UK Multinationals' Effective Use of Financial Currency‐Hedge Techniques: Estimating and Explaining Foreign Exchange Exposure Using Bilateral Exchange Rates

Abstract

Using a unique dataset of recently available accounting disclosures, this study examines the relationship between UK multinationals' stock returns and changes in the principal exchange rate to which each firm is most exposed. We find more firms with significant foreign exchange exposure estimates using this firm-specific principal currency data, compared with those exposure estimates using the broad exchange rate index data prevalent in prior studies. The cross-sectional variations in such principal-currency exposure estimates are explained in relation to the financial currency-hedge techniques that each firm specifically identifies as being used to manage its currency risk. In particular, we provide evidence that firms effectively use foreign currency derivatives and foreign-denominated debt to reduce the currency risk associated with the bilateral exchange rate to which they are most exposed. This study is important to both the academic and the practitioner communities because it represents the first use of publicly available UK disclosures to improve the estimation and explanation of foreign exchange exposure.

The FX exposure puzzle: insights from SEC disclosures

“…Table IV provides the OLS regression estimation results for the equation (2) primary model, using either the firm-specific BRV-based jFXEj dependent variable (in models 1 and 3) or the broad TWI-based jFXEj dependent variable (in models 2 and 4). The BRV-based results indicate that the FHEDGE variable is significant (at a , 0.0001 level) and negative, consistent with Table III univariate results and our expectation based on extant evidence of effective financial hedging (Allayannis and Ofek, 2001;Makar and Huffman, 2008;Bartram et al, 2010).…”

“…Note: Significant at: * 10, ** 5 and *** , 0.01 percent two-sided levels Keeping in mind that such returns-based FXE estimates are net of hedging (Bartram, 2008), we posit that the smaller BRV-based jFXEj levels are due, in part, to firm-specific FX hedge techniques [11]. For example, extant research attributes the negative relation between returns-based FXE estimates and the use of FX derivatives or FX denominated debt to effective financial hedging (Allayannis and Ofek, 2001;Makar and Huffman, 2008;Bartram et al, 2010).…”

A three-factor model investigation of foreign exchange-rate exposure

“…We address 1 In their Table 1, Bartram and Bodnar (2007) summarize the most important FXE studies using large samples in the non-financial sectors. Subsequent to their 2007 literature review, researchers have remained focused on the non-financial sector, given the complexity of a financial firm's FXE and risk management practices (e.g., El-Masry, Abdel-Salam, & Alatraby, 2007;Makar & Huffman, 2008). In contrast, recent studies in the financial sector that are not summarized by Bartram and Bodnar include the FXE of banks (e.g., Elyasiani, Mansur, & Pagano, 2007), and insurance and real estate (e.g., Muller & Verschoor, 2008;Li, Moshirian, Wee, & Wu, 2009).…”

Impact of Exchange Rate Derivatives on Stocks in Emerging Markets

“…Consequently, this work uses high frequency traded assets for the empirical analysis, like foreign exchange rate assets and stocks traded in the organized market. Thus, exchange rate exposure is measured as the regression coefficient of the exchange rate against the stock market (Adler & Dumas, 1983;Hodder, 1982;Makar & Huffman, 2008). Accordingly, to test the theoretical model, the empirical analysis follows the equation: Fu R − is the excess return of currency derivative.…”

“…The latter implies an exchange rate effect on stock prices or firm value. In this regard, several empirical studies have found either a weak or no substantial relationship between the exchange rate and stock prices (Jorion, 1990;He & Ng, 1998;Nguyen et al, 2007;Makar & Huffman, 2008;Lee & Suh, 2012;Inci & Lee, 2014). In a multinational context, an explanation for this puzzling weak relationship is that firms have been hedging their exchange rate risk using foreign currency derivatives (Kambi & Ali, 2016;Singh, 2017;Caves, 2007;Allayannis & Ofek, 2001).…”