Article Review on

Hedging Foreign Exchange Exposure: Risk

Reduction from Transaction and Translation
Hedging
Niclas Hagelin and Bengt Pramborg
School of Business, Stockholm University, SE-106 91 Stockholm, Sweden

The mentioned article was published in Journal of International Financial

Management and Accounting in the year 2004. Researchers Niclas Hagelin and
Bengt Pramborg focused this article on the effectiveness of risk reduction through
hedging of foreign exchange exposure. Risk reduction is viewed at from two
angles: hedging of transaction exposure & translation exposure. Impact of financial
hedging instruments, specially the use of foreign denominated debt & currency
derivatives on both the above mentioned exposures is also investigated in this
article.

The study is based upon the consideration that FX exposure management is

expensive but they may not be effective in reducing total risk of the firm. From the
viewpoint of the shareholder, the firm should not incur expenses which are not
effective. The general idea is that hedging FX exposure reduces risk for the firm.
There have been several studies regarding the statement with varied findings
based on their varied use of samples & parameters. Japanese findings by He and
Ng (1998), Swedish findings by Nydahl (1999), US findings by Allayannis and Ofek
(2001), Guay (1999) & Wong (2000) suggest that currency derivatives may help to
reduce FX exposure. What differentiates this article from the above studies is the
use of both currency derivatives and debt denominated in foreign currency. In
addition, they have considered both transaction exposure & translation exposure
hedging.

The study, conducted from January 1997 to December 2001 collects sample data
from a number of Swedish firms. These firms were sent questionnaires to
determine exposures and firms usage of financial hedges. Based on these
questionnaires, researchers define variables that reflect each firms inherent FX
exposure as well as hedging strategy. The data found through questionnaires is

then processed through cross-sectional regression to determine the relationship

between firms FX exposures and their hedging practices.

The first step of the research finds out the stock price exposure to FX rate changes
from a time series regression model. The firms stock FX beta is then multiplied to
the firms equity-to-value ratio to compute each firms asset FX beta which is a
measure of firms FX exposure. The firms FX beta is then used in the crosssectional regressions.

To understand the relation between firm's size and exposure risk, the sample is
divided into three equal-sized groups based on book value of total assets. Total
assets (in million SEK) are calculated as the average of beginning-of-year and endof-year total assets. Three exposure measures are reported. FR is the percentage
of revenues that is denominated in foreign currency; FC is the percentage of costs
that is denominated in foreign currency; and abs(NE)is the absolute value of net
exposure, where net exposure is defined as the difference between the percentage
of revenues and the percentage of costs that are denominated in foreign currency.
The descriptive statistics on size and foreign exchange exposure for all firm year
observations found from the survey can be seen from the following table Observations
Total Assets
FR
FC
abs(NE)

Mean
Median
Mean
Median
Mean
Median
Mean
Median

Large
154
26384
11234
53.6
60
43.3
35
14.2
5

Mid
154
1377
992
45.5
40
36.1
30
19.2
10

Small
154
179
154
40.4
20
28.1
20
27.3
15

All Obs
462
9314
992
46.5
44
35.8
30
20.2
10

Table : Firm Size and Foreign Exchange Exposure

The result from the survey, as seen from the table shows that FX exposure
increases with the level of inherent exposure and decreases with firm size.

Further, the researchers investigate the impact firms may have from hedging
different types of FX exposures, as well as the impact from currency derivatives
hedging and hedging with foreign denominated debt.

