Academic journal article Multinational Business Review

Hedging Transaction Exposure through Options and Money Markets: Empirical Findings

Academic journal article Multinational Business Review

Hedging Transaction Exposure through Options and Money Markets: Empirical Findings

Article excerpt

ABSTRACT:

This study compares the effectiveness of money market hedges and options hedges for both payables and receivables denominated in British pounds, German marks, Japanese yen and the Swiss franc. Data on interest rates, exchange rates, and options contracts were obtained from public sources for two recent time periods. This information was used to determine, for each currency: 1) the lowest rate of exchange for payables, and 2) the highest rate of exchange for receivables for each hedging technique. Unique "money market hedge exchange rate factors" and "options hedge exchange rate factors" were developed to facilitate comparisons between the two hedging techniques.

BACKGROUND

The decisions that multinational corporations (MNCs) must make regarding whether to hedge, or leave open, transactions denominated in foreign currencies can have a critical impact on both their expected returns and the riskiness of their cash flows. Even if MNCs believe they will profit from an unhedged position, they may decide, nonetheless, to hedge their positions to lock in the home-currency values of their future payables and receivables. If MNCs make a judgement to hedge these transactions, they must then determine which type of hedge to utilize.

A variety of hedging techniques are available, including the money market hedge and the option hedge. The money market hedge for payables requires the MNC to borrow home currency, convert this to foreign currency, and invest this foreign currency in a money market instrument denominated in that currency. For receivables, the MNC would borrow foreign currency from the (foreign) money market, convert this to the home currency, and invest this in the (home) money market.

Utilizing call or put options to hedge transactions, alternatively, is somewhat less complicated. To hedge payables using options, the MNC can obtain an option to buy a specific currency at a specific time at a specific price. To hedge receivables, MNCs can obtain an option to sell a specific currency at a specific time at a specific price. Notwithstanding the premium paid, hedging transaction exposure using options (as opposed to the money market) provides MNCs increased flexibility because the corporation can either exercise, or not exercise, an option contract.

The globalization of the world economy and increasingly volatile exchange rates have magnified the foreign exchange exposure of multinational corporations. In this environment of increased risk, more businesses are employing techniques to hedge their foreign transaction exposure. However, multinational and other firms may be better served by employing one hedging technique as opposed to another. This study provides critical information from a recent time period which may assist these firms in developing an optimal hedging strategy. For both managers and shareholders, any increase in return or reduction in risk resulting from such a strategy will create value and enhance stock price.

OVERVIEW OF THE LITERATURE

While derivatives have existed for some time, it is only within the last decade that their use has become widespread. Today, it is not uncommon for financial managers of multinational and international firms to use a variety of derivative instruments to hedge risk associated with transactions (both receivables and payables) denominated in foreign currencies. These instruments include die use of forward and futures markets, money markets, options, and currency swaps. Haight and Morrell (1996) provide a good overview of the use of derivatives to manage foreign exchange rate risk.

A number of key decisions must be made by firms (i.e., managers) facing foreign exchange rate risk. First, they must make a determination as to whether or not the foreign exchange rate risk should be hedged, or left unhedged. Kawaller and Zabal (2001) list the key questions that managers should ask when assessing risk:

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