Operational Hedges and the Foreign Exchange Exposure of U.S. Multinational Corporations Author(s): Christos Pantzalis, Betty J.

Simkins, Paul A. Laux Source: Journal of International Business Studies, Vol. 32, No. 4 (4th Qtr., 2001), pp. 793-812 Published by: Palgrave Macmillan Journals Stable URL: http://www.jstor.org/stable/3069477 Accessed: 15/01/2009 10:53
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Operational Hedges Exchange








BettyJ. Simkins**

Paul A. Laux***

This paper examines the impact of operational hedges of US multinational corporations (MNCs)on their exchange rate exposure. The two important contributions of this study are: First, it documents the importance of operational hedges as significant determinants of exINTRODUCTION A number of empirical studies have examined the question of whether corporations are exposed to foreign exchange risk (see Jorion, 1990; Bodnar and Gentry, 1993; Bartov and Bodnar, 1994, 1995; and Chow, Lee and Solt, 1997 among others). Studies to date have only uncovered a weak relationship between the stock returns of firms and exchange rate fluctuations. Yet case studies (Pringle, 1991), survey results (see Bodnar,

change rate risk, as measured by "breadth"and "depth" dimensions of the MNC foreign subsidiary network. Second, this finding remains robust even after examining the impact of operational hedges on exposure separately for negatively and positively exposed MNCs.
Hayt, Marston and Smithson, 1998), and anecdotal evidence show that foreign exchange exposure is an important concern of corporations and that many corporations actively engage in risk management activities to reduce exposure. This research expands on previous studies of exchange rate exposure by examining whether the ability of US multinational firms (MNCs) to construct operational hedges (as proxied here by the structure of the firm's multinational net-

*ChristosPantzalis is an Assistant Professor at the University of South Florida. **Betty J. Simkins is an Assistant Professor at Oklahoma State University. ***Paul Laux is an Associate Professor at Case Western Reserve University. The authors wish to thank participants at the 1999 Eastern Finance Association Annual Meeting, the 1999 Financial ManagementAssociation Annual Meeting and HarriRamcharran for useful comments.


work) impacts their exchange rate exposure. Operational hedges are best suited for managing the impact of exchange rate changes on the firm's competitive position across markets and products and include a variety of the firm's decisions (e.g. those related to marketing, production, sourcing, plant location, treasury, etc.). We measure exposure as the association between changes in the value of the dollar and stock returns using a timeseries regression and controlling for the overall direction of the stock market. While a few studies have investigated the impact of financial hedges (i.e. the use of currency derivatives) on foreign exchange exposure, no study to date has examined the influence of the MNC network structure on exposure. Yet, theoretical papers argue that operational hedges are more effective in managing long-run exposure, whereas financial hedges are more effective for managing short-run (see Logue, 1995; and exposures Chowdhry and Howe, 1999). We proxy the MNCs' ability to design effective ways to manage their economic exposure to foreign exchange risk by examining two dimensions of the foreign network structure: the subsidiaries "breadth" (defined as the degree of a network's spread across many foreign countries) and the "depth" (defined as the degree of a network's concentration in a few foreign countries). We test the impact of these network characteristics on the degree of the MNC's foreign exchange exposure and also examine other characteristics of the network such as the use of financial subsidiaries located in foreign countries and the level of industrial diversification. We document the importance of operational hedges for managing exchange rate risk. In particular, MNCs with

greater network breadth are less exposed to currency risk whereas firms with more highly concentrated networks (greater depth) are more exposed. This effect remains even after a separate examination of MNCs with positive currency exposures and negative currency exposures. Furthermore, the results are robust to different currency exposure measurement techniques and to controlling for the use of financial hedges. These findings are important because they provide the first empirical support to the widely accepted notion that the exposure of non-contractual cash flows (i.e., operating exposure) to currency risk is best managed through adjustments of operating policies across a firm's network of business units. This paper proceeds as follows. In the next section, we describe the sample of MNCs studied, discuss the importance of operational hedges and financial hedges to exchange rate exposure risk management, and explain how exchange rate exposure is measured. The subsequent sections investigate the determinants of exchange rate exposure and present concluding remarks. HEDGESAND OTHER OPERATIONAL OF EXCHANGE DETERMINANTS RATE EXPOSURE This section provides background information on the importance of operational hedges in the management of exchange rate risk and describes our research hypotheses. After that, it describes how the sample of MNCs was selected, how exchange rate exposure is measured and discusses the data employed in our study. Refer to Table 1 for a summary of the hypotheses tested, definitions of variables examined, and sources of information.


