INTERNATIONAL FINANCIAL MANAGEMENT FINAL ASSIGNMENT A STUDY ON THE IMPACT OF EXCHANGE RATE RISK ON COMPANY STOCK RETURNS

Akua Serwaa Ansah Grenoble Graduate School of Business MIB 31 Group A

INTRODUCTION Since the 1970s the volatility of exchange rates and the risks that come with it have become a topic of interest in international financial management. According to standard economic analysis, exchange rate movements tend to affect the returns of a company and in effect the value of that firm, and this notion has been further heightened by the currency fluctuations that have been experienced over the last few decades, and has led to many studies on the impact of the risk and finding methods in managing it. Exchange rate risk on the whole is the risk that the operations or investment value of a business would be affected by if there are changes in the rates. Changes in the value of currencies used in doing business have an effect on the loss or gain of the investment when money conversions are being made. This risk therefore has an effect on the business.

METHODOLOGY Data used for this regression analysis consisted of the stock prices of 30 companies. The sample period for each of the companies was 6 years from January 1st 2005 till December 30th 2006. The 30 companies were all listed on the Copenhagen Stock Exchange (CSE) which forms part of the NASDAQ OMX stock market. The CSE serves as an international marketplace for Danish securities which include shares, bonds, and treasury bills and notes etc. it forms part of the OMX exchanges founded in 2003 and since 2008 became part of the NASDAQ OMX Group. Among the various indices that the CSE works with, the KAX index was used for the purpose of this analysis. It is an all-share index which was introduced in 2001 to replace what was used previously. It
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has been instituted to conform to the Global Industry Classification Standard developed by Morgan Stanley, Dean Witter and Standard & Poors.

RESULTS OF ESTIMATED EXPOSURE OF 30 DANISH COMPANIES TO EXCHANGE RATE RISK Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company Company 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Beta Index Significance Beta XR significance 0.019174 0.460005 -0.000817 0.974895 0.053419 0.039348 0.030789 0.234762 0.014042 0.588281 -0.031363 0.226729 0.023239 0.370501 0.009823 0.704998 0.289072 0.000449 0.118079 0.144514 -0.005376 0.835903 -0.006850 0.791842 0.045974 0.076052 0.046473 0.072922 0.016098 0.535009 0.017654 0.496295 0.103376 0.000065 0.004458 0.862905 0.029016 0.262870 0.051720 0.046064 0.049000 0.059000 0.053000 0.039000 0.048497 0.061426 -0.026417 0.308087 0.006088 0.814476 0.024986 0.335608 0.204113 0.000000 0.014222 0.575682 0.097431 0.000168 -0.005734 0.824334 0.106343 0.000040 0.017379 0.500665 0.014721 0.571725 0.009198 0.723823 0.003000 0.917000 -0.005000 0.859000 0.263039 0.000000 0.035659 0.154434 -0.066116 0.606882 -0.287602 0.028228 0.047546 0.066798 0.010948 0.672813 0.105085 0.000049 -0.006626 0.797374 0.039865 0.124061 0.043370 0.094320 0.057480 0.074976 -0.001762 0.956447 0.115802 0.000007 0.043420 0.092030 0.075680 0.003499 -0.001001 0.969161 0.044010 0.089736 0.019366 0.455110 -0.014612 0.598355 -0.029735 0.283831 0.006679 0.796862 -0.021199 0.413978 -0.004975 0.847982 0.009811 0.705399
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The table above therefore represents the regression results for the firms in Denmark. Companies were selected across different industries. The historical data for this analysis was retrieved from Yahoo Finance and the data frequency choice was daily, to ensure a sufficiently high number of observations and provide an adequate representation of volatility fluctuations.

