42

i) Long-term forward contract: Until recently, these contracts were seldom used.

But today they are popular. Long forwards are especially attractive to firms that

have set up fixed-price exporting or importing contracts over a long period of

time and want to protect their cash flow from exchange rate fluctuations.

ii) Currency swap: A second technique for hedging long-term transaction exposure

to exchange rate fluctuations. It can take many forms. One type of currency swap

accommodates two firms that have different long-term needs. To create a

currency swap, firms rely on financial intermediaries who can accommodate their

needs. Large banks and investment firms employ brokers who act as

intermediaries for swaps. Corporations that want to eliminate transaction exposure

to specific currencies at certain future dates contact a broker, who then finds one

firm that needs the currency another firm wants to dispose of (and vice versa) and

matches them up. The broker receives a fee for the service. Overtime, the

currency swap obligation may become undesirable to one of the parties involved.

The swap agreement may require periodic payments from one party to the other to

account for exchange rate movements, so as to reduce the possibility that one

party will not fulfill its obligation by the time the exchange of currencies is

supposed to occur.

iii) Parallel Loan: A Parallel loan is also known as back-to-back loan involves an

exchange of currencies between two parties, with a promise to re-exchange

currencies at a specified exchange rate and future date. It represents two swaps of

currencies, one swap at the inception of the loan contract and another swap at the

specified future date. A parallel loan is interpreted by accountants as a loan and is

therefore recorded on financial statements.

43

2.7.1.2 Internal or Natural Hedging Techniques:

When a perfect hedge is not available or is too expensive to eliminate transaction exposure, the

firm should consider methods to at least reduce exposure. Such methods include:

1. Leading and Lagging: The act of leading and lagging involves an adjustment in the

timing of a payment request or disbursement to reflect expectations about future currency

movements.

2. Cross hedging: A common method of reducing transaction exposure when the currency

cannot be hedged.

3. Currency diversification: Currency diversification can limit the potential effect of any

single currency’s movements on the value of an MNC.

4. Invoicing: A firm may be able to shift the entire exchange risk to the other party by

invoicing its exports in its home currency and insisting that its imports too be invoiced in

its home currency.

5. Netting and Offsetting: A firm with receivables and payables in diverse currencies can

net out its exposure in each currency by matching receivables with payables. To be able

to use netting effectively, the company must have continuously updated information on

inter-subsidiary payments position as well as payables and receivables to outsiders. One

way of ensuring efficient information gathering is to centralize cash management.

Some countries impose restrictions on netting as part of their exchange control

regulations. These may limit the scope for netting or prohibit it altogether. It may still be

possible to minimize the number of currency conversions by centralizing cash

management.

44

CHAPTER THREE

3. EMPIRICAL EVIDENCE

3.1 Introduction

This part of the thesis is devoted to analyze the various research outputs conducted by different

academicians and/or practitioners on the subject of corporate foreign exchange risk management

practices and also on the relationship between exchange rate volatility and international trade

across the world.

3.2 Studies on Corporate Foreign Exchange Risk Management Practices

Talat Afza and Atia Alam (2011) studied non-financial firms of Pakistan, which were listed on

Karachi Stock Exchange. The purpose of the study was to identify the impact of factors

particularly financial distress costs, underinvestment costs, tax convexity, and managerial

incentives on firms’ decision to use foreign exchange derivative instruments to reduce foreign

exchange risk. To differentiate the users of derivative instruments from non-users they used a

non-parametric Univariate test and to identify the determinants of firm’s hedging policies, Logit

model was used. The non-parametric Univariate analysis which tested the mean difference

between the operating characteristics explained that derivative users had higher financial distress

costs, lower leverage ratio, lower interest coverage ratio, large in size, low growth opportunities,

lower level of profitability and liquidity, lower dividend payout ratio, higher managerial

ownership, more foreign currency exposure. The results of the Logit model reported that

financial distress costs, interest coverage ratio, size, asset growth over cash flow, profitability

and foreign sales have signs consistent with the theory whereas managerial ownership and tax

convexity have signs contrary to the theory of risk management and the results of the Logit

model supported the results of the Univariate analysis. The study suggested that the policy

makers should develop a well-organized exchange traded derivative market in Pakistan for the

benefit of financially constrained firms with high variable cash flows and foreign sales.

45

P.K. Jain, Surendra S. Yadav and Ashish Kumar Rastogi (2009) examined the practices and

policies of foreign exchange risk and interest rate risk management followed by the corporate

firms in India. The study used stratified sampling method to select samples, the sample included

nonbanking and nonfinancial companies pertaining to three different types of ownership control

such as government owned public sector firms, family owned private sector business houses or

group firms and foreign controlled companies and used survey methodology to collect the

primary data. The survey results revealed that sample firms are aware of risk management

techniques and appreciably a large proportion of firms are using various techniques to mange

risks. The study reported that more than four-fifth of sample firms managed the transaction risk

and two-fifth of sample firms managed economic risk, while translation risk was the least

managed risk. There were significant differences due to ownership in the usage of techniques to

manage these risks. The private sector business firms preferred to manage foreign exchange and

interest rate risks and foreign controlled firms preferred to manage all risks except interest rate

risk. The prominent reason cited by firms was exposures are not large enough to manage and the

significant reason not to use risk management techniques was inherent risk of derivatives. About

two-fifth of sample firms are risk averse and a majority of firms followed cost-center approach

towards risk management. A majority of foreign controlled firms and private sector business

group firms hedged partially while a majority of public sector firms are characterized as

negligible hedgers. Nearly half of the sample across ownership types used performance

standards to evaluate and appraise financial risk management decisions and ownership found to

be a significant determinant of firms’ strategy towards risk management. The study concluded

that the adoption of risk management techniques is still in infancy.

Riad Al-Momani and Mohammad R. Gharaibeh (2008) studied empirically the foreign

exchange risk management practices of large Jordanian non-financial firms and examined the

relationship between various factors such as firm size, sector of the firm, international business

involvement, legal structure, presumed to affect the adoption of foreign exchange risk

management techniques. The study used survey methodology and the sample included largest

non-financial firms in terms of annual sales and annual income, operating in Jordan. The results

of the study showed that sixty six percent of the sample firms managed foreign currency risk

with natural hedging techniques and usage of financial derivatives was not commonly practiced

46

by Jordanian firms. Lack of knowledge about foreign exchange risk management, was the major

obstacle in the usage of techniques by managers and other staff members of Jordanian firms.

The pegged Jordanian dinar to the US dollar, made the Jordanian dinar more stable due to which

Jordanian firms felt no need to act to transaction exposure. There was no relationship between

firm size and the management practices toward transaction exposure. The relationship between

firm’s different sectors and the hedging techniques used was significant with highest in the

manufacturing sector and also found that a firm’s international involvement and management

practices were positively correlated. Firm size negatively correlated to the management

practices and found correlation between a firm’s sector and its management practices and

commercial firms had the strongest attitude toward managing economic exposure, moreover the

legal structure of a firm and its management to economic exposure found to be significantly

related. Partnership firms seemed to have adopted managerial techniques compared to other

types of entities, to manage economic exposure. Finally, study concluded that a firm’s degree of

international involvement and its management practices toward economic exposure were

positively correlated.

Sathya Swaroop Debasish (2008) conducted an industry-wide cross-sectional study on foreign

exchange risk management practices and derivative usage by large non-banking Indian firms.

The study was exploratory in nature and the main objective was to understand the risk appetite

and foreign exchange risk management practices of Indian companies. A survey method was

used to collect the data and the sample included eighteen major industry classifications. The

study reported that fifty three percent of total sample companies used derivatives and rest of the

firms had mentioned that the most important factor which restrained them from using derivatives

was perceived confusion about derivatives followed by difficulty in pricing and policy

constraints. Most of the sample firms hedged transactions involving contractual commitments

which were less than a year and the most important reason adduced was to reduce the volatility

of the cash flows followed by maximizing share holder value. Firms’ preferred first generation

derivatives like forward contracts. The most preferred external hedging techniques were forward

contracts followed by swaps and cross-currency options and among the internal techniques, firms

desired to hedge naturally. Majority of the respondents favored open-ended hedging policy and

confirmed that they have written policies which were evolved and approved by the Board of

47

Directors or by a specially appointed Executive Committee where the risk management decisions

were taken. Around forty six percent of respondents preferred to review their risk management

policy on an ad-hoc basis and majority of them review quarterly and sixty percent of respondents

prescribed a maximum limit up to which a treasurer can trade and changed their hedging

strategies in response to exchange rate fluctuations. The treasury department of firms’ play

significant role in executing the risk management function and forty percent of the sample firms

considered their treasury department as service centre, twenty eight percent as cost centre and

twenty percent as profit centre and engaged in speculation. Most of the respondents depended on

outside market services and dealers for exchange risk management decisions, sparsely dependent

on in-house expertise. The results of the study showed that sixty percent of the respondents

reviewed performance of the treasury department and widely used Value-at-Risk, Stress or

Scenario test, and Price Value of a Basis point for evaluating the risk associated with usage of

specific derivatives. The study concluded that the currency risk management practices in India

are evolving at a slow pace.

Mihir Dash, Narendra Babu, and Mahesh Kodagi (2008) tried to address the issue of foreign

exchange risk management strategy that provides the superior results. They empirically used a

set of simulated foreign exchange cash flows and compared the profits generated from different

foreign exchange risk management strategies such as currency forwards, options, cross-currency

hedges and also evaluated these strategies. The results of the study indicated that currency

options resulted in highest mean returns for currency outflows, whereas for currency inflows

forward contracts generated highest mean returns when exchange rates were on decreasing trend

and cross currency hedging generated highest mean returns during cyclical variation in exchange

rates and no hedging strategy yielded highest mean returns when exchange rates were on

increasing trend. The study concluded that in managing foreign exchange risk firms can take

advantage by using a combination of strategies.

Karol Marek Klimczak (2008) tested empirically major contemporary corporate hedging

theories such as financial theory, agency theory, stakeholder theory and new institutional

economics theory to determine which of them accurately identify determinants of hedging. The

study basically focused on theories and not on individual hypotheses. Using CART analysis,

48

hypotheses were tested. The sample included were firms listed on the Warsaw Stock Exchange.

The results of the study indicated that to start hedging, Polish companies should not base their

decision on rationale suggested by theory, but rather focus on practical considerations. Contrary

to theory, Polish listed companies hedged direct accounting exposure rather than indirect

exposure as suggested by theory. As hedging was more popular among larger companies,

indicated that initial hedging costs were high or there existed economies of scale.

Zubeiru Salifu, Kofi A. Osei, and Charles K.D. Adjasi (2007) examined the foreign exchange

exposure of companies listed on Ghana Stock Exchange. To estimate the exchange rate

exposure of the sample firms, they have used Jorion’s two-factor model which regresses the

return on a firm against changes in the exchange rate and return on the market. The study

empirically showed that eleven firms representing fifty five percent of the total sample firms had

significant exposures to the US dollar, which was the dominant source of foreign exchange risk.