TABLE 1 DESCRIPTION OF VARIABLES AND HYPOTHESIze:n RELATIONS BETWEEN MNC AND THE ABSOLUTEVALUE OF THE FOREIGNEXCHANGE CHARACTERISTICS EXPOSURE BETA Hypothesis Operational Hedges Variable Sign Data Description (Source) Natural log (ln) of the number of foreign countries in which the firm has subsidiaries in 1991. Measures breadth of the multinational network. (Directoryof International Affiliations) Country concentration. Calculated as the (Number of Foreign Subsidiaries in the top two foreign countries)/Numberof Foreign Subsidiaries), in 1991. Measures depth of the multinational network. (Directoryof InternationalAffiliations) Measures the use of financial hedges. Indicator variable equals 0 if the firm does not have a foreign financial subsidiary and does not use currency derivatives, equals 1 if the firm either has a foreign financial subsidiary or uses currency derivatives, and equals 2 if the firm uses both. (10K statements and Directoryof International Affiliations) Foreign sales ratio (foreign sales/total sales) for




Financial Hedges



Control Variables: FSALES Foreign involvement

+ + +


Total Risk

Industrial NSEGM Diversification


(COMPUSTAT) Natural log (ln) of total assets (in million dollars) for 1991. (COMPUSTAT) Stock price risk and firm risk in 1991. Natural log of the ratio of the firm's high and low prices for the year. (COMPUSTAT) Calculated as the number of business segments at the two digit SIC level in which the firm operates. Measures industrial diversification of the firm. (COMPUSTAT)


Selection of Multinational

Hedges and Sample

on the use of derivatives (see Bodnar et
al, 1998), that exchange rate risk is of

great concern to market participants and
firm managers. Investors are concerned with the impact of unexpected changes in the exchange rate on their portfolio values, while managers who typically 795

There is ample evidence from studies on the pricing of exchange rate risk (see Jorion, 1991; and Dumas and Solnik, 1995 among others), as well as surveys
VOL. 32, No. 4, FOURTH 2001 QUARTER,


are over-invested in their own firms are primarily concerned with the exposure of their firms. As described in Smith and Stulz (1985) and Stulz (1994), risk aversion provides an incentive to manage foreign exchange risk. Foreign exchange exposure is defined as the effect of unexpected changes in the real exchange rate on firms (see Adler and Dumas, 1980, 1984; and Cornell and Shapiro, 1983 among others). We distinguish between two types of economic exposure: Transaction exposure is the effect of unexpected changes in the nominal exchange rate on cash flows associated with monetary assets and liabilities (i.e., contractually fixed cash flows). Transaction exposure is usually a shortterm exposure that can be easily hedged using currency derivatives. Operating exposure is the effect of unexpected changes in the exchange rate on cash flows associated with a firm's non-monetary (real) assets and liabilities. Operatingexposure is typically a longterm exposure that can usually be best managed through the implementation of operational hedges (see Flood and Lessard, 1986). For example, consider a firm with foreign currency cash flows that are known with certainty. The sole source of uncertainty for the firm is the exchange rate. This (transaction)exposure can easily be hedged using forward contracts. However, the use of derivatives cannot eliminate risk if the quantity of the foreign cash flows is also uncertain and not perfectly correlated with the exchange rate. These firms can rely on operating adjustments such as shifting their production in countries where significant sales revenues in the local currency are expected. Thus, the impact of unexpected changes in the exchange rate on the parent country (domestic) currency value of sales revenues would be offset

by similar changes in the value of local production costs. Past studies of MNCperformancehave documented that MNCs build value by increasing the flexibility of their operating networks' (see Allen and Pantzalis, 1996; Buckley and Casson, 1998 among others). Operating flexibility is the ability of the MNCs to arbitragemarkets by shifting factors of production across borders and by transferringresources within their network of affiliates that includes production, marketing/sales, research and financial units/subsidiaries located in one or more foreign countries. Furthermore, an MNC's operating flexibility can be viewed as a portfolio of real and financial options, obtained in the course of international diversification (see Kogutand Kulatilaka,1995). As Dunning
and Rugman (1985) noted, MNCs have

"greaterdegrees of freedom than a uninational firm confined to one country". While purely domestic firms have to rely on financial instruments to hedge their exchange risk exposure, MNCs have an additional hedging tool: the operating flexibility provided by their foreign network.
Operating exposure results from unexpected changes in the exchange rate on the firm's input costs (e.g., raw materials, labor costs, etc.) and output prices (e.g.,

product prices). Since the correlation of
prices with exchange rates is determined by the degree of segmentation of their respective markets, operating exposure depends on whether input costs and output prices are determined locally or globally. An MNC may respond to actual rate and/or exchange anticipated changes by devising operating strategies that consist of different marketing initiatives (such as market selection or pricing strategy) and production initiatives