DISCUSSION OF RESULTS The column showing the beta index represents the market rate index of the companies and the correlation that they have with the firm value. The inclusion of the return of the market index was used as a control variable for the analysis. We see from the table that only four companies show negative figures meaning that there is a negative association between the market risk and the value of the firm while the remaining 26 companies have positive values and therefore show a positive association between the market risk and the firm value. This same principle applies to the exchange rate betas. Here we see from the table that 12 of the companies show a negative correlation between the exchange rate and the firm value while 18 show a positive correlation. With regard to the level of significance for both indices, the data shaded in orange represents figures that indicate that the companies that they are assigned to have significance that is below 0.1000 which is a significance of 10%. In this case, it indicates that there is a significant impact of the foreign rate risk and as well the market rate risk on the value of the company. Therefore under the exchange rate risk we see that 6 companies show a significant impact while the remaining 34 companies do not show a significant impact of exchange rate on the value of those companies. With reference to the market rate column 15 companies show significance below 10% while the

remaining 15 show that there is no significant impact of the market rate risk on the value of the company.

MANAGING EXCHANGE RATE RISK According to financial theories one of the major reasoning behind companies non significant exposure to exchange rate risk is by finding the appropriate measures to eliminate or hedge against these risks. This comes in two forms, finding internal means and external means. External means are considerably more expensive and complicated and therefore it is often suggested that companies need to attempt to find internal methods before immediately resorting to the external measures. Hedging is a way of companies to insure themselves against the impacts of possible risks that they could face during business transactions and therefore demands certain assessments to determine whether it is necessary or not. No hedging (do nothing) Companies can make the choice to refrain from actively managing the risk which indicates that they would trade in the current spot market whenever the cash flow requirement arises. Although this is a choice it is highly risky as it is based on speculation of the rate at which the company will deal on the day and at the time that the transaction takes place. In most cases, foreign exchange rates are very volatile and these make a great difference in making a profit or a loss. It is therefore quite difficult for most companies to rely on buying or selling currencies at the spot market. This therefore opens the way to the different hedging techniques that enables managing the effect of the risk.

 Hedging with forwards One of the ways of hedging is by using forward contracts. These are customized agreements between two parties in order to fix the exchange rate for a future transaction. These contracts are able to support the reduction of volatility in certain markets but however they come with inherent risks which come with making investments. There is the possibility of selling these contracts on the secondary market but the person holding the contract at the end must take delivery of the underlying asset. A company can enter into such an agreement with any bank which provides these arrangements and therefore have the risk transferred to them. According to research however forward contracts are not as common as other forms of hedging. Hedging with futures Another form of minimizing risk that is quite similar to the forward contract is the futures contract. In this case there is again an agreement between two parties who are the buyer and the seller over a particular currency at a future date. In this case as well the exchange rate is fixed today. The one difference between the futures contract and that of the forward is the fact that the former is much more liquid since it is traded on the futures market which is like a stock market. It is also a legal contract however the obligation can be removed before its expiry date by making an opposing transaction. Therefore the company in this case if the risk involves an appreciation of the value then the company is to buy futures and on the inverse sell futures if there is depreciation. Hedging with options This is another contract between a buyer and a seller where the buyer of the option is endowed with the right to buy or sell a specified currency at a
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specified exchange rate during or before a specified date. There are two types of options available which are call options and put options. The call option gives the buyer the right to buy a specified currency at a specified exchange rate at or before the specified date. The put option gives the buyer the right to sell the currency under the same conditions mentioned before. The right comes at a fee which is known as the premium and therefore gives the seller the obligation in the event the right is exercised by the buyer.

CASE EXAMPLE Company #26 TDC is the largest telecommunications company in Denmark. It is also represented in Norway Sweden and Finland through its business unit TDC Nordica and consists of ten subsidiaries besides the parent company in Denmark. From this current analysis, it shows that the impact of foreign exchange risk is not significant as it has a figure of 0.969161. Reference is therefore being made to the financial management policies of the company to see the possible relation between that and its exposure to risk. With reference to the companys annual report, they indicate exposure primarily to exchange rate risks from the Euro, the Swedish krona and the Norwegian krone. Its exposure from financial activities in the Euro is deemed as signigicant since a large portion of the nominal gross debt is denominated in Euro. Nevertheless a fixed EUR/DKK exchange rate policy provided by the Danish central bank which is Danmarks Nationalbank, TDC considers its position relative to the Euro as an insignificant risk. It all the same produces a financial strategy to guide in monitioring and managing these risks. It has therefore included many variables which are monitored and have incorporated exchange rate hedging policies. As at 2010 the policy stipulated that investments in non-core businesses should be hedged, investments in core businesses should not be hedged and all group accounts payable and receivable should be hedged
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against local currencies. In 2011 they added this rule by stating that foreign investments in the Nordic countries which produce exchange rate exposure would not be hedged since they are regarded as long-term investments.

