Introduction

This paper discusses the effects of foreign exchange risk which arises due to fluctuations in currency rates. Firstly it identifies the risks that companies have to bear in their everyday transactions mainly because of the reqional or global footprint of these companies. To reduce this risk companies tend to hedge their currency risk by using different financial instruments such as forwards, futures, options and currency swaps or a combination of these(C. Geczy et al( 1997)). These instruments are used widely by comanies but the question whether it has any effect on the shareholders value remains contentious as after all the prime aim of a business is to increase shareholders value.

Hedging: Ways of Hedging

These risks are countered by using different hedging methods such as using forward contracts, future contracts, options and currency swaps or a combination of these. These methods are applied in different ways and in different situations depending upon the requirement of the company hence it is imperitive to understand these methods before going any further.

Forward contract: It is an agreement to buy or sell an asset at a future price on a future date. Companies use this to reduce their risk on payments which they are expected to receive on a future date or on any other transactions such as deferring the payment to the suppliers and on many more trasactions.

Future contract: It is similar to forward but an asset is traded at a defined future market price. These contracts are traded on a futures exchange rather than being traded between two parties.

Options: It is a contract between the buyer and the seller in which the buyer has the option but not the obligation to buy or to sell any underlying asset at a strike price. This is a more favourable contract as offeree is protected from an offerer's ability to revoke the contract.

Swaps: It is an agreement between two parties in which they agree to exchange their principal or interest in one currency to another currency but the value of both the currencies remain equal.

Risks

Currency volatility gives rise to some risks when companies engage in cross border trade. These risks are mentioned below:

Transaction Exposure: As M.P. Kelly (2001) mentions is the risk which the firms have to bear if they are involved in international transactions. It might be related to the payments a company expects to recieve in foreign currency or if the firm might have foreign debt. Changes in currency market rates can heavily increase this exposure and can impact on the firm's earnings or liabilities.

Accounting exposure: Firms that have their equities, assets, liabilities or income in foreign currency cannot simply convert them into home currency because of exchange rates volitility. This volatile situation poses a risk of mis-translation when formulating accounts as it can lead to a gains in assets or liabilities or vice versa. This risk is known as accounting exposure and accountants use various methods to reduce the risk if not eliminate it.

Operating exposure: This risk is concerned with the expected future cashflows of a company in a foreign currency. These cashflows arise from the intercompany or intracompany transactions which comprise of things such as payables, receivables, rent, lease payments and others(Eiteman et al.(2004)).

Motives:

There are many motives why frims use derivatives. These motives might not be solely related to reducing risk but to a wide variety of reasons. C. Geczy et al. (1997) did a study of top 500 non-financial US based firms in 1990 and found out that 372 of these firms use derivastives in some way or another. 41% of these firms were using the hedging techniques mentioned above. This data gives a hint about the importance of these derivatives. They also found that the firms which have greater growth opportunities and tighter financial constraints are highly likely to use derivatives. Most of the multi-national firms come in this category which provide excellent growth opportunities and at the same time are really concerned about their financial security.

The next reason to use derivatives is described by Shapiro and Tinman (1986) in thier study of frims in which they show a positive co-relation between the use of derivatives and the variation in cashflows. The higher the variation in cashflows the more likely the firm would indulge in hedging. C. Geczy et al. (1997) touches the same point and gives a same picture showing a positive relation between foreign pre-tax income and the use of derivatives. If the foreign pre-tax income is higher than the firm would use hedging more vigorously due to the variation in their cashflow becasue foreign exchange volatility would effect more on higher income than on lower income. Hence it would be fair to say that economies of scale are important determinants of currency derivatives use. Aretz and Bartram (2009) relate the use of derivatives to debt levels, dividend policy, holding of liquid assets. This points to the fact that if a firm has foreign liabilities, a dividend policy which emphasises on giving out dividends year on year and if the company has liguid assets based overseas than the firm is highly likely to hedge its risk.

Another motive for using hedging techniques is the fact that by reducing volitility in the cashflows and giving a more stable picture, hedging actually helps in developing an accurate budget. Accurate budgetig can impact directly on controlling the finances of the company more vigilantly.

The role of management is critical in using derivatives. Derivatives ar more likely to be used where the management has some vested financial interests as management have more information than the shareholders. Lel (2006) provides an understanding of this by pointing out that the firms or countries with weak corporate governance are more likely to hedge risk associated with executive stock plans. Hence this can be another motive for using hedging techniques

Incentives:

Taxation

It is a highly contested topic among authors which argue that using hedging increases the post-tax value of the firm. Aretz and Bartram (2009) argue that hedging can stabilise taxable income in a way that savings from higher income states exceeds additional taxes from lower icome states hence lowering the average corporate tax burden in the case of a multi-natioanl company whjose operations such as manufacturing plants are based overseas. Smith and Stulz (1985) took this point one step further by sayin that if the investors are all from one country than they all face a same tax rate hence the risk can be reduced but if they are from different countries and might face a diferent tax rate so in this case the decrease in the firms expected tax liability from hedging is offset by an increase in the expected tax liability of the investors. Although hedging can well increase the firms value in general but in some cases the firm might not prosper in hedging due to investors as mentioned before. Hence the higher the firms pre-tax income the greater the benefits from hedging (Geczy et al. (1997))

Bankrupcy and Financial Distress:

Firms that are highly levered might find it difficult to meet their payment requirements due to the volitility of their cahsflows and be forced to file bakrupcy. In this case creditors and shareholders queue up to get their share of the company. Volitility of the firm value is reduced by hedging which in turn lowers the expected cost of financial distress which results in low bakrupcy costs(Aretz and Bartram (2009)). Even before bankrupcy is filed, hedging can stabilise the cashflows of the firm and reduce the volitility. This might be enough for the company to sustain high leverage and meet its requirments. Hence if bankrupcy costs are kept low than the shareholders or claimholder's in general can get a high expected payoff moreover the firm's price for its new debt increases if the firm benefits from a reputation for hedging(Smith and Stulz (1985)).

Conclusion:

Hedging as described by Aretz and Bartram (2009) works where there are imperfections in a capital market. These imperfections give an impetus to the firms to hedge and reduce their risk which may be due to natural foreign exchange volitility or speculative.

Looking at section 4 and 5 it can be seen that how beneficial hedging can be for the firm but also for the shareholder whose main aim is to increase his value. This increase in value can only takes place if the value of the firm increases. Hence to increase the value of the firm, it has to perform efficiently and to maximise its profits. Profits will be maximised only when the firm is risk averse as much as possible. Hedging can be highly beneficial in making a firm risk averse. Although it will be fair to say that there are certain scenarios in which hedging might not prove to be beneficial which are mentioned in the text. So, whether hedging increases shareholders value or not remains a debatable question but in a nutshell it can be said that it generally benefits a firm and its shareholders.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/effect-of-foreign-exchange-risk.php


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