(such as raw materials sourcing and production location). 2 MNCs often manage their operating exposure by diversifying their operations across many countries (currency areas). Naturally, such hedges are quite costly to construct, lengthy in implementation time, and thus not easily lifted. As noted in Butler (1997) "(T)he costs of hedging through operations are less onerous for a large multinational corporation with diversified operations than for a smaller firm that is less diversified geographically. Large diversified firms face lower sunk costs when shifting production or sales between countries because they are more likely to have established operations in these countries". The implication is that MNCs with large diversified networks will be more successful in effectively managing operating exposure. We arguethat the ability of the MNCto construct operational hedges is a function of the structure of its foreign network. Thus, the level of exposure to foreign exchange risk differs for MNC networks with different characteristics. For example, MNCsthat have operations in a large number of geographic regions will be in better position to effectively construct operational hedges than similar sized MNCs whose operations are concentrated in a few geographic regions (currency areas). In order to describe the structure of the MNC's network, we focus on two dimensions: the "breadth" and the "depth" (hereafterreferredto as breadth and depth). The breadth of the MNC network is measured by the number of foreign countries that the firm has subsidiaries. Depth is a measure of concentration of the MNCs foreign subsidiaries in a few foreign countries (see Allen and Pantzalis, 1996; and Doukas, Pantzalis and Kim, 1999).
VOL. 32, No. 4, FOURTH 2001 QUARTER,

We hypothesize that the breadth and depth of the MNCnetwork have opposite effects on the MNC's currency exposure, i.e., breadth (depth) should be associated with lower (higher) levels of exposure. Consider the following example for two MNCs, A and B, that both have the same level of foreign sales. MNC A has six foreign subsidiaries, three of which are in England and three in Germany. MNC B also has six foreign subsidiaries: one subsidiary each in England, Germany, Brazil, Mexico, Australia and Japan.We expect the overall exposure of MNC B, which has greaternetwork breadth, to be lower than that of MNC A, which has less breadth and more depth. MNC B's greater breadth gives it more flexibility in constructing operational hedges (such as the ability to shift production from one country to another in response to exchange-rate changes). MNC B is also exposed to a greater number of currencies that are less than perfectly correlated. Thus, the overall firm exposure for MNC B is hypothesized to be smaller than the sum of the individual foreign units' exposures. The sample of multinational corporations is selected as follows. First, all US industrial firms (i.e., firms with SIC codes through 3999) listed on the New York Stock Exchange and American Stock Exchange in 1991 are selected, which results in 1300 firms. The Directory of International Affiliations (1992)

is used to identify only multinational firms. A multinational firm is defined as a firm that has at least one majority owned foreign subsidiary. This results in 620 firms that are identified as MNCs. Next, we select only those MNCs for which data are available on CRSP and COMPUSTATand which are included
in the Fortune 500 for 1993. Including

Fortune 500 firms allows us to analyze


currency exposure of both users and

nonusers of currency derivatives. These companies are required to report such hedging activities in their annual financial statements during our sample period. This yields a final sample size of
220 MNCs.

Other Factors Hypothesized to Impact Foreign Exchange Exposure
Empirical research documents that many corporations actively manage exchange rate risk through the use of currency derivatives (see Geczy, Minton and Schrand, 1997; Allayannis and Ofek, 2001; Allayannis and Weston, 2001; Bodnar, Hayt, Marston and Smithson, 1998). In view of the extensive use of currency derivatives and their potential for affecting exchange rate exposure, it is important to control for financial hedges in trying to understand companies' exposures. We define financial hedges as the use of currency derivatives. Recent rules passed by the Financial Accounting StandardsBoard (SFAS 105, 107 and 119) require firms to disclose significant use of currency derivatives. We have examined these disclosures in detail by reading 1993 10-K filings. We use an indicator variable to measure currency derivatives usage because the reported notional principal amounts are missing or aggregatedfor approximately 20 percent of the derivatives users. Furthermore, notional principal amounts are noisy proxies because of aggregation and netting in reporting values and because the types of contracts and terms vary widely.3 In addition to the operational and financial variables, there are other factors that may influence the MNCs currency exposure. Refer to Table 1 for a description of other variables employed in our

