Resolving the Exposure Puzzle:Resolving the Exposure Puzzle:The Many Facets of Exchange The Many Facets of Exchange

Rate ExposureRate Exposure

FDICFDICOctober 27, 2006October 27, 2006

Söhnke M. BartramLancaster University

Gregory W. BrownUniversity of North Carolina

Bernadette A. MintonOhio State University

2

MotivationMotivation

• FX risk is a major financial risk to nonfinancial firms

• “FX Exposure Puzzle”– Theoretical models predict exposure

• Bodnar, Dumas and Marston 2002; Marston 2001; Adler and Dumas 1984; Shapiro 1975

– Empirical studies find weak evidence

• Allayannis and Ihrig 2001; Dominguez and Tesar 2001a,b; Griffin and Stulz 2001; Williamson 2001

3

How to Resolve the Puzzle?How to Resolve the Puzzle?

• General idea/hypothesis of this paper– Firms do have potentially large FX risk– Pricing and financial policies reduce exposures

• Analysis– Use structural models to analyze different facets of FX

exposure and hedging• Gross (or pre-hedging) exposure• Net (or post-hedging) exposure

4

What We DoWhat We Do

• Motivating Example: Global Automotive Industry– Bodnar and Marston (2002) model– Detailed firm-level data

• Enhanced Bodnar, Dumas and Marston (BDM, 2002) model– Firm selling and producing in local and foreign market– Exposure is a function of:

• market share• product substitutability, • sales and cost in foreign currency

– Use model to analyze a large sample of global manufacturing firms around the world

5

ContributionContribution

• Resolving the Exposure Puzzle– Model predicts that firms should have large gross FX

exposures

– Firms reduce these exposures via three channels:• Pass-through (10%-15%)• Operational hedging (10%-15%)• Financial hedging (45%-50%)

– Residual FX exposures (as estimated in the prior literature) are economically and statistically small

6

Automotive IndustryAutomotive Industry

• Industry study to motivate main analysis– 16 auto manufacturers from 6 countries– Mature and competitive industry– Important FX risk (Williamson 2001)– Bodnar and Marston (2002)

h1: percent foreign sales

h2: percent foreign cost

r : profit margin

1

1211 r

hhh

1

1211 r

hhh

7

Automotive CompaniesAutomotive Companies

Volkswagen

Foreign Sales 0.52

Margin 0.16

Gross Exposure (h2=0) 3.29

8

Automotive CompaniesAutomotive Companies

Volkswagen

Foreign Sales 0.52

Margin 0.16

Gross Exposure (h2=0) 3.29

Foreign Production 0.42

Model Exposure 1.02

9

Automotive CompaniesAutomotive Companies

Volkswagen

Foreign Sales 0.52

Margin 0.16

Gross Exposure (h2=0) 3.29

Foreign Production 0.42

Model Exposure 1.02

FX-Derivatives 0.46

Foreign Currency Debt 0.18

Residual Exposure 0.38

10

Automotive CompaniesAutomotive Companies

Volkswagen

Foreign Sales 0.52

Margin 0.16

Gross Exposure (h2=0) 3.29

Foreign Production 0.42

Model Exposure 1.02

FX-Derivatives 0.46

Foreign Currency Debt 0.18

Residual Exposure 0.38

Actual Exposure 0.16

p-value [0.270]

11

Automotive CompaniesAutomotive Companies

Volkswagen Mean

Foreign Sales 0.52 0.55

Margin 0.16 0.22

Gross Exposure (h2=0) 3.29 2.70

Foreign Production 0.42 0.38

Model Exposure 1.02 1.26

FX-Derivatives 0.46 0.41

Foreign Currency Debt 0.18 0.09

Residual Exposure 0.38 0.76

Actual Exposure 0.16 0.18

p-value [0.270] [0.291]

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BDM ModelBDM Model

• FX exposure of exporter

• Exposure depends on– Product market competition => pass-through: degree of product substitutability: market share of exporting firm in foreign market

– Operational Hedging: fraction of marginal cost due to foreign currency-based inputs

2*

1

1 1ln1 1 1

ln 1 1

d

d S

13

Enhanced BDM ModelEnhanced BDM Model

• Two extensions of BDM model– Both firms can have cost in local and foreign currency– Firm sells globally

• Global firm is sales-weighted average of foreign and domestic operations ( is percent of foreign sales).