All these firms had experienced negative exposures which implied that stock returns of all these

firms fallen due to depreciation in the home currency against US dollar whereas there were seven

firms, representing thirty five percent of the total sample, were exposed to UK pound sterling

experienced positive exposure which implied stock returns of these companies increased due to

depreciation in the home currency value against UK pound sterling. The results of the study

showed that seven of the twenty firms had significant exposure to the trade weighted index i.e.,

Nominal Effective Exchange Rate (NEER). However the study showed mixed results, four firms

had positive exposure while three firms had negative exposure which implied firms were not

equally exposed to all the currencies in the index. The study also showed that manufacturing and

the retail sectors had significant positive and negative exposures respectively to the US dollar,

however based on the trade weighted exchange rate index the retail sector significantly positively

exposed to NEER which implied that this sector gained from a depreciation of the NEER. The

study concluded that all major currencies of international transaction of the country are sources

of foreign exchange risk to listed firms on Ghana Stock Exchange. The study suggested that

most firms had negative exposure coefficients, which means that the majority of the listed firms

could experience an adverse valuation effect when the local currency depreciates substantially

against other foreign currencies and benefit when the local currency strengthens in value relative

to foreign currencies. However firms which had exposure to UK pound experienced higher stock

49

returns as the local currency depreciated against pound. Therefore, for the Ghana stock

exchange listed firms, it would be advantageous to denominate their international transactions in

UK pound.

Per Alkeback, Niclas Hagelin, and Bengt Pramborg (2006) investigated Swedish non-

financial firms usage of derivatives in the year 2003 and compared the results with their earlier

study conducted on similar sample of Swedish firms in the year 1996. They have used survey

methodology and used a similar questionnaire to compare the results. They have classified the

sample firms according to firm size and industry to study the changes in derivative usage for

different types of firms. The study found that from 1996 to 2003 there was an increase of usage

of derivatives which was largely due to increased usage among medium and small sized firms.

In 1996 study, they found that most of the Swedish firms have used derivatives to hedge foreign

exchange risk whereas the 2003 study found that the frequent use of derivatives was to hedge

contractual commitments. The most common reason cited for not using derivatives is

insufficient exposure to financial risk, followed by costs of hedging exceed the expected

benefits, and exposures effectively managed by other means. The other findings of the study

include that OTC forwards and swaps are the most popular derivatives instruments among

Swedish firms and most of the large firms have used OTC forwards whereas small firms used

exchange traded products such as futures more commonly to manage foreign exchange exposure.

The principal use of derivatives is for hedging purpose and mostly to hedge anticipated

transaction of less than one year, followed by contractual commitments and anticipated

transactions of more than one year. The primary objective of using derivatives is to reduce the

volatility in accounting earnings. In the 2003 study, the financial directors of the sample firms

are more concerned about accounting treatment, followed by transaction costs, and liquidity risk.

During the last seven years, the sample firms have substantially gained knowledge about

derivatives since 1996. The derivatives activity was reported to board of directors, quarterly.

Lastly, almost every firm that used derivatives managed their foreign exchange exposure.

Yanbo Jin and Philippe Jorion (2006) studied the hedging activities of US oil and gas

producers evaluated the effect of hedging activities on firm value. They have framed a

hypothesis that hedging should increase the firm’s market value based on market imperfection

50

theory of hedging and tested the same. The study found that hedging reduces the firm’s stock

price sensitivity to oil and gas prices and also found that hedging does not seem to affect market

value for this industry. The disappearance of the hedging premium refutes the hypothesis that

risk management is always a positive-value proposition, suggesting that there exists a crucial

difference between the nature of the commodity risk exposure of oil and gas producers and the

foreign currency risk exposure of large US multinationals.

D Davis, C Eckberg and A Marshall (2006) examined foreign exchange hedging of Norwegian

exporting firms and provided empirical evidence on the determinants of the hedging decision.

The researchers used Univariate tests, a Logit model and multinomial Logit model to analyze the

data. The study found that at-least one or more foreign exchange hedging instrument was used

by seventy percent of sample firms. Large firms had higher hedging activity and used wide

range of hedging instruments. The most widely used internal and external hedging instruments

are matching/netting and currency forward contracts respectively. The Norwegian exporters

using foreign exchange instruments both internal and external to hedge their foreign exchange

exposure are found to have higher market-to-book ratios, less diversified investors, and a number

of specific corporate financial characteristics, compared to non-hedging exporters. The overall

results provided evidence in support of the firm value maximization hypotheses of

underinvestment and risk aversion, which is consistent with most of the empirical studies

conducted in other countries. However, the study found no evidence that firms’ hedge to reduce

the costs of financial distress or to avoid the need for costly external financing. The study

concluded that characteristics of firms such as size, extent of internationalization and liquidity

are found to be related to the decision to hedge foreign exchange risk.

Sohnke M. Batram (2006) investigated the motivations and practice of nonfinancial firms with

regard to using options in their risk management activities. The study also provided a

comprehensive account of the existing empirical evidence and analyzed data on the use of

derivatives in general and options in particular across different underlying and countries. The

study found that across different countries, a significant number of fifteen to twenty-five percent

of sample firms used options. The study reasoned out that options are particularly useful

hedging tools in the presence of nonlinear exposures resulting from corporate cash flows that are

51

uncertain and a nonlinear function of the risk factor, as they offer a nonlinear payoff profile. In

the end, the study suggested that differences in the accounting treatment of derivatives as well as

liquidity effects have to be considered in determining the choice of derivative instrument.

Robert W. Faff and Andrew Marshall (2005) explored some of the potential determinants of

foreign exchange exposure and firm value with emphasis on the nature of business environment

faced by multinational companies, their size, differing attitudes, and objectives of risk

management and also examined the influence of regional variations on risk exposure. The

sample included large multinational companies from UK, US and Asia Pacific. They have

argued that the use of foreign exchange hedging instruments and the firm’s objectives towards

risk management determines the usage of hedging strategies which eventually impact firm value

in light of unexpected foreign exchange rate changes. The evidences showed that UK

multinational companies had negative foreign exposures while the Asia Pacific had positive

foreign exchange exposures and the extent of internationalization showed positive association

with the magnitude of the foreign exchange exposure for UK multinational companies and

negative association for Asia Pacific multinational companies and these differences were

explained by the differing financial characteristics and international trade characteristics of the

regions. Interestingly, the study found a negative relationship between the extent of

internationalization and foreign exchange objectives and foreign exchange exposure. The results

showed that firms’ whose objective was to minimize the fluctuations of earnings had lower

foreign exchange exposure in UK and in Asia Pacific region firms whose main objective was to

increase the value had lower foreign exchange exposure and concluded that the impact of

importance and attitude towards foreign exchange risk was not reflected on the firm value.

Aline Muller and Willem F.C. Verschoor (2005) reviewed the rapidly growing exchange

exposure literature, which focused on the theoretical foundations of exchange risk exposure and

the empirical evidence on the relationship between stock returns and currency fluctuations over

the last two decades and highlighted the incomplete research in the areas of exchange exposure.

The existing literature suggested that the intrinsic characteristics of exchange risk exposure have

to be taken into account while measuring the relationship between stock returns and exchange

rate movements. The study concluded that the findings of the empirical studies as mixed and the

52

bulk of the evidence suggested that exchange rate fluctuations affected shareholder wealth to a

certain extent which implied that existing literature demonstrated that exchange risk exposure

does matter in both a practical and academic sense.

Joshua Abor (2005) reported on the foreign exchange risk management practices among

Ghanaian firms involved in international trade. The study mainly focused on how Ghanaian

firms managed their foreign exchange risk and the problems involved in managing exchange rate

exposure. It also sought to ascertain the extent of usage of foreign exchange risk management

techniques by Ghanaian firms. The results of the study indicated that close to one-half of the

firms do not have any well-functioning risk management system and also showed that just above

forty-five percent of the sample firms, have neither department nor any one responsible for

managing their foreign exchange risk. Foreign exchange risk was mainly managed by adjusting

prices to reflect changes in import prices resulting from currency fluctuation and also by buying

and saving foreign currency in advance. The main problems faced by firms were the frequent

appreciation of foreign currencies against the local currency and the difficulty in retaining local

customers because of the high prices of imported inputs which tend to affect the prices of final

products sold locally. The Ghanaian firms involved in international trade exhibited a low level

usage of hedging techniques. The reason may be attributed to the low level of education and

sophistication among the firms’ treasury personnel and also because of the under developed

nature of the financial markets.

Bengt Pramborg (2004) used survey evidence to compare Swedish and Korean firms’ foreign

exchange risk management practices. The findings of the study suggested that there were

similarities and notable differences between the hedging practices of firms in both the countries.

Korean firms hedged primarily to reduce cash flow volatility whereas Swedish firms’ objective

to hedge was to minimize fluctuations in accounting earnings. Derivatives usage was

significantly lower in Korean firms than in the Swedish firms. Korean firms extensively used

foreign-denominated debt to hedge cash flow transactions and were less rigorous in monitoring

risk exposure positions compared to Swedish firms. Majority of firms in both the countries had

used a profit-based approach to evaluate the risk management function. The decision to hedge

foreign exchange exposure was strongly influenced by both the size of the firm and its foreign

53

exchange exposure. The usage of internal hedging techniques more particularly matching of

inflows and outflows was common among firms of both countries followed by inter-company

netting in Swedish firms and leading and lagging in Korean firms.

Timothy J Brailsford, Richard A Heaney and Barry R Oliver (2003) surveyed senior officers

in Australian Commonwealth companies and statutory authorities concerning their practice and

attitudes towards the use of derivative instruments for risk management. The purpose of this

article is to document the extent of and attitudes towards derivatives use for financial risk

management in Australian Commonwealth public sector organizations. The study identified

three most important reasons for using derivatives are for budgeting purpose, improving the

value of the organization, and reducing political risk or pressure. The most important reason to

use derivatives by senior Commonwealth government officers was for budgeting and the second

most important reason to use derivatives was to reduce the risks faced by management. The

third most important reason for using derivatives was to change the volatility of cash flows. All

firms using derivatives had a documented risk management plan, whereas only one-third of the

firms which were not using derivatives had a documented risk management plan. Firms with

foreign exchange exposure primarily used forward contracts followed by options, swaps, and

futures. On an average a very few companies hedged hundred percent of their foreign exchange

exposure annually. The survey also indicated that twenty three percent of companies used

Value-at-Risk method for risk management purpose. The study concluded that a small group of

Commonwealth public sector organizations used derivatives. Second, attitudes of the public

sector companies toward derivatives appear to be different between organizations with

documented risk management policy and without documented risk management policy. Factors

such as tax and leverage are least important, whereas budget motives were most important in

using derivatives by public sector companies.

Gintautas Baranauskas, Mantas Jonuska and Indre Samenaite (2003) studied the state of

currency exposure management in largest Lithuanian companies and examined whether the

usage of currency derivatives corresponds to the economic situation in Lithuania. The study

revealed that currency derivatives were not popularly used by exporting firms, even though they

faced considerable currency exposure. Firms explained that the most important reason for not

54

using derivatives was high cost of derivatives, which was also corroborated by the model. The

model demonstrated that there existed a weak relationship between volatility of cash flows and

fluctuations of currency exchange rate and suggested that firms should try other alternatives to

decrease the volatility of cash flows. The results implied that currency exposure management

was not optimal and companies seemed to lack practical experience in using derivatives and

complexity of accounting standards as well added for less usage of derivatives. The results of

the model showed that on the industry level usage of derivatives may not be advantageous. The

study opined that, as Lithuania has open economy with increasing trade and developing financial

markets, derivatives may become popular in the future.

P.A. Belk (2002) reported the results obtained from three contemporaneous in-depth studies

conducted with multinational corporations in the UK, the US and the Germany. The study

largely focused on the organization of foreign exchange risk management, particularly the goals

of exchange risk management, the centralization of decision making, and the nature of decision

makers themselves. The study used semi-structured depth interviews to collect the data. The

study concluded that the sample companies were generally risk averse. A very few UK based

companies actively accepted the risks to increase their rewards. There was no clear formulation

of goals, which made the performance evaluation of currency risk management difficult.

