Hedging preferences and foreign exchange exposure management
The turmoil in the global financial markets, the volatility of the foreign exchange rates and the intensified global competition in the product and the resource market have complicated the decision making process and have increased the level of uncertainty regarding the outcome. The rising value of the U.S. dollar (1980-1985), the decline in its value (1985-1988) and the instability since 1988 have had a profound impact on domestic and foreign sales of U.S. MNCs on their profit levels and on their profit margins. At the same time international developments–Europe 92, the Gulf War, the breakup of the USSR and the emergence of the new democracies in Eastern Europe–are providing U.S. multinationals with renewed opportunities for overseas markets. Changes in information technologies have increased the speed and the accuracy of information while the surge of financial innovations are providing the decision makers with new hedging techniques to deal with the uncertainty regarding financial flows. This type of an environment requires Chief Financial Officers (CFOs) who are knowledgeable and who could react to perceived opportunities as well as threats.
This paper reports the findings of a survey of CFOs of multinational corporations and compares their responses to the hypothesis brought forward from other researchers. The purpose of the survey was to: (a) determine whether or not the CFOs had a clear understanding of economic exposure, transactions exposure and translation exposure; (b) determine whether the corporations surveyed managed all three types of exposure and which methods they used; (c) determine whether the CFOs had a clear definition of the three different types of foreign exchange exposure.
FOREIGN EXCHANGE EXPOSURE
Eitman and Stonehill (1986) and Shapiro (1991) define the three types of foreign exchange exposure as:
Translation exposure,… accounting based changes in consolidated financial statements caused by exchange rate changes.
Transactions exposure occurs when exchange rates change between the time that an obligation is incurred and the time it is settled, thus affecting actual cash flows.
Economic exposure reflects the change in the present value of the firm’s expected future cash flows as a result of an unexpected change in exchange rates.
The increased volatility in the earnings of MNCs in the late seventies and the translation losses which entered the income statements forced CFOs to adjust their corporate strategy (Selling and Sorter, 1983). It is reasonable to assume that the CFOs would pursue strategies that restrict or eliminate the probability of translation losses especially if their performance is judged by the stability and the growth of quarterly earnings. Stanley and Block (1978) indicate that 52% of CFOs hedged against translation exposure during this time, even though the strategy contradicted proper economic exposure coverage. For example, cash flow losses could be created from hedging by altering the structure of the balance sheet, using the forward markets, or using the money markets. In fact, Stanley and Block report that 23.2% of their respondents answered that management of translation exposure resulted in an increase in economic exposure. This implies that funds we misallocated for noneconomic or nonproductive purposes as firms were engaged in costly efforts to hedge foreign activities.
In Stanley and Block’s paper economic exposure included both the concepts of transactions exposure and economic exposure. This can, in fact, be appropriate. Both of these foreign exchange exposures deal with cash flows and their variability as a result of changing exchange rates. Transactions exposure results in short run variations in cash flows whereas economic exposure creates changes in the firm’s long run cash flows. According to Stanley and Block, among MNCs the concept of economic exposure is not sufficiently understood. As stated in their paper:
“Among those who stressed the management of economic exposure rather that translation exposure, one could infer widely differing definitions of “economic exposure.” A sizeable number of respondents indicated that they were making studies to determine the nature of their economic exposure, did not know what it was, or how to define it and/or . .. were conveniently ignoring it (1978, p. 93).”
SURVEY AND EXPECTED RESULTS
According to Fame and Miller (1972)
… the theory of finance is concerned with how resources are allocated through time and how the existence of capital markets and firms facilitates this allocation process.
Since perceptions are important determinants of how individuals and firms allocate resources perceptions are worthy of study. The decision making process in a multinational corporate environment is often not a properly defined process, but one that is very much influenced by expectations and perceptions about the current and the future course of events. The complicated and conflicting issues arising in foreign exchange risk management render surveys on valuable tools into the insight of the decision maker and the methods that this decision maker would employ.
The current survey was structured to test the CFOs knowledge, perception, and attitudes about the efficient market hypothesis as it pertains to foreign exchange rates, the time horizon used in decision making and the application of accounting principles and regulations to deal with the problems arising from the changes in the exchange rate. The expectations are as follows:
1. The importance of foreign exchange exposure management on the stability of the financial flows would imply more knowledgeable CFOs in the selection of the proper strategy. [Statements 9,10,11,12]
2. CFOs who believe that the exchange rate markets are efficient would not react to short term fluctuation in the exchange rate but would anticipate a market adjustment. [Statements 5,6,7]
3. CFOs would prefer the use of, and they would rank higher those contractual hedging tools for which they have a greater degree of familiarity and understanding. [Statements 4,5,6,7,8]
The reaction to the foreign exchange risk by the CFO would thus depend on the corporate time horizon for realizing gains/losses, the evaluation of the management’s performance and the familiarity with the various hedging techniques and strategies. A short term view would (a) lead to a preference for strategies which minimize the fluctuations in the income statement, (b) increase the magnitude of hedging, the forms of hedging and the costs of hedging and (c) CFOs would opt for using the home currency as the functional currency for greater number of foreign subsidiaries thus impacting on their operating efficiency. The specific reaction will depend on the corporate attitude about risk and speculation, the familiarity of the CFO with foreign money markets and the geographic dispersion of the subsidiaries. It is appropriate to mention again that the CFO could choose to remain passive if he/she believes that the fluctuation in the rate of exchange are cyclical and an adjustment is in the horizon.