study, together with their hypothesized relation with foreign currency exposure. These variables are size, the level of foreign sales, firm risk, and industry diversification. We include the natural log of the firm'stotal assets in the analysis as an indicator of firm size. Bodnar and Wong (2000) find that large firms with no foreign operations actually exhibit exposures that are more negative than small firms with extensive operations. As a result, a failure to control for size in crosssectional regressions causes a correlated omitted variable problem, which will misstate the significance of other variables in the regression. The firm's degree of international involvement is measured by the foreign sales to total sales ratio. Firms with a large proportion of foreign sales are expected to be more exposed because prior studies have identified foreign sales ratios as important determinants of exposures in cross-sectional tests (Jorion, 1990; Bodnar and Wong, 2000). We include total risk (measured by the logarithm of the high to low stock price for the year 1991) in order to investigate whether foreign exchange exposure is a significant part of the firm's overall risk. Therefore,we hypothesize a positive relationship between total risk and foreign exchange exposure. Industry diversification is measured as the number of reported business segments in which the firm operates. This variable proxies for the capability to reduce exposure through diversification across multiple business lines (Heston and
Rouwenhorst, 1994).

Measuring Exchange Rate Exposure
We employ the following methodology for measuring the currency exposure of sample firms. This measure is analogous to that in other papers on this topic

CHRISTOS BETTY PAULA. LAUX PANTZALIS, J. SIMKINS, (see, for example, Jorion, 1990; Bodnar and Gentry, 1993; Bartov and Bodnar, 1994; Choi and Prasad, 1995; Simkins and Laux, 1996; and Bodnar and Wong, 2000). Our basic tool for measuring a stock's currency exposure is the timeseries regression equation for each stock i:
Rit = ai + 3iRmt + yiRct + cit, (1)

it will have a net long economic position
in foreign currency.4 Firms in this category include not only exporters, but also firms whose overseas sales result in a net inflow of foreign currency, or even firms that are import competitors whose cash flows are influenced by the competitive pressure of foreign import prices. To operationalize this regression, we obtain security price data from the University of Chicago CRSP data base for the sample period January 1989 through December 1993. For Rit, we use the stock's cum-dividend return. For Rmt, we use two different measures: (1) the valueweighted CRSP market portfolio return (VWR) and (2) the equally-weighted CRSP market portfolio return (EWR). The VWR is employed because it is commonly used in prior studies on exchange rate exposure and allows us to compare our results to that of prior studies. However, Bodnar and Wong (2000) point out that the VWR can distort the sign and size of the resulting exposures because of an inherent relation between market capitalization and exposure. They state that exposure studies using the VWR control not only remove the "macroeconomic" effects from the exposure estimates, but also cause a distribution shift in the positive direction for exposure estimates. They show that replacing the VWR with the EWR in equation 1 results in residual exposures that are more consistent with the actual cash flow impact of exchange rate changes predicted by corporate finance models. As a result, the EWR control corrects the potential bias of the VWR control in exposure estimates and leads to less distortion in the residual exposures. The sample period of 1989 to 1993 is chosen for two reasons. First, we know which firms actively use derivatives in 1993 based on reporting disclosures, and 799

where Rit is the rate of return on the ith company's common stock in month t, Rmtis the value-weighted market return, Rct is the rate of change in the exchange rate index, and eit is the idiosyncratic error term. The exchange rate is measured as the price of the US dollar in foreign currency; therefore, a positive value for Rct indicates a strengthening dollar. For each stock, the estimated coefficient yi is a measure of the association between changes in the value of the dollar and stock returns, controlling for the influence of the US stock market. The sign of y1 can be either positive or negative depending on the net exposed asset and liability position of firm i. What the sign of the exposure coefficient, y , really means is that the firm has either a long or a short economic position in a particular currency dollar (see also the relevant discussion in Bartov and Bodnar (1994)). Specifically, US MNCs with a net long position in a foreign currency will benefit from a depreciation of the US dollar, while US MNCs with a net short position in a foreign currency will suffer from an appreciation of the US. The long or short economic position of firms in a particular currency is determined by the structure of their expected future cash inflows (revenues) and outflows (costs). For example, if a US MNC has expected cash inflows that are primarily denominated in foreign currency,
2001 VOL. 32, No. 4, FOURTH QUARTER,