RELATED STUDIES Due to the rising interest in this area over the years several studies have been conducted to be able to assess the impact of exchange rate on firm value. A study conducted by Doige, Griffin and Williamson (2002) were aimed at providing new evidence regarding foreign exchange exposure. Using traditional linear regressions, it is observed that a greater number of firms are exposed to exchange rate movements but the percentage is not overwhelming. Further regression of exposure betas on the determinants of exposure (sales, company size etc) however show that variables related to foreign operations have a relationship with exchange rate exposure. Similar studies performed by Beirne, Caporale and Spagnolo (2009), in sixteen countries including Denmark, US and Japan and for three different financial sectors (banks, financial services and insurance). This study differentiates itself from others based on the extensive country coverage and modeling of risk sensitivity and the presentation of causality-in-mean and causality-in-variance effects. Earlier studies like this paper have focused on single countries. The results on the whole did not however differ from what previous studies have seen in relation to the sensitivity of firms to exchange rate volatility.

FAILURE OF EMPIRICAL STUDIES IN SUPPORTING THEORY While finance theory and even intuition strongly maintain that the value of a firm is sensitive to volatility in exchange rate, empirical studies are not
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conclusive. It has been realized that such studies tend to find limited evidence of the relation between these two factors and therefore drawing the conclusion that the relation is too small to have any economic importance. According to empirical research, exchange rate fluctuations do not explain the variations in stock returns and this has been illustrated in studies performed by Jorion (1990), and Bartov and Bodnar (1994). This is also supported by Griffin and Stulz (2001) who demonstrated that the impact is indeed very little. Finance theory backs its position with a wide range of parameters which determine a firms level of sensitivity to exchange rate risk. This includes the firms cost and revenue structure, pricing strategies and its competitive position and environment. On the inverse, empirical studies which have so far seen results of weak relationships between exchange rates and US stock returns have also seen evidence from other economies showing more significant risk. Researchers have attributed these inconsistencies to the attempt of companies to eliminate these risks by through hedging. However since exchange rate fluctuations are difficult to determine, one cannot be certain of the real effectiveness of hedging done for future cash flows. These controversies have therefore led to the development of new means of estimating foreign exchange exposure.

CONCLUSION This paper made considerable advances in a simple way of understanding exchange rate risk exposure and the divergent views of empirical thought and finance theory. In the way forward, one would have to agree with the suggestion of empirical findings that a more complete understanding of this exposure is needed. This should also include further study into hedging activities, their true impact and which firms need or do not need these measures. Furthermore, there is the need to look into the effect of this increased volatility on shareholder wealth during financial crisis.
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Bibliography
Aline, M., & Willem F.C., V. (2005, October 19). Foreign Exchange risk exposure: Survey and suggestions. Retrieved May 11, 2012, from Science Direct: http://ces.univparis1.fr/membre/toubal/M2/risk/MuVer.pdf Craig, D., John, G., & Rohan, W. (2002, May 8). Does Exchange rate exposure mattter? Retrieved May 11, 2012, from J. Griffin: http://www.jgriffin.info/Research/ExchangeRate.pdf John, B., Guglielmo Maria, C., & Nicola, S. (2009). Market, Interest Rate and Exchange Rate Risk Effects on Financial Stock Returns: A GARCH-M Approach. Quantitative and Qualitative Analysis in Social Sciences , 44-68. Managing Foreign Exchange Risk. (n.d.). Retrieved May 9, 2012, from Desjardins Caisse centrale: http://www.desjardins.com/en/entreprises/solutions/services-internationaux/devises-etrangeres/gerisque-change.pdf

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