A survey of 12 questions was mailed to CFOs of 150 U.S.-based MNCs in late 1990 early 1991. A cover letter explained that all responses would be anonymous and confidential; no serial numbers or other identifying marks were used to ensure anonymity of the responses. Postage-paid reply envelopes were provided to the respondents returning the surveys. Other suggestions of Singhvi (1981) were followed.
A total of 36 usable responses were returned, for a response rate of 24%. The study concentrated on smaller size companies for a number of reasons:
a) smaller size companies are often over-looked in studies of this nature
b) the global environment in which business compete necessitates ever increasing knowledge of foreign exchange by CFOs even of smaller companies
c) traditionally smaller companies have relied heavily on banks and outside consultants for advise on foreign exchange exposure matters.
Table 1 (omitted) summarizes the dimension of data sought and collected through the survey.
The first three statements provided evidence of the international component of the respondent’s operations, assets, and global dispersion. On the average 13% of sales and 25% of assets of the responding corporation were foreign. These numbers, although not as high as those of the largest MNCs, are nonetheless substantial to draw the attention of top management to foreign exchange matters.
Statement 4 sought information on the CFOs knowledge of functional and reporting currency as it pertains to the operations of its foreign affiliates. On the average the dollar was used as the functional currency for 43.36% of the affiliates while the local currency was used for over 56 percent.
Statements 8 through 11 sought information on the CFOs knowledge and definition of the three types of foreign exchange exposure. Specifically: statement 8 instructs the CFOs to rank economic, transaction and translation exposure in terms of importance to their organization, statements 9, 10, and 11 refer to the CFOs definition of each type of exposure and statement 12 seeks to identify if the CFOs could clearly distinguish between transaction exposure and economic exposure. The results appear on tables 2 and 3.
The evidence presented in Table 2 (omitted) indicates that transaction exposure was the overwhelming choice of CFOs in terms of the attention that it ought to receive, with over 67% ranking it as number 1, followed by economic exposure 27%. Translation exposure received the highest number in ranking 2 with 43%, followed by economic 32%. Interestingly translation received over 45% of the number 3 rank. It is important to point out the balance in the ranking of economic exposure by the CFOs: 27% ranked No. 1, 32% ranked No. 2 and close to 40% ranked it No. 3. This could imply that: (a) firm specific situations differ across the respondents with regard to economic exposure; (b) the CFOs are not familiar with the long term influence of a devaluation on an exporting subsidiary or (c) the CFOs are uncertain as to how the financial markets would evaluate such an event. Although there is a clear preference in rank for transaction exposure there is no clear preference for translation and economic exposure as far as importance and attention required. These findings are reconfirmed by the responses to question 12, with 73% indicating a clear difference between economic and transaction exposure.
The various definitions of foreign exchange exposure and the results are presented in Table 3. Over 94 % of the respondents correctly defined translation exposure as a change in the consolidated financial statements as a result of a shift in the exchange rates. The definition is very similar to the one given by Shapiro (1991) and Stonehill-Eiteman (1986). With respect to transaction exposure 92% of the respondents defined it as a change in the amount the firm has to pay or receive on its outstanding obligations as a result of a shift in the exchange rate. The overwhelming choice indicates a clear, precise, definition of transaction exposure. Over 70% of the respondents defined economic transaction correctly while six respondents confused unexpected changes in the exchange rate with expected changes in the exchange rate. Surprisingly 2 respondents confused translation and economic exposure. Overall it appears that CFOs have a clear understanding of the different types of foreign exchange exposure. Their understanding of economic exposure, although high, is significantly less than their understanding of translation and transaction exposure. The findings seem to deviate from the findings of Stanley and Block. Their findings and their conclusions indicated that the concept of economic exposure is not clearly understood. Specifically:
… a sizeable number of respondents indicated that they were making studies to determine the nature of their economic exposure, did not know what is was, or how to define it and/or were conveniently ignoring it (1978, p. 93).
The adverse impact of the exchange rate fluctuation on the financial performance of their corporations and the intensity of that impact in the late 80’s has induced CFOs to become more knowledgeable. The clear understanding of transaction exposure is evident of the attention that smaller companies pay to short run fluctuations in cash flows and profit margins.
Statements 5, 6, and 7 seek to identify the hedging tools/techniques and the frequency with which these tools/techniques are used in managing translation, transaction and economic exposure. The tools/techniques could be classified under two strategies: contractual and operational. The results are presented in tables 4, 5 and 6. (Tables 4, 5, and 6 omitted.)