so must limit the sample period to one in which it can reasonably be assumed that firms' currency hedging practices are consistent with the disclosure. Second, prior studies by Bartov and Bodnar (1995), Allayannis (1996) and Chow, Lee and Solt (1997), have found that a firm's exposurechanges over longertime frames, and so we requirea compact time period. To compute monthly changes in the value of the dollar, R,t, we use two different exchange rate indexes: (1) the X-131 index published by the Federal Reserve Bank of Dallas and (2) the Multilateral Exchange Rate Model (MERM) developed by the InternationalMonetary Fund (Artus and McGuirk, 1981). The X-131 index was chosen because it is the most comprehensive index available, measuring the value of the US dollar against all U.S. trading partners. The X-131 is computed using moving weights that are adjusted annually to reflect the importance of the various currencies in US foreign trade, rather than fixed trade weights as used in other indexes. Cox (1986) states that this allows the index to accurately reflect current trade patterns and the dollar's value over time. However, the index includes the currencies of several high inflationary economies and as these depreciate substantially, the index can misrepresent the real exchange rate, which is important for competitiveness (see Coughlin and Pollard, 1996). For this reason and to compare our results to Jorion (1990), we also calculate exposures using the MERMindex. The MERMis comprised of 15 currencies representing the major U.S. trading partners.

forms of equation 1, these being: (1) the

The Exposure of US Multinational Corporations
Exchange rate exposure of sample firms is measured using two different

X-131 exchange rate index using the VWR market portfolio control and (2) the MERMexchange rate index using the EWR market portfolio control.5 This allows us to examine the results obtained using the most common marketportfolio control (VWR) and an index that includes all of the US trading partners (X131) with results obtained using the market portfolio control recommended by Bodnar and Wong (2000) and an index used in prior studies. Table 2 summarizes the cross-sectional distribution of the 220 US multinationals' estimated exchange rate exposure coefficients, y, as defined in equation 1 for the full sample and separately for firms with positive and negative exposures. Panel A presents the exposure estimates using the X-131 index and the VWRmarket portfolio control and Panel B presents the exposures using the MERMindex and EWRmarket portfolio control. Note that 39 percent of sample firms in Panel A exhibit negative exposure as compared to 71 percent in Panel B. Furthermore,the range of exposures is higher in Panel A than Panel B (7.42 versus 4.42). For the full sample in Panel A, the mean coefficient is 0.42 indicating that on average, sample firms benefit from a strengthening dollar. In comparison, the mean exposure in Panel B is -0.27 indicating that on average, sample firms experience negative stock price reactions to dollar appreciations. These results are consistent with Bodnar and Wong (2000)'s findings that the VWR market control causes a positive distribution shift in exposure estimates whereas the EWR market control does not cause this bias. Furthermore,Panel B results are more consistent with expectations of MNC exposures because these








(N = 220) -2.62 -0.45 0.36 1.17 4.80 0.42 7.42 220 11 33 49 (100%) (5%) (15%) (22%)

A: Results Using the X-131 Index VWRControl
Exp. (N = 134) 0.04 0.44 0.96 1.48 4.80 1.12 4.76 134 6 18 28 (61%) (4%) (13%) (21%) Exp. (N = 86) -2.62 -0.94 -0.60 -0.27 -0.01 -0.67 2.62 86 5 15 21 (39%) (6%) (17%) (24%)


Full Sample Firms Positively
y Distribution Characteristics ? Minimum First quartile Median Third quartile Maximum Mean Range Number of firms (% of total sample firms) Firms (%) exposed at 1% level Firms (%) exposed at 5% level Firms (%) exposed at 10% level Firms (%) exposed at 10% level that use a financial hedge

Firms Negatively Full Sampl
(N = 220) -2.51 -0.67 -0.31 0.08 1.90 -0.27 4.42

220 (100%) 12 (5%) 24(11%) 42 (19%) 33 (15%)

39 (18%)

20 (15%)

19 (22%)

The table summarizesthe distribution of exposure coefficients y,, that result from estimating equati

00, o


firms generally experience cash flow increases when the dollar depreciates. As shown in Panel A, the stock returns of 15 (22) percent of MNCs are significantly exposed to the value of the dollar as measured by the X-131 index at the 5 (10) percent level using the full sample. Panel B exposures using the MERM index are comparable, yet have slightly weaker significance levels. Relative to other studies (see Jorion, 1990, among others), we find slightly more significant exposure coefficients using either index. This may be due to the fact that our sample is restricted to large multinational firms, a sample that is expected to be more exposed to exchange rate risk. When separating firms by positive and negative exposures, slightly more negatively exposed firms have significant exposures when compared to positively exposed firms. Also, note that exposure is significant both for firms that use and do not use financial hedges. This finding indicates that the exchange risk faced by the firm is not fully eliminated by financial hedging. Table 3 contains a comparison of mean values for descriptive variables between net firms with positive exposure coefficients and firms with negative exposure coefficients. As before, Panel A separates by exposures obtained using the X-131 index and VWR control and Panel B separates by exposures obtained using the MERM index and EWR control. As shown in both panels, the difference of means t-statistics are significant among the two groups for variables measuring breadth and depth of the MNC network, foreign sales and risk. More specifically, negatively exposed firms have more foreign country operations (greater breadth), lower country concentration (lower depth), higher levels of foreign sales, and lower levels of total risk. Note 802

