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

Resolving the Exposure Puzzle: The Many Facets of Exchange Rate Exposure FDIC October 27, 2006. Söhnke M. Bartram Lancaster University Gregory W. Brown University of North Carolina Bernadette A. Minton Ohio State University. Motivation.

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

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  1. Resolving the Exposure Puzzle:The Many Facets of Exchange Rate ExposureFDICOctober 27, 2006 Söhnke M. Bartram Lancaster University Gregory W. Brown University of North Carolina Bernadette A. Minton Ohio State University

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

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

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

  7. Automotive Companies

  8. Automotive Companies

  9. Automotive Companies

  10. Automotive Companies

  11. Automotive Companies

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

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

  14. Enhanced BDM Model • Foreign Exchange Rate Exposure • Foreign Exchange Rate Pass-Through

  15. Parameters

  16. Parameters

  17. BDM vs. Enhanced BDM

  18. Automakers Again…

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

  20. Sample Statistics

  21. Model Exposures & Pass-Through

  22. Model Exposures & Pass-Through

  23. Level of Model Exposure

  24. Level of Model Exposure

  25. Level of Model Exposure

  26. Level of Model Exposure

  27. Hedging Effects

  28. Hedging Effects

  29. Hedging Effects

  30. Hedging Effects

  31. Hedging Effects

  32. Importance of Hedging Channels • Gross FX exposure = 0.674 • no market share, no foreign assets, no financial hedging • values at sample means, rf=rd =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

  33. Industry Portfolios

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

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