Statement 5 deals with the strategies and tools of managing translation exposure. Over 75% of the respondents utilized some form of hedging, 16% did not (Table 4). Of the various tools available the credit swaps, the money market hedge, and the futures foreign exchange hedge are among the least used. In fact only two respondents used credit swaps very infrequently, three used the money market hedge frequently and two used the futures hedge very frequently or frequently. The most frequently used tools are: the acceleration or deceleration of payments in foreign currency, the forward foreign exchange hedge, the diversification of financial resources, and the diversification of plant, operations and marketing. Of these, the diversification of the financial base is most highly used in both frequency and intensity. The results seem to indicate that a higher percentage of CFOs hedged against translation exposure at this time, 75%, than did previously in the 1978 Stanley and Block study, 52%.
Statement 6 seeks evidence of hedging activity and preferential hedging tools by CFOs in managing transaction exposure. The responses indicate that over 90% do hedge for transactions exposure (Table 5). The findings are very much in line with the clear understanding of transaction exposure by CFOs and the high ranking that transactions exposure received (Statements 8 and 10). The least used techniques are: credit swaps, money market, futures and currency swaps. Of the least used techniques the currency swap is used very frequently by one CFO and the money market hedge by two. The most preferred tools of hedging for transactions exposure are: the forward foreign exchange hedge, the acceleration/deceleration of payments in foreign currency and the diversification of the financing sources. In fact, the forward hedge is the most preferred technique, in terms of both frequency and intensity of use, preferred by 83% of the respondents.
Statement 7 seeks evidence of hedging activity and the preferred tools used by CFOs in managing economic exposure. Over 22% of the respondents indicated that they do not hedge for economic exposure while another 22 % indicated that they do something else. This is not surprising given that: (a) over 27% of the respondents did not feel that there is a distinction between transaction and economic exposure, (b) a lower number of CFOs had a clear definition of economic exposure (c) there was no clear preference in the ranking of economic exposure among the CFOs. The least preferred hedging tools are: credit swaps, money market hedge futures foreign exchange hedge, and currency swaps. The most preferred hedging techniques are diversification of plant, operations and marketing, diversification of financing sources, forward foreign exchange hedge, and acceleration or deceleration of payments in foreign currency. Of these the diversification of techniques are the most preferred.
The findings of this survey indicate that financial managers of smaller Fortune 500 companies have a clear understanding of the different types of foreign exchange exposure. Their understanding of translation and transaction exposure is better than their understanding of economic exposure and there seems to be more of a consensus as to how they affect economic value. Whether this is a result of short term versus long term orientation and focus in evaluating exchange rate fluctuations, or simply an indication by the CFOs that the immediate results are weighted heavier than the longer term results by the financial markets is something that requires further investigation.
The majority of the respondents did get involved in some type of hedging. The hedging is greater for translation and transaction than for economic exposure.
The ranking of the hedging tools in order of importance:
1. Forward contracts
2. Diversification of financing sources matching maturity-duration of exchange rate sensitive assets and liabilities
3. Acceleration or deceleration of payments in foreign currency
4. Diversification of plants operations and marketing.
The reason for these ranking seems to be the certainty about the cost, the flexibility and the liquidity that they provide.
Currency swaps were used considerably more that futures contracts and options, indicating that there are either not easily understood by CFOs or they were deemed undesirable. The lack of preference for the higher interest rate credit swap and the money market hedge could be indicative of the inability of the smaller firms to obtain loans or a line of bank credit because of higher credit requirements by banks at this time.
There is no consensus among CFOs as to the use of specific strategies for dealing with economic exposure. The preference is for leads and lags in payments and diversification of the financial and operating base.
This study sought evidence of understanding of foreign exchange exposure by CFOs and preference for hedging strategies and instruments utilizing the survey method. A number of conclusions are possible. One, CFOs have an improved understanding of exposure especially translation and transaction exposure. This can be attributed to their belief that investors will evaluate CFO performance on a short term horizon, and that the visibility of losses/gains resulting from such exposure is important in such an evaluation. Two, there is a clear preference among CFOs for managing transaction exposure. This is attributed to the greater impact of transaction gains/losses on the financial statements of smaller companies. Three, the forward foreign exchange hedge is the preferred instrument for handling exposure, followed by operating strategies, especially diversification of the financial and operating base and changes in the timing of leads and lags in payments. It should be pointed out that there is substantial confusion as to the use of the forward foreign exchange contract as a hedging technique when managing translation exposure. Clearly this is not a hedge but forward speculation as to the sum of the book loss. Four, there is uncertainty as to the selection of a proper strategy for hedging economic exposure perhaps because the cost of flexibility and the cost of reacting to exchange rate changes is greater than an optional hedge.
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Copyright College of Business Administration. University of Detroit Mercy Fall 1995
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