Centralized decision making was predominantly prevailed among the majority of companies in

all the three countries. Transaction exposure was predominant over translation and economic

exposure among the sample companies. US based companies followed centralized decision

making, whereas German companies’ headquarters were strictly monitoring the decision making

of German subsidiaries. In UK based companies, strategic and tactical level decisions were

formulated at Board level or by senior treasury/finance personnel, whereas day-to-day decision

making was done at subsidiary level.

Henk Berkman, Michael E. Bradbury, Phil Hancock and Clare Innes (2002) examined the

relation between derivatives usage and financial characteristics of Australian Industrial and

Mining firms. The financial characteristics were financial distress costs, tax losses, managerial

ownership, growth opportunities, the ability to generate operating cash flows and liquidity. The

study showed that industrial firms which used derivatives were significantly large, less liquid,

55

and more likely to have tax losses and these results were consistent with the hypothesis framed

and contrary to their stated hypothesis non users had higher managerial share ownership and for

all the other variables there was no significant difference between derivative users and non users.

Whereas for mining firms the variables leverage, firm size and growth had positive and negative

relationship respectively with derivative usage while for all the other variables there was no

significant difference between derivative users and non users. Firm size and leverage explained

the derivative usage and both these variables had expected sign and all the other variables have

showed no systematic relationship to derivative usage. The study concluded that Australian data

provided only limited support for theoretical determinants of derivative usage.

Hoa Nguyen and Robert Faff (2002) investigated the determinants of derivative usage by large

publicly listed Australian companies, particularly to address two issues - the decision to use

financial derivatives and the extent to which they are used. The Univariate test results showed

that derivative users are statistically different from non-users with respect to leverage, current

ratio, dividend yield, liquidity, size, market-to-book value, and substantial shareholding.

Consistent with theoretical predictions, derivative users were large, more highly levered,

financially constrained, and paid significantly higher level of dividend. They found that

leverage, firm size and liquidity are consistent with theoretical predictions which implied that

leverage and firm size had a positive relationship whereas liquidity had a negative relationship

which means higher the liquidity less likely the firm uses derivatives. Interestingly, the Tobit

results found that market-to- book value had a negative effect on the extent of derivative usage

and further suggested and observed that the extent of derivative usage and executive option

holdings had insignificant relationship and found a negative relationship between executive

shareholdings and the extent of derivative usage. The overall results indicated that Australian

companies use derivatives with a view to enhance the firms’ value rather than to maximize

managerial wealth.

Gregory W. Brown (2001) investigated the foreign exchange risk management program of a US

based durable equipment manufacturer. The study showed that the company under investigation

used option contracts and forward contracts to reduce its exposure of anticipated transactions and

transactions with firm foreign currency commitments. The company had a precise foreign

56

exchange risk management policy which limited the types, sizes, and timing of derivative

positions and also specified the procedures followed by all employees involved with foreign

exchange transactions. The policy document assigned the functions to three broad groups. The

first group, oversight includes Board of Directors, Finance Committee, and Foreign Exchange

Management Committee whose job was to approve policy revisions, review quarterly

performance and the annual policy. The second group was accounting and control whose main

functions were confirming all foreign exchange transactions, determining the accounting

treatment of derivatives positions, and monitoring compliance with exposure management

guidelines, that is, to verify the hedging activity with firm policy and GAAP. The last group was

Foreign Exchange Group that executes the hedging strategy approved by the foreign exchange

management committee and provided with operational responsibilities for foreign exchange risk

management. The documented policy of this particular company recognized three types of

currency exposures such as transaction, translation, and economic exposures. The firm hedged

only transaction exposure and confusion prevailed about transaction and economic exposure

within the company. Mostly the firm used the policy defined hedging instruments such as spot

and forward contracts and options and the firm was not allowed to enter into long-term swap

contracts and for hedging anticipated economic exposures beyond four quarters required

approval of Finance committee. The firm used a hedge rate as the basis for internal planning and

evaluation. Further, the study observed that foreign exchange hedging operations of the firm

were part of the firm-wide operations and affected from planning through reporting.

Edward H. Chow, Wayne Y. Lee and Michael E. Solt (2001) examined the exchange rate risk

exposure of US stocks and bonds returns over a longer horizon. The effects of real exchange-

rate changes on expected returns are different for bonds, which have fixed income streams, from

those for stocks, which have variable cash-flow streams. The study revealed that bonds were

positively exposed to exchange rate changes across all horizons which implied a negative

correlation between exchange rate and domestic interest-rate changes, while stocks were

positively exposed only for longer horizons. The results of the study implied that the exchange

exposure for stocks reflects both interest rate and cash flow effects. The cash flow effects which

include transactions exposure and economic exposure were short-run and long-run in nature and

57

the effect of unanticipated changes in the real exchange rate on earnings was negative over

shorter horizons and positive over longer horizons.

Marc J. K. De Ceuster, Edward Durinck, Eddy Laveren and Jozef Lodewyckx (2000)

documented the survey results of large Belgium non-financial firms about their derivatives

usage. They have found that around sixty six percent of total sample firms used derivatives. The

most important reason for hedging was earnings volatility. The survey results showed that

seventy percent of sample firms hedged current contractual commitments and sixty eight percent

of firms hedged anticipated transactions up to one year. Belgium firms extensively used

symmetric products such as forwards and swaps to manage currency risk, compared to

asymmetric products such as options and swaps. They have concluded that eighty six percent of

sample firms have risk management policy, which was formulated by the board of directors or by

the executive committee in consultation with the treasury department, whereas forty four percent

of sample firms’ risk management policy was formulated by the treasurer. Seventy percent of

the firms characterized their treasury departments either as service or cost centre, whereas only

fifteen percent see their treasury department as profit centre. Thirty seven percent of sample

firms valued their derivative positions on a monthly basis. The study showed that there was no

much importance for performance measurement of the treasury departments.

Ali Fatemi and Martin Glaum (2000) surveyed German non-financial firms listed on the

Frankfurt Stock Exchange with a minimum sales volume of DM 400 million in the year 1997.

The study results have showed that the sample firms were most concerned about industry or

competitive risk followed by financial risk among the different types of risks they have faced.

Firms regularly assess, quantify and manage financial risk. The most important goal of risk

management was ensuring the survival of the firm followed by increasing the market value of the

firm. The sample firms have showed highest degree of risk averse towards foreign exchange risk

and counter party risk. Only a minority of sample firms run their treasury department as a profit

centre. Among the sample firms high level of centralization existed. The sample firms most

frequently used currency forward contracts for hedging purpose and a very few firms used

derivatives for speculative purpose. The most important problems faced by the sample firms

were measuring the risk of derivatives and German accounting standards. The firms’ were most

58

concerned about transaction exposure. The results showed that only a small minority of the

firms fully hedged their exchange rate exposure and more than half of the sample firms’ based

their hedging decisions on foreign exchange forecasts. Moreover, majority of the firms manage

exchange positions on a net exposure basis and most of the firms have no hard and fast rule with

respect to time horizon for hedging.

Abolhassan Jalilvand, Jeannette Switzer and Caroline Tang (2000) documented important

similarities and differences in derivative usage among the Canadian, US and European risk

managers. The study used survey methodology and the sample included large Canadian non-

financial corporations selected from Montreal Exchange. The study found that seventy five

percent of sample firms used derivative products and European firms have widely used

derivative products. The most important objective of derivative users was managing the

volatility of cash flows and earnings and reducing the cost of funds. The study further

mentioned that non-regulated companies have used derivatives largely. Most of the Canadian

firms’ treasury departments operate as cost or service centers which suggested that Canadian

firms mostly use derivative products for hedging purposes only. Measuring treasury

performance was considered important by sixty four percent of sample firms and the

performance was measured per transaction basis. The treasury performance was benchmarked

mostly on a monthly and annually basis by the board of directors and operations managers.

Eighty percent of Canadian and seventy six of European firms have written hedging policies set

by board of directors and treasury departments. Further, thirty five percent of derivative users

reported that their risk management policy does not influence their financing decisions.

Andrew P. Marshall (2000) surveyed the foreign exchange risk management practices of large

UK, USA and Asia Pacific multinational companies. The study observed that majority of

respondents stated that foreign exchange risk management as significant and important and there

was no statistically significant difference between UK and US MNCs but there existed a

significant difference with UK, US and Asia Pacific MNCs. The industry sector had also a

significant impact on the views on the importance of foreign exchange risk. The service industry

did not consider foreign exchange risk as important as all the other industry sectors. The

objective of managing foreign exchange risk management was significantly different, as UK and

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US MNCs objective was to achieve certainty of cash flows and to minimize the fluctuations in

earnings, whereas the prime objective of Asia Pacific MNCs was not to maintain a steady and

certain stream of cash flows but to minimize fluctuations in earnings. Transaction exposure was

considered highly important by majority of the respondents in all the regions. The study

illustrated a significant difference between the regions and emphasis on translation exposure, as

US MNCs placed least emphasis on translation risk compared to Asia Pacific and UK MNCs.

There existed a significant difference between the regions and the emphasis on economic

exposure, as Asia Pacific MNCs placed highest emphasis in comparison with USA and UK

MNCs. Majority of UK, USA and Asia Pacific companies used both internal and external

methods to manage transaction exposure and UK companies used both internal and external

methods to manage translation exposure as well but majority of US and Asia Pacific companies

had used only internal methods to manage translation exposure. Forward contracts were used

popularly by majority of the companies in all the three regions to manage transaction exposure.

Exchange traded derivatives such as currency options and swaps were not favored by a majority

of MNCs. The percentage of overseas business was not a significant factor but the size or the

industry sector of the MNCs were statistically significant with respect to the significance or

importance of exchange rate risk, emphasis on economic and translation exposure and external

methods used in hedging. The regional factor was the only statistically significant influence in

the difference in responses on the objectives of managing foreign exchange risk, the internal

hedging methods used and the policies in managing economic exposure.

Andreas R Prindl (2000) reviewed the responses of some international companies to

unpredictable markets, floating rates, and credit restrictions and described ways in which these

companies have augmented their internal information systems, strengthened their control

techniques and showed why these are positive changes and concluded with guidelines for

companies with similar financial management problems. The author suggested the international

corporation managers to make financial management anticipatory, review and strengthen its

reporting system, centralize control over exposure risk and liquidity utilization, cover economic,

transaction and translation risk, analyze and make financial decisions on an after tax basis,

ensure availability of credit in uncertain markets on an individual subsidiary basis, look

skeptically at exchange rate forecasting, coordinate exchange risk management closely with

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liquidity management, be aware of the nonfinancial implications of financial strategy.

Implementation of international financial management along these lines allows a structured

approach to an increasingly complex and critical area and leads to optimal development of

international money management within the company. A more consistent approach, if adopted

by most multinationals, could not only benefit the organizations themselves but could also

contribute to more orderly markets in general.

Claudio Loderer and Karl Pichler (2000) surveyed the currency risk management policies of

Swiss industrial corporations. The study used survey methodology and questionnaire was sent to

all firms listed on the Zurich Stock Exchange except banking and insurance companies, in the

year 1996 and also to nontraded firms randomly selected from the 1994-95 issue of Kompass.

The study found that firms are unable to quantify their currency risk profile of firm value and

about half of the sample firms’ do not know the currency risk profile of their cash flows. Firms

failed to understand that why currency risk, reduces firm value. The study concluded by raising

many questions with respect to the overall risk management approach followed by sample firms.

