Hedging Preferences and Foreign Exchange Exposure Management
Malindretos, John, Tsanacas, Demetri, Multinational Business Review
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. …