systems, but essentially the objectives of a political system where non-

economic objectives dominate, which is particularly true with respect to countries with

exchange-control regimes.

As a result, the financial strategy of a firm, and thus the structure of its liabilities, will

generally be driven by its assets with the intent to accommodate or enable the optimal,

i.e. value-maximizing, operative strategy. Moreover, even firms with large asset exposure

should exhibit little stock price exposure (net exposure) if the gross exposure is reduced or

even eliminated through hedging. As a matter of fact, while a large number of empiricalstudies have investigated the impact of exchange rate risk on the stock returns of non-

financial firms, the general result of these studies is that only few firms have significant


17/20


foreign exchange rate exposures (e.g., Griffin and Stulz, 2001; Dominguez and Tesar, 2001;

Bartram, 1999; He and Ng, 1998; Bartov et al., 1996; Bartov and Bodnar, 1994; Jorion,

1990). To illustrate, Bartram and Karolyi (2003) find 9.9% of the 701 multinational firms

from 20 countries in their study to be affected by exchange rate risk (at the 5% significancelevel). Allayannis and Ihrig (2001) study different industry sectors in the United States and

find in 22.2% of them significant foreign exchange rate exposures. Similarly, about 14% of

the 1079 Japanese firms in the study by Doukas et al. (2003) are significantly exposed to

exchange rate risk. Overall, the bottom line of this large and growing body of evidence on the

exposure phenomenon appears to be that only about 1025% of all firms show significant

foreign exchange rate exposures regardless of the study characteristics. While this result

has often been perceived as below prior expectations based upon theoretical and anecdotal

predictions, it is very consistent with endogenous financial and operative hedging at the

firm level that reduces exposure to a level likely difficult to detect empirically given the

degree of noise in exchange rates and returns (Bartram and Bodnar, 2004).

One of the important implications of the above analysis is to establish the priority of

financial hedges over operative hedges (Dufey and Giddy, 1997). The ex ante economic

cost of choosing among alternatives of denominating debt (in uncontrolled markets) or

using straight-line derivatives is close to zero. In contrast, building flexibility into opera-

tions or shifting sources and markets after unexpected exchange rate changes, especially

when implemented on short notice, is usually quite costly. Only if financial hedges are not

feasible when financial markets are underdeveloped because of governmental controls

and regulations or if exposures are highly complex and quickly shifting, will opera-

tive hedging constitute the first best solution. This straightforward conclusion may have tobe modified, however, in those situations where adopting operating hedges involves real

options, which enhance the value of the firms investment. Having recognized this point,

the burden of proof of the superiority of an operating hedge over near zero-cost financial

hedging must be established on a case-by-case basis and will usually fail.

5. Conclusion

In the presence of deviations from parity conditions such as purchasing power parity and

the international Fisher effect, non-financial corporations are confronted by risks stemmingfrom the impact of unexpected exchange rate changes on the value of the firm. Nevertheless,

professional firm-wide risk management does not yet seem to be in place at all non-financial

institutions. Consequently, the need for implementing or improving risk management sys-

tems appears especially strong for firms outside the financial sector.

To this end, the lack of focus on economic foreign exchange rate exposure exhibited

by such firms justifiably deserves criticism. This is so particularly at a time when risk

management has become even more important in light of the globalization of business

activities, with increased competition and lower profit margins. This paper therefore ana-

lyzes the economic exposure of non-financial firms, focusing on cash flows. In this context,

the time dimension and other complexities of exposures are explicitly addressed. Theseconsiderations are then linked to corporate hedging decisions broadly defined. The role of

the competitive environment and the relevance of concepts of currency of denomination and


18/20


currency of determination are emphasized. The paper provides clear conceptual foundations

with the aim of improving managerial decision-making.

Acknowledgements

Helpful comments and suggestions by an anonymous referee and participants of the

Australasian Conference on Banking and Finance 2004 as well as financial support by

Lancaster University Management School is gratefully acknowledged.

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Documents

A primer on the exposure of non-ﬁnancial