Stephen D. Makar and Stephen P. Huffman (2000) examined the association between firm

value effects and exchange rate changes in relation to the use of short-term foreign exchange

derivatives for US multinationals. The sample was selected from S&P Compustat pcplus

database having foreign sales equal to twenty percent or more of their total sales. The data was

collected from the annual reports of the sample firms. The study demonstrated that the use of

foreign exchange derivatives play a significant role in understanding the lagged market response

to changes in exchange rates. The results of the study showed that the lagged firm value effects

of exchange rate changes are particular to companies with low foreign exchange derivative use

relative to their foreign sales, and the magnitude of such foreign currency exposure decreases

monotonically across all foreign exchange derivative groups. The study results also

demonstrated that multiple lagged exchange rate changes contribute to explaining the abnormal

returns of low foreign exchange derivative users, irrespective of firm size or degree of foreign

involvement and the magnitude of lagged foreign currency exposure is inversely relative to

foreign exchange derivative use.

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John R. Graham and Clifford W. Smith, Jr. (1999) investigated convexity induced by tax

code provisions using simulation methods and also analyzed the distribution of convexities to

reason out the potential importance of motive for hedging. The authors assumed that hedging can

reduce the volatility of taxable income consequently reducing expected tax liability of a firm

facing tax convexity. The analysis suggested that the distribution of potential tax savings from

hedging was quite skewed. The study found that much of the convexity was induced by the

asymmetric treatment of profits and losses in the tax code. Carry-back and carry-forward

provisions effectively allow firms to smoothen their losses, thereby reducing tax function

curvature at its most convex points and making the function convex over a broader range of

taxable income. In contrast, the alternative minimum tax and investment tax credits have only a

modest effect on the convexity of the tax function. The study simulated the tax savings from

reducing the volatility of taxable income and found that the distribution of potential tax savings

was quite skewed, the convexity was driven mostly by asymmetric treatment of profits and

losses, Net Operating Loss carry-forwards and carry-backs smoothened the tax function,

consequently reducing its most extreme curvature, but broadening the range of convexity and the

Alternative Minimum Tax introduced a modest increase in convexity and Investment Tax

Credits had little impact.

Antti Hakkarainen, Nathan Joseph, Eero Kasanen and Vesa Puttonen (1998) employed a

questionnaire survey and financial accounting data to study the foreign exchange exposure

management practices of large Finnish industrial firms. The study identified that ninety seven

percent of the respondents have a foreign exchange corporate hedging policy and forty percent of

sample firms described that the objective of foreign exchange risk management is to secure

business profitability. The sample firms placed more emphasis on transaction exposure than on

economic and translation exposure and most of the firms managed transaction and translation

exposure using internal hedging techniques. The respondents were neutral in the prediction of

foreign exchange rate changes in the short term and disagreed in the prediction of foreign

exchange rate changes in the long term. Only thirty three per cent of the firms hedged partially

with a view to generate profits and twenty two percent of the firms have not maintained open

foreign exchange positions which were exactly offset by underlying exposure. The sample firms

which are having formalized foreign exchange policies monitored their net open positions daily

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while firms with documented foreign exchange guidelines monitored their net open foreign

exchange positions weekly or monthly. The study summarized that respondents who strongly

agreed that the forward rate as unbiased, hedged the transaction exposure to a large extent and

firms which had a foreign exchange policy within the last two to five years hedged more of their

transaction and translation exposure compared to economic exposure. The exposure

management and hedging decisions were strongly influenced by the economic, managerial and

regulatory environments of Finnish firms and also on the treasury managers’ perceptions about

the foreign exchange market uncertainty.

Gordon M. Bodnar, Gregory S. Hayt and Richard C. Marston (1998) surveyed financial risk

management practices and derivatives usage of US non-financial corporations. The study

reported that fifty percent of total sample firms used derivatives and comparatively the usage

increased from the year 1994 but the percentage of firms using derivatives remained constant

over the last three years. The derivative usage was highest among large firms with eighty three

percent followed by medium and small firms particularly it was greatest among primary product

producers with sixty eight percent. In comparison to manufacturing or primary-product

producing firms, derivatives usage increased in service firms. Across the risk classes foreign

exchange risk was most commonly managed with derivatives by manufacturing firms, compared

to interest rate risk, commodity risk, and equity risk. The centralized risk management activities

were more common among all the risk classes except commodity risk management where some

degree of decentralized structure was prevalent. Firms were more concerned about the

accounting treatment of derivative usage followed by unforeseen changes in the market value of

derivatives positions. The majority of the firms felt the new FASB’s rule will have no effect

either on their derivative usage or risk management strategies. The foreign currency derivatives

were the most commonly used class of derivatives and most frequently cited motivations for

transacting were hedging near term directly observable exposures and the most commonly

hedged exposures were on–balance sheet commitments. Partial hedging appears to be normal

practice for these firms and short term derivatives with original maturity of ninety days or less

were used by majority of firms. A very few firms indicated that they altered either the size or the

timing of the hedges already entered depending on the market view on exchange rates with a

majority of firms occasionally incorporated market view into their hedging decisions. Firms

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have also mentioned that they have no benchmark for evaluating foreign currency risk

management process. The foreign exchange options were most commonly used, particularly

European style options and the firms which have not used them explained the reason as too

expensive. Most of the derivative users had a documented policy and majority of firms indicated

that there was no preset schedule in reporting about the derivative activity to the board of

directors. A significant proportion of the firms revalued their derivatives portfolio either daily or

weekly basing on the internal sources and majority of the firms indicated that they calculated

Value-at-Risk measure. The important philosophy for evaluating the entire risk management

function was reduced volatility. The sample firms having too small exposures have not used

derivatives. Finally the researchers summarized that many of the results of this study confirmed

and reinforced the results found in their earlier studies.

Gordon M. Bodnar and Günther Gebhardt (1998) have compared studies of 1995 Wharton

School survey of derivative usage among US non-financial firms and a 1997 companion survey

of derivative usage among German non-financial firms. The study results showed that

derivatives were largely used by German firms compared to US firms and the usage increased

with firm size and derivative usage was similar across industries in both US and Germany with

an exception of German mining industry. The most important argument cited by both US and

German firms for not using derivatives was exposures were not large enough. The firms in both

the countries used derivatives primarily to manage foreign exchange and interest rate risk,

however German firms employed derivatives more than US firms. The primary goal of using

derivatives by US and German firms was different, majority of US firms focused on minimizing

the variability in cash flows, while a majority of German firms’ goal was to minimize variability

in accounting earnings. A vast majority of German firms hedged their on balance sheet

transaction exposure frequently while US firms also mentioned the same. Firms in both the

countries were not worried about translation exposure. Anticipated foreign currency transactions

within the next twelve months were frequently hedged by a majority of US firms and the

percentage of German firms doing the same was lesser compared to US firms and hedging the

transactions beyond twelve months frequency was lower in firms of both the countries. The firms

in both the countries preferred simple foreign exchange instruments more particularly currency

forwards were used for hedging contractual commitments and usage of Over-the-Counter

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instruments dominated the exchange traded derivative instruments. The US and German firms

differed with respect to hedging strategy based on their market view. In contrast to US firms,

German firms not only altered the timing and size of the hedge but also took active positions

based on their market view. Across the two countries firms having documented policies were

around eighty percent of the total proportion of firms and it appeared that compared to smaller

German firms, more smaller US firms had documented policy and vice-versa. In contrast to US

firms, German firms reported their derivatives activities to the executive board most frequently

once in a quarter and at-least in a month to CFO, while US firms reported only as needed. Firms

in both the countries more importantly relied on commercial banks for derivative transactions

and nearly ninety percent of the firms had a policy regarding the creditworthiness of counter

parties. German firms indicated that they dealt with counter parties having credit rating of AA or

higher for derivatives of less than a year and US firms were satisfied with A or lower credit

rating. However, for derivatives of more than a year, the firms in both the countries required the

same AA or better credit rating. Firms in both the countries used a combination of derivative

dealers, market quote services, or in house software intensively in valuing their derivatives and

derivatives were valued more frequently by both the US and German firms. The results

suggested that firms in both countries used sophisticated techniques on par to evaluate the

riskiness of their derivative positions. The most common technique used by the firms in both the

countries was stress technique followed by Value-at-Risk.

Shawn D. Howton and Steven B. Perfect (1998) examined usage patterns and determinants of

currency and interest rate derivatives in 451 Fortune 500/S&P 500 (FSP) firms and 461

Randomly Selected (RS) firms. The study by using a continuous measure of derivatives contract

value, documented the dollar value of different types of hedging instruments and examined the

determinants of derivative usage. More than sixty percent of FSP firms used some type of

derivatives contract whereas only thirty six percent of RS firms used derivatives. More than

ninety percent of the firms in both the samples used swaps to cover interest rate risk and more

than eighty percent of the firms in both the samples used futures and forwards to cover currency

risk. By using both fair value and notional value of contracts, the study found that interest rate

swaps and currency futures and forwards are the largest contract types in terms of dollar value.

For the FSP sample, the study produced that derivatives usage was directly related to financial

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distress, external financing costs, tax considerations, and currency risk exposure and inversely

related to hedging substitutes which is consistent with the earlier studies. For the RS sample, the

results differed considerably from previous studies and showed that derivatives usage was

unrelated to most of the proxies for the theoretical hedging instruments.

Jia He and Lilian K. Ng (1998) investigated the impact of exchange rate changes on the value

of Japanese multinational corporations and investigated the effect of lagged exchange rate

changes on stock returns as well. The sample was selected based on firms’ foreign activities as

measured by the export ratio, overseas ratio, or trade ratio. The export ratio represents a firm’s

exports as a percentage of total sales, the overseas ratio expresses a construction firm’s ratio of

construction carried out overseas, and the trade ratio measures a trading firm’s ratio of export,

import, and offshore trading relative to total sales. The study found that twenty five percent of

the total sample firms yielded significant positive exposure coefficients suggesting that Japanese

firms benefitted when the Yen depreciated. The exploratory investigation, indicated that

Japanese multinational firms with low short-term liquidity or with higher financial leverage had

more incentive to hedge and hence have smaller exchange rate exposures. The foreign exchange

rate exposure increased with size of the firm and these results were consistent with the optimal

hedging theories as well as the previous studies. The results provided that non-keiretsu firms

having tighter financial constraints were more likely to hedge and less exposed to foreign

exchange risk compared to keiretsu firms.

Kevin Grant and Andrew P Marshall (1997) have presented the results of surveys conducted

on large UK companies about their derivative usage. This study primarily reported the findings

of two previous surveys. The study reported that vast majority of UK companies used

derivatives to manage the traditional financial price risks of foreign exchange and interest rate

risk. The study observed that usage of swaps grown rapidly and dominating followed by

forwards/futures in UK companies. The primary objective of treasury department of sample

companies found to be risk management only. The study reported that compared to 1995, most

of the treasurers were concerned about the control and complexity of derivative contracts and

reporting of derivative positions in the 1994 study. In the 1995 study, forty percent of sample

companies stated that they reviewed their board policy on an ongoing basis, while thirty four

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percent reviewed annually. In both 1994 and 1995 studies most companies agreed about the

relevance of disclosure and fifty percent of sample companies disclosed information relating to

derivatives in their financial statements. The study concluded that well-publicized disasters have

not restricted usage of derivatives by large UK companies and the study indicated that

derivatives were commonly used to reduce the volatility of firm’s cash flows.