that in Panel A, firms with positive exposure coefficients have higher absolute exchange rate exposure than firms with negative exposure coefficients whereas in Panel B, the opposite is found. This can be explained by the evidence presented in Table 2, where the ranges are larger and more positively skewed when using the X-131 index with the VWR market control. We consider these factors when structuring our regressions for the determinants of exchange rate exposure presented in the next section. Furthermore, based on Bodnar and Wong (2000) and our findings in Tables 2 and 3, results using the MERM index with the EWR market control are the most reliable for measuring exchange rate exposure.

We investigate the empirical determinants of currency exposure by estimating a cross-sectional regression that has the absolute value of the estimated exposure coefficients from equation (1) as the dependent variable: lyil = So + 51BREADTH, + 82HEDGEi+ 63SIZEi + 84FSALESi+ 85RISK,
+ 86NSEGM, + ei


where ]yil for each stock is the absolute value of the exposure coefficient estimated in the previous regression; BREADTHi is the natural logarithm of the number of foreign countries the MNC operates in (high BREADTH indicates a firm with high network breadth); HEDGEi is an indicator variable for financial hedges and takes the value of "0"





Panel B

Variable Exposure coefficient,IjYl BREADTH DEPTH HEDGE FSALES SIZE

Full Sample
(n = 220) 0.944 2.003 0.492 1.068 0.262 7.959

Firms Positively Exp.
(n = 134) 1.122 1.805 0.546 0.978 0.218 7.703

Firms Negatively Exp.
(n = 86) 0.668 2.312 0.408 1.209 0.331 8.358

Difference in Means
t-stat 4.82*** -3.48*** 3.21 * * * -2.37** -4.42*** -3.64***

Full Sample
(n = 220) 0.528 2.003 0.492 1.068 0.262 7.959


0.546 2.477

0.589 2.366

0.478 2.651

3.31*** 1.26

0.546 2.477

This table compares the mean of descriptive variables for sample multinational firms and reports the between the samples consisting of firms with positive and negative exposures. Significance levels a



if the firm does not have a foreign financial subsidiary and does not use currency derivatives, takes the value of "1" if the firm either has financial subsidiaries or uses currency derivatives, and takes the value of "2"if the firm has both attributes (i.e. has financial subsidiaries and uses currency derivatives);6SIZEiis measured by the natural logarithm of the firm's end of year 1991 total assets (in millions of dollars); FSALESi is the foreign sales ratio for firm i (calculated as total foreign sales/total sales) for 1991; RISKiis the logarithm of the high-to-low
stock price for the year 19917; and si is

placing the BREATH variable with a variable DEPTHthat captures the degree of concentration of the foreign subsidiary network of each MNC.8 This relationship is analyzed in equation (2b) below.
1,il = o8 + 61DEPTHi + 82HEDGEi + 83SIZEi + 64FSALES, + 85RISKi + 86NSEGMi
+ ei


an errorterm. Since, as discussed earlier, firms are both negatively and positively exposed to currency risk, we use the absolute value of the estimated exposure coefficient to measure the effectiveness of operational and financial hedges in reducing the firm's absolute currency exposure. It is important to note that analyzing the absolute value of the exchange rate exposure can obscure the predictions of certain variables such as foreign sales and does not detect the separate influences of the MNC network on positive and negative exposures. For these reasons, we also investigate the positive and negative exposures separately in equations 3a and 3b (discussed later). We estimate equation 2a (and 2b discussed next) via weighted least squares (WLS)and report robust standard errors (White, 1980). The weighting factor in WLS is the reciprocal of the squared standarderrorof the exposure coefficient from estimating equation (1). The WLS procedure uses exposure estimates efficiently by employing the weighting factor to give more weight to exposure coefficients that are estimated more precisely (Greene, 2000). We also explore the effects of the other dimension of the MNC network by re804

DEPTH is measured as the ratio of the number of foreign subsidiaries in the two countries where the MNC has the majority of its operations (measured by subsidiaries) divided by the total number of foreign subsidiaries. Although the two MNC network structure measures do not fully capture the materiality of a firm's investment in a particular country, they are still quite useful for the purpose of our analysis. As was shown in Allen and Pantzalis (1996), the MNC network's operating and flexibility increases with "Breadth" decreases in "Depth".These two characteristics of the MNC network measure two different dimensions of the degree of multinationality. 9 The results of our analysis for regressions (2a) and (2b) are presented in Table 4. Table 4 presents results using y i from equation (1) with the X-131 exchange rate index and a value-weighted market portfolio (Panel A), as well as with the MERM exchange rate index and an equally-weightedmarket portfolio (Panel B). The results are quite similar in both cases. As shown, MNCsthat have greater BREADTHare less exposed to currency risk. This finding supports our hypothesis that MNCs with broad (spread-out)

