Foreign Exchange Exposure Perception and Management of Turkish SMEs

Kula, Veysel, Journal of Small Business and Entrepreneurship

Introduction

The last decade has witnessed alarmingly volatile movement of the value of Turkish Lira against foreign currencies. For example, as the statistics of Turkish Central Bank (2004) say, the nominal value of Turkish Lira vis-a-vis 1 Euro depreciated from 628,301 TL on January 1, 2001 to 1,303,172 TL on January 1, 2002. This ever-increasing degree of exchange rate volatility has elevated the management of foreign exchange (FX) exposure to the position of prominent managerial concern.

Foreign exchange risk, the adverse affects of the changes in exchange rates on a company cash flow and eventually on a company value, is usually broken down into three categories: translation exposure, transaction exposure and economic exposure. Translation exposure, which is valid for only multinational companies, may occur while consolidating a subsidiary's financial statements in the parent company's currency. Marshall (2000) presents the view that the translation exposure should not be managed as it is purely an accounting concept not related to cash flows. On the contrary, Sucher and Carter (1996) point out that although there is no cash flow impact, hedging the translation exposure could be appropriate when a company is close to specified debt limitations and currency movements may lead the translated group accounts to show a breach of borrowing covenants. Additionally, the decision on hedging the translation exposure is influenced by the financial reporting requirements at play in the reporting country (Marshall, 2000).

Transaction risk, on the other hand, is the adverse effect of FX rate changes on cash flows, which is derived from the time lag between foreign currency-denominated contract date and the settlement date. As stated in the International Encyclopedia of Business and Management (1996), the concept of economic exposure links exchange rates to the value of the firm as it attempts to capture the impact of exchange rate movements on the net present value of its future cash flows. In contrast to transaction exposure, economic exposure takes a longer view of how future cash flows will respond to changing exchange rates; therefore it does not lend itself to easy quantification. As Martin and Mauer (2003: 438) put forward, economic exposure arises from changes in the sales prices, sales volumes, and the costs of inputs of the firms and its competitors as a result of exchange rate changes. Bradley and Moles (2001: 52) argue that absence of foreign currency transactions does not automatically eliminate economic exposure as even purely domestic firms with foreign-domiciled competitors or with suppliers sourcing abroad are affected from FX rate movements.

Most of the empirical firm-level studies of FX management focus on multinational companies (MNCs) or indigenous companies from developed countries. This study contributes to general knowledge by presenting evidence which relates to companies in an emerging market economy, Turkey. Furthermore, selection of small and medium-sized enterprises (SMEs) warrants special importance, because, as stated by Molindretos and Tsanacas (1995), the smaller-sized companies are often overlooked in studies of this nature. Given the fact that SMEs are regarded as the powerhouse of several countries, the success of SMEs has a direct influence on the national economy. Since they constitute 99% of all business establishments and employ 53% of the workforce in the manufacturing sector (Sariaslan, 1994; Taymaz, 1997), SMEs play a very important role in the Turkish economy. Focusing on SMEs and presenting new data and insights into this relatively unexplored research area in Turkey, the study will fill a knowledge gap on the foreign exchange perception and management of Turkish companies.

Managing transaction exposure aims at preserving or maximizing the current home currency cash flows of foreign currency-denominated contracts, whereas economic exposure management is about maximizing firm value by preserving or maximizing the future cash flows from operations. Therefore, as Grant and Soenen (2004: 53) put forward, these two exposures bear relation to the management's supposed goal of shareholder's wealth maximization. Due to their relevance to the wealth-maximizing firm, hence, this study will limit its focus to transaction and economic exposure perception, and thereof attendant management practices of SMEs in Turkey. The rest of the paper is organised as follows: In the following section of the study, the nature and the importance of the transaction exposure will be discussed. The next section will focus on the measurement and importance of economic exposure. Following that, the extant literature on both the transaction and the economic exposure measurement and practices will be reviewed. The section following that will detail the findings of the survey. The paper will end by presenting a summary and discussion.

The Nature and Management of Transaction Exposure

Transaction exposure concentrates on cash flows which require the actual conversion of currencies, and it arises whenever there is a time gap between a company committing itself to a foreign currency denominated cash flow and the time of its settlement (Glaum, 1990).

Transaction exposure is the exposure that many companies have in mind when they refer to FX exposure management. Though the transaction exposure is easy to manage, it tends to be relatively small in scale and generally has short-term implications (Coppe, Graham and Koller, 1996). Marshall (2000) reports that management of transaction exposure is the centerpiece of the FX management. The emphasis placed on transaction exposure is understandable in view of immediacy of impact of transaction exposure on the cash flows and profitability.

Companies can take a variety of positions against FX exposure. One of these strategies is "do nothing," in which the company accepts the currency exposure by sitting idly and leaves itself with the full upside as well as downside result associated with exchange rate movements. If cash flows are very minor and of little significance to the business as a whole, then it may be better not to hedge at all (Sucher and Carter, 1996). It is a fully legitimate strategy if it is a fully conscious decision supported by a market outlook and managed within the context of a defined level of exposure tolerance as well as a return objective (Latin Finance, 1996). In their study covering Canada, Germany, Japan, Switzerland, and the United Kingdom, Morey and Simpson (2001) support this view. There are four types of data used by the authors: spot exchange rates, forward exchange rates, share price indexes and consumer price indexes. The findings of the study show that though the selective hedging strategy based upon large forward rate premia generally outperforms the other strategies for the period of 1989-1999, in every sample and time horizon period, an unhedged strategy performs better than the strategy of always hedging with forward contracts. As FX is just one extra risk that a company may have to face, "taking a view" on FX movements and leaving currency cash flows uncovered may be a realistic commercial decision (Sucher and Carter, 1996). Faced with FX exposure, companies may wish to follow another alternative: managing the risk.

Risk managers can be either risk averters or risk takers. Risk-averse managers follow the strategy of seeking to protect the returns of their primary business operations when engaging in FX transactions. Risk seekers, on the other hand, engage in FX transactions with the intention of profiting from their trading activities. Risk aversion mechanisms attempt to eliminate uncertainty and are typically categorised as hedging (Mathur and Knowles, 1985).

Thus, hedging is a term used to describe risk avoidance and includes all actions that the firm takes with the intention of changing its risk exposure due to changes in the relative values of currencies (Mathur and Knowles, 1985). If a company decides it is in its best interest to …

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Publication information: Article title: Foreign Exchange Exposure Perception and Management of Turkish SMEs. Contributors: Kula, Veysel - Author. Journal title: Journal of Small Business and Entrepreneurship. Volume: 18. Issue: 4 Publication date: Fall 2005. Page number: 437+. © Not available. COPYRIGHT 2005 Gale Group.

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