Henk Berkman, Michael E. Bradbury and Stephen Magan (1997) surveyed the derivatives

usage of New Zealand public companies listed on New Zealand Stock Exchange and compared

the results with the earlier surveys conducted on US firms. The New Zealand firms are more

active derivatives users relative to their size. The New Zealand industry sectors used derivatives

more than the US industry sector except commodity-based industries such as agriculture,

refining and mining. In contrast to US firms, a very few New Zealand firms used derivatives to

manage commodity price exposure and firms in both the countries had used derivatives similarly

to manage foreign exchange and interest rate risk exposures. The firms in New Zealand used

OTC products extensively for hedging compared to exchange traded derivatives while in US it

was exactly opposite. Apart from derivatives majority of New Zealand firms used foreign debt

financing as an alternative for derivatives and they were exposed mostly to US dollar followed

by Australian dollar. Unlike US firms, New Zealand firms used derivatives to reduce funding

costs. Firms in both the countries used derivatives to hedge contractual commitments anticipated

within one year or twelve months. The important objective of firms in both the countries was to

reduce the fluctuations in earnings followed by reduction of cash flow variance. The majority of

New Zealand firms reported monthly, about the derivative positions to the board of directors,

whereas in US quarterly reporting, was more prevalent and in both the countries there was no set

reporting schedule. Unlike US firms, the New Zealand firms not relied on outside vendor for the

management of their derivatives positions. The study concluded that across all the firm sizes,

New Zealand firms used derivatives relatively more.

Robert C. W. Fok, Carolyn Carroll and Ming C. Chiou (1997) examined off balance sheet

corporate hedging activities and firm value. The results indicated that hedging reduces the

probability of financial distress costs, agency costs of debt and some agency costs of equity,

however found no evidence for the hypothesis that hedging increases firm value by reduces

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expected tax liability. The study also found that larger firms and firms with higher growth

opportunities were more inclined towards hedging, multinationals preferred off-balance sheet

hedging and convertible debt served as a substitute for corporate hedging and ownership

structure as significant in the corporate hedging decision. The LOGIT regressions provided no

support for the tax reduction motive for hedging and the results indicated that managers may

choose to hedge to reduce the agency costs of debt. The large firms, firms with more growth

opportunities and institutional investors and firms with less liquid current assets were more likely

to hedge and findings showed that operational hedging and derivatives hedging as complements.

Christopher Geczy, Bernadette A. Minton, and Catherine Schrand (1997) examined the

usage of currency derivatives to differentiate existing theories of hedging behavior and also

examined the impact of magnitude of exposure on the level of benefits derived from risk

reduction and the costs associated with risk reduction. The Univariate and multivariate test

results found that firms with greater growth opportunities and tighter financial constraints used

currency derivatives. The firms with foreign operations and foreign denominated debt, research

and development expenses and short-term liquidity were not significant determinants but these

variables were significant determinants for firms without foreign denominated debt which

implied that for hedging foreign operations, foreign denominated debt acted as a substitute for

currency derivatives. The results also found that usage of currency derivatives was positively

related to foreign pretax income and sales, foreign denominated debt which suggested that

currency derivatives were used by large firms with extensive foreign exchange rate exposure and

firms which used other types of derivative instruments.

Henk Berkman and Michael E. Bradbury (1996) empirically studied the determinants of

corporate usage of derivative instruments from the audited financial statements of the New

Zealand firms. The study found that derivative usage increases with leverage, size, the existence

of tax losses, the proportion of shares held by directors, and the payout ratio this is in line with

theoretical models of corporate risk management whereas corporate derivative usage decreases

with interest coverage and liquidity. The derivative usage positively related to the value of the

firm’s growth options only when fair value of the contract was used as a measure of hedging

activity and also found that short-term asset growth, the proportion of foreign assets to total

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assets, and the use of alternative capital instruments were not related to derivative usage. The

study concluded that results are insensitive to their measure of derivatives use and are consistent

with theoretical models of corporate risk management.

Peter Tufano (1996) examined the corporate risk management practices in the Gold Mining

Industry of North America. The study suggested that risk management practices appear to be

associated with both firm and managerial characteristics. The evidence shows that mangers who

own more options manage less risk, and those who own more shares of stock mange more risk.

Contrary to value maximizing theory of risk management, the study found no relationship

between risk management and firm characteristics. Firms with lower cash balances manage

more gold price risk and firms with a greater percentage held by outside block holders tend to

manage less risk. Firms having new chief financial officers seemed to manage a larger

proportion of their firm’s risks. The study alluded that not only the level of management’s

equity ownership, but also the form by which that equity stake is held, is related to firms’ risk

management choices.

Shehzad L. Mian (1996) provided empirical evidence on the determinants of corporate hedging

decisions in light of compulsory financial reporting requirements and the constraints placed on

anticipatory hedging. The study concluded that varying evidence was found with respect to

different models of hedging such as financial distress cost, contracting cost, capital market

imperfections, and tax based models. The evidence supported the hypothesis that hedging

activities exhibited economies of scale. The study provided empirical evidence on the

determinants of hedging using non-survey data for large sample of firms. The study also

provided evidence on the models of the hedging decision, which emphasize that hedging is

desirable because it lowers contracting costs, financial distress costs, taxes, and external

financing costs associated with capital market imperfections and found mixed evidence with

respect to models of hedging emphasizing the role of contracting costs and capital market

imperfections. Evidence was consistent with these models is that regulated utilities are less likely

to hedge. There was no evidence that hedgers have more growth options relative to assets in

place in their investment opportunity set.

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Gordon M. Bodnar, Gregory S. Hayt and Richard C. Marston (1996) survey on derivatives

use and risk management practices of US non-financial firms indicated that sixty percent of large

firms have used derivatives followed by medium-sized firms and only thirteen percent of small

size firms have used derivatives. The survey indicated that seventy six percent of all derivative

users managed their foreign exchange risk using some type of foreign currency derivatives.

More than seventy five percent of firms chose forwards as their top choice of foreign currency

derivative followed by OTC options. The important objective of using derivatives in risk

management was managing cash flows followed by managing fluctuations in accounting

earnings and lastly managing the total market value of the firm. The major concern of

derivatives users was credit risk followed by ability to evaluate the risk involved in proposed

derivative transactions and lastly about, accounting treatment for hedges. The firms were

motivated to use foreign currency derivatives for hedging contractual commitments and

anticipated transactions expected within the year. The most important instrument used in

hedging contractual commitments was forward contract followed by futures contracts and

options. Based on the market view on the exchange, around eleven percent of total sample firms

altered the size of timing of hedges. About seventy six percent of total sample of firms have

documented policy with respect to the usage of derivatives and only twenty nine percent of firms

reported to the board of director either monthly or quarterly. The most important source for

valuation was the dealer and a significant number of firms also relied on in-house valuations as

the primary source of valuation. Nearly forty eight percent of sample firms used stress testing or

scenario analysis for risk measurement. The major concern was uncertainty about hedge

accounting treatment. Most of the small firms refrained from using derivatives due to lack of

knowledge about derivatives. The researchers have concluded that the number of firms using

derivatives have increased compared to their previous survey, however majority of these firms

are large firms coming from commodity and manufacturing sectors.

Aaron L. Philips (1995) conducted a survey on derivatives practices and instruments among the

member organizations of Treasury Management Association (TMA) have concluded that around

sixty three percent of the sample companies used derivative contracts, derivative securities, or

both. Seventy one percent of the total sample companies reported that their organizations used

derivatives for financial risk management. Sixty seven percent of the users have shown that their

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organizations used them in conjunction with obtaining funding, and twenty one percent of the

users have reported that their organizations use them for investment purposes. Manufacturing

sector represented highest usage of derivatives with twenty nine percent, among various

industries. The survey examined organizations of differing sizes to determine the influence of

size on derivatives practices. Nearly seventy five percent of total sample of 415 organizations

have faced foreign exchange risk. They found that exposure to risk appears to be an increasing

function of organization size. About thirty seven percent organizations of total sample have used

only derivative contracts such as over-the-counter options and forwards as well as exchange

traded options and futures while twenty six percent of total sample organizations have used

derivative securities such as structured securities, traditional securities with embedded options,

and asset backed securities and nearly thirty seven percent of total sample organizations have

used both derivative securities and derivative contracts.

Kurt R. Jesswein, Chuck C.Y Kwok, and William R. Folks (1995) examined the extensive

usage of various major innovative foreign exchange products by US corporations with the help

of a survey questionnaire and categorized these products into three generations. The study

reported that majority of the respondents heard about all the three generation products and the

average percentage of awareness across all products was around eighty four percent. However,

the most popularly used product was forward contract that was used by ninety three percent of

total respondents followed by second generation products such as foreign currency swaps and

over-the-counter currency options with fifty two and forty nine percent respectively. Overall, the

usage of first, second, and third generation products were ninety three, twenty five and fourteen

percent respectively. The foreign exchange risk management products were used by finance,

insurance and real estate industries most frequently followed by manufacturing industry. The

study found that degree of international involvement influenced the firms to use foreign

exchange risk management products but not the firm size. The study advised new corporate

managers to focus on more basic products such as currency forwards, currency swaps, and OTC

options and it also indicated that tailor made OTC products were more appealing to corporate

clients.

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Gordon M. Bodnar, Gregory S. Hayt, Richard C. Marston and Charles W. Smithson

(1995) undertook a survey on derivatives use and risk management practices of non-financial

firms of United States. The study indicated that derivative usage was not much widespread

particularly among the small firm and derivatives were not commonly used for speculation but

derivatives were commonly used to reduce the volatility of firm’s cash flows. Derivatives were

used by around sixty five percent of large firms and thirteen percent of small firms. Across the

industries, traditional commodity based industries such as agriculture, refining, and mining have

highest usage at fifty percent followed by manufacturing industries with forty percent. Around

thirty two percent of regulated industry segment firms consisting of transportation and utilities

have used derivatives. Derivative usage was least common in service industries, with twenty

nine percent of retail and wholesale trade compared to fourteen percent of other service firms.

The sample firms have indicated that swaps were used to manage interest rate risk, while forward

contracts dominated as the foreign exchange risk management instrument followed by swaps and

OTC options. Most of the large firms have used OTC products, while small firms used a mixture

of OTC and exchange-traded products. Hedging firm-commitment transaction exposures with

derivatives was more common with eighty percent of firms doing very frequently, while only

forty four percent of firms used derivatives to hedge the balance sheet exposures. The survey

indicated that thirty four percent of firms seldom used derivatives to take a view on foreign

exchange rate movements. The firms have expressed that their greatest concern was accounting

treatment of derivative transactions followed by credit risk and liquidity risk. The primary

objective of risk management was minimizing fluctuations in cash flows with sixty seven percent

of sample firms have assigned their importance. In using derivatives, firms were also concerned

about counterparty risk, for derivative transactions with a maturity of twelve months or less,

majority of firms required a rating of A or better for their counterparty, whereas for maturities

greater than twelve months, firms required AA or better. The study results indicated that majority

of large firms, have utilized swap and option pricing software, compared to small firms.

Centralized risk management activity was common across all sizes of firms. A very few firms

report derivatives activity to the directors on a monthly basis. The study concluded that

derivative usage is still not widespread among small firms and derivatives were most commonly

used to reduce the volatility of the firm’s cash flows.

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Kenneth A. Froot, David S. Scharfstein and Jeremy C. Stein (1994) had presented a

framework which guides top-level managers in developing a coherent risk-management strategy

and suggested to integrate company’s risk management strategy with its overall corporate

strategy. They have highlighted the significance of risk management program which ensures

enough cash flows to make value enhancing investments. They have argued against the theory

envisioned by Modigliani and Miller and outlined that comparatively the cost of external

financing is more than internally generated funds because of which companies prefer retained

earnings for investments and follow financial pecking order. They have illustrated the benefits of

hedging with the help of a hypothetical example. The study concluded that it is very important

for a company to devise a risk-management strategy that is based on good investments and is

aligned with its broader corporate objectives.