C3 Z3


O 31g^~~ i?C

0.2872 -0.1381***

Panel B: R


Model (2a t-value

Intercept BREADTH

1.18 -2.61


0.4524*** -0.0698**


0.0729 0.8935***
0.0043 0.8777*** -0.0092 0.1803

1.02 4.41
0.16 3.69 -0.43

0.4730*** 0.0518 0.8475***
0.0031 0.8873*** -0.0106 0.1816

2.73 0.75 4.30
0.11 3.79 -0.49

0.0774** 0.3812***
-0.0068 0.2232* -0.0170 0.0818





This table reports estimates of the determinants of exchange rate exposure for 220 sample firms. Cr using models (2a) and (2b). Weighted least squares regressions with robust standard errors (White, 1 dasticity. Significance levels are indicated as follows: ***1%, **5%, *10%.

c cJIl


operational networks have the ability to devise operational hedges that effectively lower exposure to exchange rate risk. Furthermore, MNCs with greater DEPTH are found to be more exposed to foreign exchange risk. Thus, these results highlight the importance of the MNC network structure in enabling the MNC to devise operational hedges. The coefficient of the financial hedges variable (HEDGE) was found to have a significant (positive) effect on foreign exchange exposure in Panel B. This should not be interpreted as an ineffectiveness of financial hedges, since we do not account for the percentage of inherent exposure from operations the firm's currency hedging attempts to offset or the relative size of the financial subsidiaries. Unfortunately, such detailed information on hedging practices are not available. Our interpretation of these findings is not that financial hedges increase exposure, but instead firms that are more highly exposed to exchange rate risk may choose to use currency derivatives to mitigate this risk. We find that firms with higher levels of foreign involvement (FSALES) are positively and significantly more exposed to currency movements (consistent with Jorion, 1990; Bodnar and Wong, 2000 among others). The SIZE coefficient is positive, but not significant. As hypothesized, MNCs with greater stock price volatility, RISK, are also more exposed to foreign exchange risk. This finding is consistent with the notion that foreign exchange exposure is a significant part of total firm risk. The results of the control variables are generally consistent for both (2a) and (2b), as well as for both Panels A and B. As previously discussed, the proportion of the MNCs included in the sample that have negative exposure coefficients 806

varies from 40% to 71% depending on whether the X-131 or the MERM exchange rate index, as well as on whether the VWR or EWR control is used in equation 1. The large proportion of negatively exposed firms in the sample makes it imperative to examine whether the independent variables included in models (2a) and (2b) display similar effects on both the negative and the positive exposure coefficients, y1.lo Following He and Ng (1998), we test for this by introducing dummy variables and their interactions with the independent variables in the regression equations (3a) and (3b):


+ 84DxSIZEi + 65DXRISKi
+ 86DXNSEGMi + 8od(1-D)

+ 81d(1-D)XBREADTHi
+ 81d(1-D)XBREADTH, + 82d(l-D)X


+ 83d(1-D)XFSALES,
+ 84d(1-D) SIZE,

+ 64d(1-D)X SIZE,

+ 85d(1-D)XRISKi
+ 86d(l-D)XNSEGMi

+ es


Equation (3b) is identical to (3a) except BREADTH is substituted for DEPTH in (3a). The models (3a) and (3b) contain interactions of the independent variables from models (2a) and (2b) with a dummy variable (D) which indicates whether the firm displays positive (D=1) or negative foreign exchange exposure (D=0), as


well as with the (1-D) term. The inclusion of the interactions of each variable with both D and (1-D) in the regressions, enables us to separately analyze the effect of each variable on a firm's' exchange rate exposure between cases where y i is positive (interactionvariable D) and cases where y i s negative (interaction variable (1-D)). For example, a positive explanatory coefficient for positive exposure y's indicates the explanatory variable is associated with higher positive exposure and a positive explanatory coefficient for negative exposure y's indicates the explanatory variable is associated with higher negative exposure. Table 5 presents regression results for models (3a) and (3b), where the explanatory variables' effects on positive and negative exchange rate exposures are examined separately. As before, Panels A and B presents results using the two methods. The coefficients of all variables are generally consistent with the results of the previous models (2a and 2b, in Table 4). The coefficients on BREADTH and DEPTH have the expected signs. Most importantly, the network variables significantly impact the exposures of both positively and negatively exposed firms in all four regressions, with the exception of the positively exposed firms for model (3a) of Panel A. This implies that the ability to construct operational hedges significantly affects firm exposure to foreign exchange risk, regardless of the sign of the firm's overall exposure. A firm that is spread out over many countries (i.e. high breadth) is able to reduce its exposure, because it is in a better position to structure its operations so that exposures in different currencies cancel each other out. On the other hand, MNCs with foreign operations concentrated in few geoVOL. 32, No. 4, FOURTH 2001 QUARTER,

