Currency Exposure In Exchange Risk

Foreign exchange risk management is an important consideration for international companies and plays an important role for a stable performance of a company. Firms that engage in exporting and/or importing products or in any way have to deal with at least two currencies within their operations are vulnerable to changes in currency exchange rates. Currency exposure can have an impact on company’s cash flows, market value and financial reporting. Therefore for firms with such exposures it is vital to be aware of how good their hedging strategies are and what are the best ways to deal with these risks.

Events such as currency crisis can pose a threat to the stable cash flows of a multinational firm. A firm can benefit from or be harmed by the fluctuations in exchange rate, depending on whether it is an exporter or importer. However most firms are concerned with lowering their cashflow variability rather than try to be on “the right” side of the trade. While firms usually hedge the foreign exchange risk, such severe and difficult to predict events can exceed their hedging capacity and cause damage to firms’ operations. According to Adler and Dumas (1984), a firm can hedge currency exposure perfectly if exposure of future cash-flow is known. However it has been documented more than once, that on average firms do not hedge their currency exposure fully (Bodnar et al, 1998; Joseph, 2000). The reason could be that firms use derivatives only during highly volatile periods and not during tranquil periods, therefore on average their exposure is not fully hedged. Other explanation could be that firms use derivatives for speculation purposes and that their usage does not indicate firms’ intentions to hedge the risk.

To react to a quickly chang...

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...firms are exposed to currency crises (see literature review section). Furthermore, in light of mixed empirical result in FX exposure literature, this paper attempts to find meaningful and determinant links between rare exchange rate events and stock performance.

In the first step of this investigation I will identify the currency shocks and determine the months when they have occurred. For this part I will use exchange market pressure index (EMP) with three variables (exchange rate, international reserves and interest rates), originaly defined by Eichengreen et al. (1994), which is now commonly used. In the second step I will estimate augmented market model proposed by Jorion (1990) with a dummy variable to determine the impact of currency crisis. Finally I will investigate how firm’s size and foreign income can explain cross-sectional variation in FX shock effects.