Jonathan Batten, Robert Mellor and Victor Wan (1993) conducted an industry-wide cross-

sectional study on Foreign Exchange Risk Management Practices and Products Used by large

Australian Firms. The sample included various industries such as manufacturing, construction

and building, agriculture, forestry and fishing, mining and processing, recreational, personal and

other services, finance and insurance, wholesale and retail trade, and transport and storage. The

largest was manufacturing industry with twenty six firms comprising thirty six percent of the

total sample firms. The study indicated that forty four firms, which comprised about sixty one

percent of the total firms, managed transaction exposure and to manage foreign exchange

exposure, thirty nine percent of the total sample firms used short-term foreign funding techniques

and a similar percentage of firms have used long-term foreign funding techniques. The most

popular short-term facilities were euro notes and euro commercial paper while Eurobonds were

the most popular long-term facility. The study suggested that foreign exchange risk management

can be managed by using both physical and synthetic products such as forward and options

respectively, forty nine percent of the firms used both physical and synthetic products and

forward contracts were the most preferred physical product and with respect to synthetic

products, options were most preferred. The study showed some interesting results such as

twenty one firms of the total number of sample firms remain fully hedged and twenty six firms

partially hedged their foreign exchange risk and traded foreign exchange risk to some extent.

Lastly twenty two firms actively traded their unhedged foreign exchange exposures and forty

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eight firms had appeared to take on some foreign exchange risk. Seventy one percent of the

firms used technology such as personal computers to mange foreign exchange risk. The study

finally concluded that characteristics of the firm have major impact on the risk management

practices of the firm more particularly the characteristic variable size measured by foreign

exchange turnover had significant impact on management practice variables such as technology,

products, and foreign funding activities employed of the firm. There was no significant

statistical relationship between the degree of centralization and the size of the firm’s foreign

exchange exposure and the form of ownership and legal structure of the firm had significant

impact on the degree of centralization of the treasury management.

Deana R. Nance, Clifford W. Smith, Jr. and Charles W. Smithson (1993) tested the

hypotheses explaining corporate hedging policy and offered empirical evidence on the relative

importance of these corporate hedging motives. The researchers used survey methodology to

collect data on firms’ usage of derivative contracts. The sample included Fortune 500 and the

S&P 400 firms. The evidence suggested that off-balance sheet hedging can increase the value of

the firm by reducing expected taxes, financial distress costs or agency costs. The examination of

the tax hypothesis was found to be significantly different between hedgers and non-hedgers with

respect to investment tax credits and pretax income in the progression region. However, there

was no significant difference with respect to tax loss carry forwards. The comparison of the

means of the hedgers and non-hedgers indicated that hedgers are significantly larger and had

larger R&D expenditures and with respect to leverage or the ratio of book-to-market reflected no

significant difference. The results indicated that hedgers had significantly less liquid assets and

higher dividend yields and concluded that firms with more convex tax schedules relatively hedge

more.

P. A. Belk and M. Glaum (1990) investigated the current practices of UK multinational

corporations and concluded with reservations due to the limited nature of the study, that

accounting exposure was managed actively by majority of the companies, transaction exposure

as the centerpiece of foreign exchange risk management, and the management of economic

exposure was practiced heterogeneously. The sample included UK industrial companies, which

were included in the sample basing on their significant degree of international involvement. The

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research method applied in the study was structured interviews. The study showed that there

existed a lower degree of centralization among the majority of surveyed multinational companies

and majority of the companies described themselves as totally risk averse while a small minority

of companies characterized themselves as risk taking.

P. Collier, E. W. Davis, J. B. Coates and S. G. Longden (1990) have done a case study

analysis of currency risk management practices and presented the information gathered through

interviews from large UK and US multinational companies which have significant international

business and substantial element of foreign exchange exposure. The study identified that in UK

one-third of the companies resorted to hedging and two-third of the companies actively managed

the transaction risk, while in US it was quite opposite, majority of the firms resorted to hedging

and a very few companies actively managed. The main objective of UK companies was

avoidance of significant losses and US companies was risk averse as well. Translation exposure

management was a lesser concern of the sample companies and there was a mixed opinion

regarding the translation exposure management among UK and US companies. The study

concluded that firms with high transaction risk had adopted a close-out policy.

Philippe Jorion (1990) examined the exposure of US multinational companies to foreign

currency risk. The study identified association between the value of a firm and exchange rate to

be positively and reliably correlated with the degree of foreign involvement whereas firms

without out foreign operations does not appeared to be differed.

Luc A. Soenen and Raj Aggarwal (1988) surveyed banking practices in the United Kingdom

and cash management services in Netherlands and Belgium. The study compared the practices

of these three countries with regard to banking relations in the areas of cash and foreign

exchange management. The number of banking relationships used by a company seemed to be

related to the size of the company and UK based companies had larger number of banking

relationships followed by Netherlands and Belgium based companies. All the companies had

one lead bank with half of the total surveyed companies had maximum of two lead banks and

one fifth of the companies surveyed made use of cash management services such as cash balance

reporting, funds transfer, and consulting services provided by banks. All the companies in the

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three countries were satisfied with the services of domestic and US banks. Idle cash of the

companies mostly invested in short-term bank deposits, whereas in UK, companies popularly

invested in overnight deposits. The sample companies used multitude of credit facilities and they

have also used financial publications as the major source of information in forecasting exchange

rates. The study concluded that banking relations seemed to be a significant aspect of the

management of cash and foreign exchange among larger companies in UK, the Netherlands, and

Belgium.

P. Collier and E. W. Davis (1985) conducted a study into organization and practice of currency

risk management by large UK multinational companies. The study used survey methodology

and the sample included companies within the Times Top 200. The study found that in majority

of UK multinationals degree of centralized control existed and formal exposure management

policies. The centralized control appears to be less marked for overseas subsidiaries than for

those in the UK and active management of currency transaction risk is associated with

centralized control. The decision to hedge seems to be linked with a less centralized structure.

The study supported the hypothesis that, where the overall dimension of currency risk appears to

be high, firms adopted the policy of close-out or hedging and where the risk appears to be low,

the evidence suggested active management. The treasurer was responsible for active

management. There existed an association between high risk and the Finance Director in the

management of currency transaction risk.

Clifford W. Smith and Rene M. Stulz (1985) analyzed the hedging behavior of firms for which

they examined taxes, contracting costs, and the impact of hedging policy on the firm’s

investment decisions of large widely held corporations and developed a positive theory of

hedging by value-maximizing corporations where hedging forms part of overall corporate

financing policy. The study empirically showed that firms are motivated to hedge more, if

excess profits, taxes or investment tax credits increase the convexity of the tax function. On the

contrary, allowing trading in tax credits reduces the convexity of the tax function and reduces the

tax benefits of hedging. The tax function concavities produced by the provisions of the tax code

induce the firms to reverse hedge. The study proved that a value maximizing firm to reduce its

financial distress costs could hedge. The study implied the manager’s expected utility depends

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on firm’s market value and its accounting earnings and often a part of manager’s compensation

depends on accounting earnings and a firm would principally hedge these earnings when

manager’s expected utility is concave and heavily depends on these earnings which also implies

that manager’s risk aversion induces them to hedge. On the contrary, a manger would be better

off if the firm does not hedge as his compensation is convex to the value of the firm.

Michael Adler and Bernard Dumas (1984) measured and distinguished between currency risk

and exposure and also discussed the practical implications of the approach. Currency risk can be

summarized as the probability that the actual domestic purchasing power of home or foreign

currency on a given future date will differ from its original anticipated value, and exposure was

defined in terms of what one has at risk. They have showed that exposure can be best measured

as a statistical regression coefficient beta, which is a single comprehensive measure that

summarizes the sensitivity of the whole firm, as of a given future date, to all the various ways in

which exchange rate changes can affect it.

Christine R. Hekman (1983) studied the effect of exchange rate fluctuations on the economic

value of the firm and corroborated the significance of measuring exposure by cash flows

approach. The study evaluated the components of economic measure with the help of more

familiar analytical tools and these components were aggregated into a single measure of

exposure which shows the response of economic value to exchange rate changes. The economic

approach recognizes not only the financial hedges such as debt service and forward contracts but

also indirect or natural hedges. The study defined that product of sensitivity of foreign returns to

inflation and sensitivity of foreign inflation to exchange rate changes represents the foreign

exchange exposure of a firm’s operating cash flows. The economic foreign exchange exposure

of a firm which also means the proportion of the firm’s operating cash flows is determined by

subtracting the natural hedge parameter from the financial hedge parameter. The study concluded

that economic values as measured by the present values of net cash flows, are less sensitive than

accounting conventions imply.

Gunter Dufey and S. L. Srinivasulu (1983) have done a case study analysis of corporate

management of foreign exchange risk. They have showed that in the real world firms are subject

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to foreign exchange risk and also argued that if market imperfections such as incomplete

securities markets, positive transactions and information costs, dead weight costs of financial

distress, and agency costs exist then foreign exchange risk management can be made at the

corporate level.

Ike Mathur (1982) surveyed US companies and examined the risk management practices of

these firms engaged in international trade. The study utilized simple random sampling and the

sample included firms from Fortune 500 list of US industrial firms. The study found, that there

exists a statistically significant relationship between the size of the firm and written foreign

exchange management policy. Nearly one-third of the total sample firms, particularly smaller

firms have no written foreign exchange policies. Majority of the sample firms were concerned in

minimizing transaction losses and they used forward contracts to hedge the foreign exchange

transactions and firms forecasted their foreign exchange risk exposure based on commercially

available economic forecasts.

Rita M. Rodriguez (1981) summarized a continuing study involving both extensive and

repeated interviews with the chief international financial offices of major US multinational

companies. The researcher evaluated financial data regarding the foreign exchange positions

firms and the behavior of firms during the period 1967-74. The 1974 interviews revealed that

translation exposure was used exclusively as the measure of exposure and as the basis of hedging

exchange risk during this period, however by 1977 transaction exposure was followed in most of

the companies and the preferred tools to cover exposure were leading and lagging payments

together with direct money market transfers. The study reasoned that in many cases manager’s

disinclination towards exchange losses have deterred them from using forward exchange

contracts. The interviews also showed that when managers expected the forward rate at a

discount then majority of them preferred to hedge the exposure and when the forward rate was

expected at a premium then a very few managers opted to hedge the exposure. The study

indicated that two accounts of MNCs which directly impacted the foreign exchange markets

were cash and forward contracts showed that companies were moving their funds according to

the market movements and companies accumulated funds and maintained long positions in

forward contracts in strong currencies to a much larger degree compared to weaker currencies,

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whereas for accounts receivables and inventory the opposite is true, the companies maintained

larger balances in weak currencies. Regarding the three liability accounts, accounts payable,

short-term debt, and long-term debt, there was a tendency of average level of weak currencies

higher than the average level of the strong currencies. The average holding of liquid funds for

the sample companies were higher in strong currencies than in weak currencies in each crisis

period. The risk aversion nature of the managers made the funds to flow from weak currencies

into strong currencies which had a destabilizing impact on the markets.

Laurent L. Jacque (1981) reviewed extensively the literature on foreign exchange risk

management which had grown during the last decade. The author had taken a normative

approach and reviewed key informational inputs such as forecasting exchange rates and

measuring exposure to exchange risk, required for any foreign exchange risk management

program and available decision models for handling transaction and translation exposure were

reviewed as well. Lastly, the study identified the gaps in the existing literature and suggested

directions for future research.

Luc A. Soenen (1979) explained the importance of foreign exchange exposure management and

explained sources, categories of foreign exchange exposure and corroborated the need for the

centralized control of foreign exchange management. The general policy rules for hedging

devaluation prone currency positions. The authors of the study believed that the traditional

approach to foreign exchange management as inadequate because it fails to examine the inherent

relationships among the currencies maintained in a company’s foreign exchange portfolio and

elicited that the total risk of the currency portfolio as a function of the level of correlation among

all currencies, the volatility of all currencies individually, and the proportion of each currency to

the dollar equivalent sum of all currencies in the portfolio and defined the objective of foreign

exchange management as minimization of the variance of its currency portfolio which involves

hedging costs and crafted out several strategies which can be applied by an international

company to obtain an equilibrated low risk foreign exchange portfolio.