• Model is more broadly applicable– Captures global firms in global markets– Allows for broader set of exposures and pass-through– BDM model is a special case of enhanced model

14

Enhanced BDM ModelEnhanced BDM Model

• Foreign Exchange Rate Exposure

• Foreign Exchange Rate Pass-Through

2

2

11 1

1 1

11 1 .

1 1

f f f f

f f f

f f

d d d dd d d

dd

1 21 1 1 ,df f f f d d d

15

ParametersParametersDescription Empirical Counterpart

Percent foreign sales Percent foreign sales

Percent domestic sales 1-Percent foreign sales

Exporting firm

γf1Firm’s fraction of marginal costs in foreign currency

Percentage of foreign assets of firm

f2Import competing firms’ fraction of marginal costs in the foreign market, also foreign currency costs of other exporting firms

Weighted average of the percentage of domestic assets of foreign firms and percentage of foreign assets of other domestic firms

fMarket share of firm in foreign markets

Rest-of-world GDP-weighted average of import penetration ratio

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ParametersParametersDescription Empirical Counterpart

Import-competing firm

γd1Exporters’ fraction of marginal costs in the domestic market, also domestic currency costs of other domestic, import-competing firms

Weighted average of the percentage of foreign assets of foreign firms and percentage of domestic assets of other domestic firms

d2

(=1- γf1)

Firm’s fraction of marginal costs in the domestic currency

1-Percentage of foreign assets of firm

dMarket share of import competing firm in domestic market

1-Domestic market import penetration ratio

f, dDegree of product substitutability in the foreign (f) and domestic (d) markets

Specified exogenously

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BDM vs. Enhanced BDMBDM vs. Enhanced BDM

-2

-1

0

1

2

3

0.0 0.2 0.4 0.6 0.8 1.0

f=d

Feasible Exposures in BDM

Additional Feasible Exposure in Enhanced Model

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Automakers Again…Automakers Again…

-2

-1

0

1

2

3

0% 20% 40% 60% 80% 100%

Automakers' Actual Exposuresdmaxdmin

Foreign Sales %

Maximum Exposure - Enhanced Model

Minimum Exposure - Enhanced Model

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Sample and DataSample and Data

• 1,161 manufacturing firms from 16 countries

• Accounting data (USD) (Thomson)

• Market data (LC) (Datastream)

• Import penetration (UNIDO, SSIS)

• Herfindahl indices to measure industry competition (complete Worldscope universe)

• Collect data from annual reports for FX derivatives and foreign currency debt

20

Sample StatisticsSample Statistics

Mean Stdev 25th Perc. 75th Perc.

Actual FX Exposure 0.071 1.945 -0.806 1.058

Foreign Sales 34.5% 27.2% 11.6% 53.5%

Foreign Assets 19.1% 21.7% 2.2% 27.7%

Foreign Debt Dummy 0.871

FX Derivatives Dummy 0.659

Import Penetration 24.1% 17.3% 11.9% 32.8%

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Model Exposures & Pass-ThroughModel Exposures & Pass-Through

Mean Stdev

Model Exposure

f =d=0.5 0.428 0.296

f =d=0.7 0.477 0.316

f =d=0.9 0.549 0.355

22

Model Exposures & Pass-ThroughModel Exposures & Pass-Through

Mean Stdev

Model Exposure

f =d=0.5 0.428 0.296

f =d=0.7 0.477 0.316

f =d=0.9 0.549 0.355

Model Pass-Through

f =d=0.5 -0.088 0.215

f =d=0.7 -0.061 0.218

f =d=0.9 -0.035 0.223

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Level of Model ExposureLevel of Model ExposureHigh Low p-value

