Resolving the Exposure Puzzle: The Many Facets of Exchange Rate Exposure FDIC October 27, 2006

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Resolving the Exposure PuzzleThe Many Facets of
Exchange Rate ExposureFDICOctober 27, 2006

• Söhnke M. Bartram
• Lancaster University
• Gregory W. Brown
• University of North Carolina
• Bernadette A. Minton
• Ohio State University

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Motivation

• FX risk is a major financial risk to nonfinancial
  firms
• FX Exposure Puzzle
• Theoretical models predict exposure
• Bodnar, Dumas and Marston 2002 Marston 2001
  Adler and Dumas 1984 Shapiro 1975
• Empirical studies find weak evidence
• Allayannis and Ihrig 2001 Dominguez and Tesar
  2001a,b Griffin and Stulz 2001 Williamson 2001

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How to Resolve the Puzzle?

• General idea/hypothesis of this paper
• Firms do have potentially large FX risk
• Pricing and financial policies reduce exposures
• Analysis
• Use structural models to analyze different facets
  of FX exposure and hedging
• Gross (or pre-hedging) exposure
• Net (or post-hedging) exposure

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What We Do

• Motivating Example Global Automotive Industry
• Bodnar and Marston (2002) model
• Detailed firm-level data
• Enhanced Bodnar, Dumas and Marston (BDM, 2002)
  model
• Firm selling and producing in local and foreign
  market
• Exposure is a function of
• market share
• product substitutability,
• sales and cost in foreign currency
• Use model to analyze a large sample of global
  manufacturing firms around the world

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Contribution

• Resolving the Exposure Puzzle
• Model predicts that firms should have large gross
  FX exposures
• Firms reduce these exposures via three channels
• Pass-through (10-15)
• Operational hedging (10-15)
• Financial hedging (45-50)
• Residual FX exposures (as estimated in the prior
  literature) are economically and statistically
  small

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Automotive Industry

• Industry study to motivate main analysis
• 16 auto manufacturers from 6 countries
• Mature and competitive industry
• Important FX risk (Williamson 2001)
• Bodnar and Marston (2002)
• h1 percent foreign sales
• h2 percent foreign cost
• r profit margin

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Automotive Companies
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Automotive Companies
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Automotive Companies
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Automotive Companies
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Automotive Companies
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BDM Model

• FX exposure of exporter
• Exposure depends on
• Product market competition gt pass-through
• r degree of product substitutability
• l market share of exporting firm in foreign
  market
• Operational Hedging
• g fraction of marginal cost due to foreign
  currency-based inputs

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Enhanced BDM Model

• Two extensions of BDM model
• Both firms can have cost in local and foreign
  currency
• Firm sells globally
• Global firm is sales-weighted average of foreign
  and domestic operations (f is percent of foreign
  sales).
• Model is more broadly applicable
• Captures global firms in global markets
• Allows for broader set of exposures and
  pass-through
• BDM model is a special case of enhanced model

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Enhanced BDM Model

• Foreign Exchange Rate Exposure
• Foreign Exchange Rate Pass-Through

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Parameters
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Parameters
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BDM vs. Enhanced BDM
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Automakers Again
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Sample and Data

• 1,161 manufacturing firms from 16 countries
• Accounting data (USD) (Thomson)
• Market data (LC) (Datastream)
• Import penetration (UNIDO, SSIS)
• Herfindahl indices to measure industry
  competition (complete Worldscope universe)
• Collect data from annual reports for FX
  derivatives and foreign currency debt

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Sample Statistics
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Model Exposures Pass-Through
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Model Exposures Pass-Through
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Level of Model Exposure
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Level of Model Exposure
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Level of Model Exposure
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Level of Model Exposure
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Hedging Effects
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Hedging Effects
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Hedging Effects
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Hedging Effects
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Hedging Effects
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Importance of Hedging Channels

• Gross FX exposure 0.674
• no market share, no foreign assets, no financial
  hedging
• values at sample means, rfrd 0.7
• Firms reduce FX exposure via 3 channels
• (1) Pass-through (10-16)
• - Market shares at sample average
• (2) Operational hedging (9-16)
• - Foreign assets at sample average
• (3) Financial hedging (46 - 50)
• - FC Debt (45)
• - FX Derivatives (1)
• Consistent with Guay and Kothari (2003),
  derivatives have limited impact on risk profile
  of the firm

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Industry Portfolios
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Summary

• Comprehensive analysis of FX exposure
• Resolving the Exposure Puzzle
• Firms have large gross FX exposures
• Firms reduce these exposures via pass-through,
  operating and financial hedging
• Residual FX exposures are economically and
  statistically small
• FX risk management is effective, and companies
  can stop whining about FX risk