Alan C. Shapiro and David P. Rutenberg (1976) presented a comprehensive view of exchange

risk management and offered alternative decision criteria for hedging. The study covered topics

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like traditional hedging strategy and techniques, currency forecasting, the value of hedging,

accounting and economic concepts of exchange risk, and tax effects of exchange rate changes.

The study showed that the traditional financial hedging technique is based on reducing

accounting or balance sheet exposure involves simultaneously increasing or decreasing hard

currency assets or soft currency assets respectively and decreasing or increasing hard currency

liabilities or soft currency liabilities respectively. Traditional financial hedging techniques

cannot be applied without currency forecasts which are based on some macroeconomic

indicators such as balance of payments deficit, gold and hard currency reserves, SDR

borrowings, national incomes, relative interest rates, and relative inflation rate. The study

reiterated the significance of Purchasing Power Parity Theory in providing an approximate

exchange rate. The study stated that if an investor accomplishes foreign currency diversification

the corporate hedging would be superfluous and attempt to reduce foreign exchange costs would

be possible only in imperfect markets otherwise prices will adjust to reflect expectations of

future exchange rate changes. The study clarified that through traditional financial hedging firms

cannot cover their economic exposure and pointed out that the amount to hedge and the

willingness to pay the hedging costs depends on a treasurer’s risk bearing capacity or decision

criteria. A firm can limit its fluctuations in its current reported earnings due to exchange rate

changes through selectively hedging its accounting exposure, beyond the first year. Lastly, the

study recommended that a firm cannot gain abnormal profits through speculation rather spending

time on currency forecasting and selective hedging techniques, a firm should decide the

maximum exposure it can take and what to hedge, considering tax factors, since the goal of any

hedging strategy is to avoid fluctuations in the reported earnings in the current year.

Robert K Ankrom (1974) presented the Chrysler Corporation’s experiences in managing its

foreign exchange exposure and also defined and discussed the two sources of foreign exchange

exposure as translation exposure which arises when balance sheet accounts are translated into US

dollars or home currency and the other source was transaction exposure which arises from future

actions of sales and profit planning rather than in balance sheet accounts and the combination of

these two sources was referred as economic exposure. The study highlighted the significance of

centralized control as a prerequisite for rational and consistent way of controlling exposure of the

whole group. The study recommended a routine, periodic and comprehensive reporting system

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which includes forecasted exposure and coordinates with other financial reports of the company

and also recommended the involvement of top management in the decision making process

through periodic committee meetings. In the light of hedging costs, the study foreshadowed the

complexity of adopting a foreign exchange policy which usually depends on management’s

outlook, willingness to assume risks, and knowledge and familiarity with the size and probability

of risks. The study undermined the management’s judgment or opinion of experts in analyzing

possible future foreign exchange movements and corroborated the significance of hedging in the

light of company’s inability to withstand the potential loss.

Newton H. Hoyt, Jr (1972) studied the management of currency exchange risk of the Singer

Company, defined exchange risk and described the different effects that currency fluctuations

have on the dollar values of various assets and liabilities of the company. The singer company

recognized at the outset that to lessen exchange risk, it must reduce parent company investment

and to increase significantly the amount of local currency borrowings. The study recommended

that if the exchange risk is high and the amount of receivables are large in any country efforts

must be made to borrow locally equivalent to the total value of net receivables even though

interest rates are high. To reduce exchange risk local currency borrowing can be supplemented

by the forward exchange contracts. The study showed that the Singer Company had used

adjustment of intra company accounts technique to protect itself from volatile trading currencies

such as Pound sterling, French Franc, and Japanese yen which were floating upward against

dollar. The study stressed the importance of the role of treasurer in designing the overall

program of managing exchange risk and the treasurer or chief financial officer of the parent

company must see that the program is carried out effectively.

R B Shulman (1970) argued about foreign exchange risk measurement and found that the most

common method in dealing with exchange risk was intuition rather than a plan and for a US

businessman limited sources of competent advice existed on measurement of exposure to

exchange risk and eliminating the same. The analysis of this study suggested that there are only

two approaches of exchange exposure measurement. The study explained about the difficulty of

measuring the degree of risk than the measurement of amount at risk and reiterated the

separation of real risk from perceived risk for sound decision making.

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3.3 Studies on the relationship between Exchange Rate Volatility and International Trade

Tatre Jantarakolica and Porjai Chalermsook (2012) intended to determine impact of

exchange rate volatility on Thai export quantity in Textile and Garment products. The

researchers, in order to correctly measure export volume, they have computed export quantity as

dependent variable rather than export value. Exchange rate risk was determined using three

different methods, that is , quarterly variance, Univariate GARCH model of spot exchange rate,

and the bivariate GARCH models of spot and forward exchange rate. They have employed

Panel data with fixed effects and random effects models to study the impact of export price and

exchange rate risk on Thai export quantity and also included subprime crisis as a dummy

variable in measuring the impact. The estimated results indicated that the bivariate GARCH

model was the most appropriate method in determining exchange rate volatility. The empirical

results indicated that the Thai exports in textile and garment products are significantly influenced

by its export price and exchange rate volatility, which implies that higher exchange rate volatility

can cause reduction in export quantity.

Longjiang Chen (2011) examined the relationship between changes and volatility of China’s

Renminbi (RMB) exchange rates and its agricultural export. The study applied GARCH (1,1)

model to measure the exchange rate volatility and estimated autoregressive distributed lag

(ARDL) regression with structural break dummy variables, based on the results of unit root test

with structural break. The results of the study showed that both the bilateral nominal exchange

rate and its volatility risk are important factors affecting China’s agricultural export to Japan.

The empirical results indicated that the RMB depreciation against Yen will promote export

growth while appreciation possesses a significantly negative impact that is, hinders exports. The

exchange rate volatility risk possesses a significantly positive effect. However the effect is much

smaller than that of exchange rate level, leading to a negative net effect to the export.

Tahir Mukhtar and Saqib Jalil Malik (2010) investigated the impact of exchange rate

volatility on exports of three South Asian Countries, India, Pakistan and Sri Lanka. The study

used Cointegration and VECM techniques and the empirical findings indicated the presence of a

unique Cointegrating vector linking real exports, relative export prices, foreign economic activity

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and real exchange rate volatility in the long run and real exchange rate volatility exerts

significant negative effects on exports both in the short run and the long run. The results also

revealed that improvements in the terms of trade and real foreign income exert positive effects

on export activity.

Justin B May (2010) estimated the effect of real exchange rate volatility on Thai exports of key

agricultural commodities, after controlling for both the level of the real exchange rate and

foreign incomes. The study used daily exchange rate data, monthly data on Thai production,

exports, and prices for the period 1981-2006. Exchange rate uncertainty was modeled using four

distinct ways, such as standard deviation of the real exchange rate, ARMA (5,4), ARIMA(2,1,3)

and GARCH (1,1). The study found that the effect of volatility on export volume as negative

and significant. However, no such relationship existed between lagged values of exchange rate

volatility and agricultural production.

C. Veeramani (2008) explored the relationship between the real effective exchange rate and

exports for the period 1960-2007. The researcher analyzed separately, the merchandise exports

and service exports to discern the exchange rate has any differential impact in the two sectors.

The estimated eclectic model postulated that the dollar value of India’s merchandise exports is a

function of Real Effective Exchange Rate (REER), India’s real GDP, and world merchandise

exports. The study found that the appreciation of the REER leads to a fall in the dollar value of

India’s merchandise exports.

Mohsen Bahmani-Oskooee and Scott W. Hegerty (2007) examined the vast empirical

literature up to 2005, to assess the main trends in modeling and estimating these trade flows at

the aggregate, bilateral, and sectoral levels. The empirical findings of the study stated that the

increase in exchange rate volatility since 1973 has had indeterminate effects on international

export and import flows. The general assumption is, an increase in risk may lead to a reduction

in economic activity, however the theoretical literature provided justifications for positive as

well as insignificant effects and similar results have found in empirical results. Over the time,

various modeling techniques have evolved to incorporate new developments in econometric

analysis and no single measure of exchange rate volatility has dominated the literature.

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Anjum Aqeel and Mohammed Nishat (2006) empirically determined the long-run relationship

between exchange rate volatility and exports growth in Pakistan. They have employed a

multivariate Cointegration and Error Correction Model techniques on quarterly data during 1982

first quarter to 2000 fourth quarter to establish the relationship. In order to draw meaningful

conclusions on the speed of adjustment and for performing hypothesis tests on the coefficients

entering the Cointegrating vectors, they have used multivariate techniques suggested by

Johansen and Johansen and Juselius. The other variables considered for multivariate estimation

include world trade volume, domestic export price index and world export price index. The

results suggested that exchange rate volatility has negative impact on exports and the exports in

Pakistan also driven by the volume of world trade and world export prices as the coefficients of

these factors are positive and statistically significant in both short-run and long-run.

P.K.M. Tharakan, Ilke Van Beveren and Tom Van Ourti (2005) empirically analyzed the

determinants of Indian exports of software services and the total Indian goods exports. The

study implemented gravity model which is of partial equilibrium nature, dealing with the exports

of software services from India to all the other countries. The results of the study found that the

distance does not have significant effect on Indian software exports, which suggested that Indian

software exporters might have overcome the informational asymmetry problem and also found

that both knowledge of the English language and the ability to tap into network connections are

important determinants of the Indian exports of software.

Nicolas Peridy (2003) proposed a sectoral theoretical model in an imperfect competition

framework, with country-specific and industry-specific variable such as factor productivity, scale

economies, or product differentiation and tested the impact of exchange rate volatility on G-7

countries’ exports. Exchange rate volatility was measured using two measures, the moving

sample standard deviation and the GARCH process. The study showed that the impact of

exchange rate volatility on exports varies considerably, depending on the industry covered and

the export destination markets and there was both a sectoral and geographical aggregation bias

when estimating the effects of exchange rate variations.

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Murat Dogae Anlar (2002) examined the impact of exchange rate volatility on the exports of

five Asian countries, Turkey, South Korea, Malaysia, Indonesia and Pakistan. The impact of a

volatility term on exports is examined by using Engle-Granger residual-based Cointegrating

technique. The results indicated that the exchange rate volatility reduced real exports for these

countries, implying that producers in these countries are risk averse and the producers would

prefer to sell in the domestic markets rather than exporting with an increase in exchange rate

volatility.

Ivan T Kandilov (2002) extended Cho, Sheldon, and McCorriston’s (2002) analysis of the

effect of exchange rate volatility on agricultural trade among the G-10 countries to a broad

sample of developed, emerging and developing nations and replicated their original finding that

exchange rate volatility has a large negative impact on agricultural trade between G-10 members.

The study used gravity equation to estimate the determinants of bilateral trade. Exchange rate

volatility was measured using GARCH (1,1) process. Overall, the results suggested that

exchange rate volatility has adverse impact on agricultural trade only when G-10 country pairs

are considered and using the extended sample found that the effect of exchange rate volatility is

much larger for developing country exporters than for developed exporters.

Guedae Cho, Ian M. Sheldon and Steve McCorriston (2002) explored the effect of exchange

rate uncertainty on the growth of agricultural trade as compared to other sectors using a sample

of bilateral trade across ten developed countries between 1974 and 1995. A gravity model, was

applied which allows for cross-country determinants of trade including income, distance,

membership of customs unions, common borders, exchange rate uncertainty and so on. The

results showed that the real exchange rate uncertainty has had a significant negative effect on

agricultural trade compared to other sectors over this period.