Actual FX Exposure 0.128 -0.091 0.033

24

Level of Model ExposureLevel of Model ExposureHigh Low p-value

Actual FX Exposure 0.128 -0.091 0.033

Foreign Debt 0.978 0.764 <0.001

FX Derivatives 0.799 0.519 <0.001

25

Level of Model ExposureLevel of Model ExposureHigh Low p-value

Actual FX Exposure 0.128 -0.091 0.033

Foreign Debt 0.978 0.764 <0.001

FX Derivatives 0.799 0.519 <0.001

Import Penetration 0.289 0.193 <0.001

Foreign Import Penetration 0.295 0.293 0.474

Industry Herfindahl 0.152 0.140 0.151

Country-Industry Herfindahl 0.478 0.355 <0.001

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Level of Model ExposureLevel of Model ExposureHigh Low p-value

Actual FX Exposure 0.128 -0.091 0.033

Foreign Debt 0.978 0.764 <0.001

FX Derivatives 0.799 0.519 <0.001

Import Penetration 0.289 0.193 <0.001

Foreign Import Penetration 0.295 0.293 0.474

Industry Herfindahl 0.152 0.140 0.151

Country-Industry Herfindahl 0.478 0.355 <0.001

Model Pass-through -0.211 0.088 <0.001

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Hedging EffectsHedging Effects

(1)

Intercept -0.37***

FC Debt

FX-Derivatives

28

Hedging EffectsHedging Effects

(1) (2)

Intercept -0.37*** -0.10

FC Debt -0.31***

FX-Derivatives

29

Hedging EffectsHedging Effects

(1) (2) (3)

Intercept -0.37*** -0.10 -0.30***

FC Debt -0.31***

FX-Derivatives -0.10

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Hedging EffectsHedging Effects

(1) (2) (3) (4)

Intercept -0.37*** -0.10 -0.30*** -0.10

FC Debt -0.31*** -0.30***

FX-Derivatives -0.10 -0.01

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Hedging EffectsHedging Effects

Coef. p-value

Intercept -0.15 [0.156]

FC Debt only -0.22 [0.086]

FX Derivatives only 0.42 [0.156]

Both -0.27 [0.019]

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Importance of Hedging ChannelsImportance of Hedging Channels• Gross FX exposure = 0.674

– no market share, no foreign assets, no financial hedging

– values at sample means, f=d =0.7

• Firms reduce FX exposure via 3 channels

(1) Pass-through (10%-16%)

- Market shares at sample average

(2) Operational hedging (9%-16%)

- Foreign assets at sample average

(3) Financial hedging (46% - 50%)

- FC Debt (45%)

- FX Derivatives (1%)

• Consistent with Guay and Kothari (2003), derivatives have limited impact on risk profile of the firm

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Industry PortfoliosIndustry Portfolios

R2 = 0.75

-0.2

-0.1

0.0

0.1

0.2 0.3 0.4 0.5 0.6 0.7

Model Exposure

Model Pass-through

R2 = 0.18

0.000

0.200

0.400

0.600

0.2 0.3 0.4 0.5 0.6 0.7

Model Exposure

Foreign Import Penetration

R2

= 0.15

0.000

0.100

0.200

0.300

0.2 0.3 0.4 0.5 0.6 0.7

Model Exposure

Foreign Assets

R2 = 0.54

50%

60%

70%

80%

90%

100%

0.2 0.3 0.4 0.5 0.6 0.7

Model Exposure

FC Debt or Derivatives

34

SummarySummary• Comprehensive analysis of FX exposure

• Resolving the “Exposure Puzzle”– Firms have large gross FX exposures

– Firms reduce these exposures via pass-through, operating and financial hedging

– Residual FX exposures are economically and statistically small

– FX risk management is effective, and companies can stop whining about FX risk