To establish the relation between foreign currency exposure and hedging types, the
researchers classified the previous subsets of firms (large, medium, small) into four
distinct groups regarding hedging of different types of FX exposure; namely
transaction and translation exposure. TRTL denotes the firms that hedge both
transaction exposure and translation exposure, TR denotes the firms that hedge
transaction exposure only, TL denotes the firms that hedge translation exposure
only and the base case including the firms that do not hedge against FX exposures.
Next, to establish the relation between foreign currency exposure and hedging
instruments, another classification is done The firms which use both currency
derivatives and foreign denominated debt (CDFD), the firms which use currency
derivatives but no foreign denominated debt to hedge (CD), and the firms which
use foreign denominated debt but not currency derivatives to hedge (FD) and base
case containing firms that do not hedge with financial instruments.
The descriptive statistics on hedging practices, reported for all firm year
observations found from the survey can be seen from the following table
Panel A. Hedging and Types of Exposure, 19982001
Large
(%)
Mid
(%)
Small
(%)
All obs
(%)
Total
128
128
127
383
H*
121
95
89
70
32
25
242
63
TRTL
65
51
20
16
3
2
88
23
TR
49
38
60
47
29
23
138
36
TL
7
5
9
7
0
0
16
4
Panel B. Hedging and Instruments, 19972001
Large
(%)
Mid
(%)
Small
(%)
All obs
(%)
Total
154
154
154
462
H*
145
(94)
115
(75)
47
(31)
307
(66)
CDFD
93
(60)
48
(31)
3
(2)
144
(31)
CD
35
(23)
42
(27)
41
(27)
118
(26)
FD
16
(10)
24
(16)
3
(2)
43
(9)
*In the table, when hedgers (H) are broken down into groups, the resulting
number of firms may not add up to total number of hedgers due to incomplete
responses.
Table : Hedging Practices
The table contains the number and percentage (in parenthesis) of observations
that are for firms that hedge.

In order to investigate the effect from inherent FX exposure and financial hedging
on firms' FX exposures, researchers use cross-sectional regression models. Through
the models the researchers investigate cross-sectionally whether firms that hedge
are characterized by lower FX betas or not.
The models show following results:
1. A larger difference between revenues and costs in foreign currency results in
larger FX exposure.
2. Larger firms may have lower FX exposures than small firms.
3. Firms that use financial instruments to hedge, reduce their FX exposure
compared with firms that do not.
4. FX exposure is reduced for transaction hedgers as well as for translation
hedgers.
5. Firms are reducing exposure effectively using currency derivatives as well as
with foreign denominated debt or with a combination of these financial
instruments.

In summary, the results demonstrate that foreign exchange exposure, as measured

by firms foreign exchange betas, is increasing in inherent exposure. Also, exposure
is decreasing in firm size. It is suggested that larger firms may have lower inherent
exposure due to their ability to use operational hedges. Also, it is suggested that
large firms are more likely to be multinational corporations (MNCs) with production
and sales in many currencies, which can reduce FX exposure. Further, it is found
that financial hedges are effective in reducing firms foreign exchange exposure.
Particular interest is directed towards the impact from transaction exposure hedges
and translation exposure hedges respectively. This is of interest because
translation exposure and transaction exposure tend to affect firms differently. The
results suggest that there are risk reducing effects from transaction exposure
hedges as well as from translation exposure hedges.

However, hedging is not as black and white as the article suggests. Hedging
against foreign exposure may be beneficial to reduce the risk but at the same time
it has some demerits.

As the article itself mentions, anticipating the consequences of hedging is

difficult since so many other economic factors change when FX rates change.
As a consequence, hedging activity risks being wasteful to the firms shareholders, and may actually increase exposure.

Survey evidence suggests that firms management perceive hedging as

complicated. Hence, inexperienced investors could suffer losses when they
are unable to follow the strategies correctly.
Hedging usually involves huge costs and expenses that can eat up a big
chunk of firms profits.
The risk protection advantages of hedging can also be viewed as its main
weakness. As hedging does not provide ample flexibility that allows investors
to quickly react to market dynamics, so sometimes potential profits is
reduced.
In the end, currency hedging can be an investment trap if its risks are not
considered. As with any type of investment approach, hedging also has risks
that can result in huge losses.

Therefore, hedging can be a risk mitigating tool only when it is applied correctly.