Kyriacos Aristotelous (2001) investigated the impact of exchange rate volatility and exchange

rate regime on the British exports to the US using data for the period 1889 – 1999. The study

used a generalized gravity model, to investigate the relationship between exchange rate volatility

and volume of trade. The estimates of the models indicated that the managed float exchange rate

regime and the freely floating exchange rate regime did not have a statistically significant effect

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on British exports to the US in relation to a fixed exchange rate regime. The empirical results

suggested that the exchange rate volatility did not have an effect on the volume of British exports

to the US and there is no evidence that any of the exchange rate regimes of the late 19th and 20th

centuries had any impact on the volume of British exports to the US.

Augustine C. Arize, Thomas Osang and Daniel J. Slottje (2000) investigated empirically the

impact of real exchange rate volatility on the export flows of thirteen Less Developed Countries

over the quarterly period 1973-1996. They have used Johansen’s multivariate procedure to

estimate Cointegrating relations and estimates of short-run dynamics are obtained for each

country using Error Correction Model technique. The results of the study showed that increase

in volatility of the real effective exchange rate, exerted a significant negative effect on the export

demand in both the short-run and the long-run in each of the thirteen Least Developed Countries.

The effects resulted in significant reallocation of resources by market participants.

Suchada V. Langley, Marcelo Giugale, William H. Meyers and Charles Hallahan (2000)

empirically examined the actual effect of enhanced international financial volatility on selected

agricultural commodities such as corn, pork, poultry, natural rubber, soybeans, sugar, and wheat

trade in Canada, France, Korea, Japan, Mexico, Thailand, and the United States. The researchers

used time variance or conditional variance of the series of exchange rate changes as a measure of

exchange rate volatility. The exchange rate volatility was computed by estimating the real

exchange rate series as a GARCH process. In this study, the researchers employed a model,

similar to Asseery and Peel’s study, which used a standard relationship between export volume,

real GDP for foreign countries, a relative measure of competitiveness, and a measure of real

exchange rate volatility or exchange rate risk and assumed transportation costs and tariffs to be

fixed proportions of exported quantity. The researchers of this study have performed

Cointegration tests following the Engle-Granger methodology and applied Error Correction

Model as well. The exchange rate risk is significant in explaining poultry exports but not

aggregate exports. The coefficients of income, lagged residual term, and exchange rate risk are

highly significant for poultry exports which indicated that the average speed of export

adjustment differs depending on whether the adjustment is in response to foreign income,

relative price, or real exchange rate volatility. The income coefficient was much larger than that

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for relative price changes and the estimated volatility measure was statistically significant and

positive for Thai poultry exports while for the aggregate export equation, it is not statistically

significant. The positive coefficient of volatility measure indicates the attitude of the poultry

firms that react to exchange rate risk by rushing to take advantage of the depreciated currency in

exports markets.

Stilianos Fountas and Donal Bredin (1997) recognized that exports and its determinants are

potentially non-stationary variables and estimated a demand function for Irish exports to the UK,

the most important market for Irish exports, since the launch of the EMS in March, 1979. The

study included real exports as dependent variable and quarterly GDP, exchange rate and

exchange rate volatility as the explanatory variables. The exchange rate volatility was measured

using the moving standard deviation of the growth rate of the real exchange rate. The long-run

and short-run export demand functions were estimated using Cointegration analysis and Error

Correction Method respectively. The Johansen and Johansen and Juselius methods were used to

test the Cointegration relationship. The results of the study indicated that both income and

relative prices have the appropriate signs and are statistically significant, while the elasticities are

larger for overall Irish exports. The positive error correction term indicated that exports do not

restore the long-run equilibrium. The larger relative price coefficient than the income coefficient

indicated that Irish exports to the UK are more responsive to changes in relative prices than to

changes in income in the UK. The measure of volatility had a negative sign and was statistically

significant which implies that in the short-run exchange rate volatility had negative effect on

Irish exports to the UK.

A. C. Arize (1996) investigated the statistical relationship between exports and real exchange

rate uncertainty for the developing economy of Korea. The study used multivariate Cointegration

methodology developed by Engle and Granger and also suggested by Johansen and Johansen and

Juselius and also employed Error-Correction Method. The study used long-run equilibrium

export demand function which included logarithm of desired real exports as dependent variable

and logarithm of real foreign income, logarithm of price of Korea exports relative to trade-

weighted foreign prices, logarithm of export-weighted effective exchange rate, and a measure of

exchange rate uncertainty. The exchange rate uncertainty was measured using the moving

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sample standard deviation of the growth rate of the real effective exchange rate. The results of

the Johansen’s multivariate Cointegration technique suggested that long run equilibrium

relationship among the variables and the effect of real exchange-rate uncertainty on real exports

is negative and significant and the Error correction method suggested that the real exchange rate

uncertainty has short-run effects on real exports.

Augustine C. Arize (1995) examined the impact of exchange rate uncertainty on the demand for

real exports. The long-run export demand function included the logarithm of desired real exports

as a dependent variable and logarithm of real foreign income, logarithm of the exchange rate

adjusted index of the price of US exports relative to trade-weighted foreign prices, and a measure

of exchange rate uncertainty as explanatory variables. The unconditional exchange rate

uncertainty was determined using five-quarter moving average of the variance. The result of the

estimated demand relationship was positive and elastic for world income, negative and inelastic

for relative price and exchange rate uncertainty. The estimated income elasticity implied a fairly

large response of exports to changes in world income. The study concluded shown that exchange

rate uncertainty has a negative effect on US real exports and opined that the overall export

demand equation exhibits serious dynamic misspecification and becomes structurally unstable

when exchange rate uncertainty is excluded. The results have substantiated the hypothesis that

exchange rate uncertainty impedes trade.

Abdur R. Chowdhury (1993) examined the impact of exchange rate volatility on the trade

flows of the G-7 countries in the context of a multivariate error-correction model. The results

indicated that the exchange rate volatility has a significant negative impact on the volume of

exports in each of the G-7 countries. The error correction models do not show any sign of

parameter instability. Assuming market participants as risk averse, the results implied that

exchange rate uncertainty causes them to reduce their activities, change prices, or shift sources of

demand and supply in order to minimize their exposure to the effects of exchange rate volatility,

which consequently can change the distribution of output across many sectors in these countries.

Susan Pozo (1992) examined the effect of exchange rate volatility on the volume of trade from

Britain to US during 1900 to 1940. The study measured exchange rate uncertainty using a rolling

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standard deviation and also generalized autoregressive conditional heteroskedastic (GARCH)

process. The study assumed that US real GNP, relative prices for British and US goods, and a

measure of exchange rate volatility are the basic determinants of the volume of British exports to

the US in real terms. The study included four dummy variables to control for changes in the

international monetary system and other unusual events that took place during 1900 to 1940

period. The results of estimation using the two measures of exchange rate volatility suggested

that increase in the volatility of the real exchange rate reduces the volume of trade.

Daniel H. Pick (1990) analyzed the effect of exchange rate risk on US agricultural bilateral trade

flows. A model which incorporates exchange rate risk is applied to ten countries. The study

used quarterly data from 1978-87 for empirical analysis. The ten countries included in the study

are Japan, South Korea, Canada, Australia, West Germany, France, Netherlands, United

Kingdom, Brazil, and Mexico. Exchange rate uncertainty was measured using a moving four

quarters standard deviation of the relative change in the real exchange rate and the second

measure is based on monthly observations therefore, a moving twelve months standard deviation

of relative changes in the real exchange rate. While exchange rate risk was not significant in the

seven developed markets, results indicated that the exchange rate variable adversely affected US

agricultural exports to the three developing countries used in the analysis. These findings

underscored the importance of exchange rate risk in developing countries’ trading behavior.

Faik Koray and William D. Lastrapes (1989) used VAR models to investigate the impact of

real exchange rate volatility on US bilateral imports from the UK, France, Germany, Japan and

Canada. The VAR model was constructed and estimated for each bilateral case using monthly

data from 1959 to 1985. Each of the models contained the US money supply, output level, price

level, and interest rate, the foreign counterparts of these variables, bilateral US imports, the

nominal exchange rate, and a measure of exchange rate volatility. The exchange rate volatility

was measured using a moving standard deviation of the growth rate of the real exchange rate.

The overall result suggested a weak relationship between US bilateral trade flows and a measure

of exchange rate volatility. The impact of volatility on imports increased from the fixed

exchange rate regime to the flexible rate regime and permanent shocks to volatility do have a

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negative impact on the measure of trade, and those effects are relatively more important over the

flexible rate regime.

David A. Bessler and Ronald A. Babula (1987) empirically investigated the dynamic

relationship among the real index of weighted average exchange values of the US dollar, US

wheat export shipments, per bushel real prices of number-one red winter wheat and US wheat

export sales. The researchers chose to study flexible or market determined exchange rates, thus

observed monthly data from January 1974 through March 1985. The results of the study found

evidence that wheat sales data are useful in forecasting wheat shipments and real exchange rates

do seem to have an impact on real wheat prices.

Jerry G. Thursby and Marie C. Thursby (1987) examined the effect of exchange rate

variability in a gravity-type trade model derived from an underlying demand and supply model.

The researchers estimated the model for seventeen countries for the period 1974-1982. The

study found strong support for the hypothesis that increased exchange rate variability affects

bilateral trade-flows, as all the ten coefficients on exchange rate variability are negative and

significant. The study strongly supported the gravity-model and all coefficients of the model are

significant and had the expected signs.

Richard K Abrams (1980) presented a model of macroeconomic developments of trade flows

between developed countries. The model used to estimate the trade losses which may have

occurred during the 1973-76 period as a result of exchange rate uncertainty. The incomes of

both the exporting and importing countries, the distance between the trading countries, and

membership in the same trade preference organization were found to have a significant impact

on international trade flows. The findings of the study supported the hypothesis that countries

with more similar demand characteristics tend to engage in more bilateral trade.

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3.4 Conclusions and knowledge gaps emerged from survey of literature:

Generally, the empirical reviews made in this chapter clearly reveals that adequate research

studies have not been made (both in number and quality) in the area of corporate foreign

exchange risk management practices in the country. Although most of the available literature

focus on foreign exchange risk management practices of companies, the majority of them have

some procedural limitations like inappropriate sample selections, insufficient sample size,

selection and placement bias, and lack of appropriate comparison groups. There are a few

studies, where the representation of Software companies in the sample was insignificant in

comparison to other sectors, due to which the results were biased. In addition, there are no

significant studies on the relationship among Indian software exports, US economic activity and

INR-USD exchange rate volatility.

To sum up, while some studies seems to have been made only a handful have used appropriate

frameworks and sizable samples that can meet the objectives in answering the research questions

of corporate foreign exchange risk management practices. Cognizant of this, the present study

has made an attempt to assess the foreign exchange risk management practices of software

companies having registered office in Hyderabad. The study differs from other studies in that it

has aimed not only to assess the foreign exchange risk management practices of software

companies operating from Hyderabad but also aimed to examine the relationship among Indian

software exports, US economic activity and INR-USD exchange rate volatility.

To achieve these objectives, a standardized Questionnaire Schedule developed by Bodnar et al

was adapted with some modifications.

Hence, the study was needed because:

(i) It is comprehensive – that is, it will investigate the foreign exchange risk management

practices of companies pertaining to Software industry.

(ii) It is new – that means, so far, no study appears to have been made in India

exclusively on one particular industry and examined the relationship among Indian

software exports, US economic activity and INR-USD exchange rate volatility.