graphic areas (i.e. high depth) are more exposed. The coefficients of RISKare significant in both cases in Panel A, while this effect is significant only for MNCs with positive exposures in Panel B. Negatively exposed firms with high foreign sales ratios are significantly associated with higher exposures. This is consistent with other studies (see, for example, Bodnar and Wong, 2000). The coefficients of the remaining control variables are generally insignificant with the exception of SIZEin model (3a) of Panel B, where firm size is found to be positively related to exposure for positively exposed firms. Overall, the results from Table 5 indicate that the impact of the firms' ability to construct operational hedges effectively reduces exposure to currencyrisk both for firms with positive exposures and those with negative exposures.

This research expands on previous studies of exchange rate exposure and presents the first empirical evidence on the influences of operational hedges for the management of exchange rate risk. Strong evidence is found in support of our hypotheses. We find that the firm's ability to construct operational hedges, measured by variables describing the MNC network of operations (such as the breadth and depth of the MNC network) impacts the firm's exchange rate risk exposure. MNCs with greater breadth are less exposed to currency risk whereas firms with more highly concentrated networks (greaterdepth) are more exposed. The ability to construct operational hedges leads to lower exposures for the pooled group of MNCs, as well as for firms with positive exposure coefficients and firms with negative exposure coefficients. Our results hold after controlling 807




Panel A: Results Using the X-131 Index with the VWRControl Model (3a) Variable

Panel B:

Model (3b) Coefficient

Model (3 Coefficient




-0.1112 -0.0241 0.3166

-1.57 -0.30 0.63

-0.1135** 0.3784* -0.0220 0.2538

1.73 -0.27 0.53

0.0705 -0.0569

BREADTH X (1 - D) DEPTH x (1 - D) FSALES x (1 - D) SIZE X (1 - D) RISK x (1 -D) NSEGMX (1 - D) R2

1.0931*** -0.0007 0.0609

3.43 -0.02 0.17

1.1474*** -0.0002 -0.4605

3.60 -0.01 -1.11

0.7412*** 0.0112 0.6865***

HEDGEx (1 - D)

1.0052*** 0.0177 0.8806***

3.88 0.47 2.75

0.9448*** 0.0172 0.8635***

3.57 0.44 2.71

0.3481** -0.0210 0.1195


-0.27 48.74


-0.36 43.82





This table reportsdeterminantsof exchange rate exposure using models (3a) and (3b) for 220 sample f on positive and negative exchange rate exposures are examined separatelyusing the methodology of H the interactionsof each variablewith a dummy variableD, where D = 1 representspositive exposure a Cross-sectionalregressions with robust standard errors (White, 1980) are performed using weighted
indicated as follows: ***1%, **5%, *10%.

A. LAUX CHRISTOS PAUL BETTY J. SIMKINS, PANTZALIS, for commonly used determinants of foreign exchange exposure such as the presence of financial hedges, the degree of foreign involvement, the size of the firm, the degree of the firm's industrial diversification and firm risk. NOTES 1. The value of operating flexibility is, in essence, the rent from ownership and operation of a global network of operations. Mello, Parsons and Triantis (1995) show that while financial hedging may be utilized to reduce the variance of the firm's cash flows, only the real operating flexibility option can increase expected cash flows by enabling the MNCto move outward to a new production possibilities frontier. 2. An MNC typically will possess a network that spans several geographic areas. The degree of segmentation of the geographic markets is importantbecause the more segmented the different markets spanned by an MNC's network, the lower the correlation of prices for inputs and outputs in the different markets. In addition, a lower correlation between in inputs/output prices due to exchange rate movements increases the probability that an MNC can reap advantages from changes in operating policies, such as shifting production or input sourcing. 3. Notional principal is an amount used as a base for computations in derivatives contracts, but not an amount that is actually transferredfrom one party to another;hence, the term notional principal is used. The notional principal is a commonly reported amount in the derivatives industry as an indicator for the overall level of market usage but is considered as a weak measure for usage by individual firms. 4. A firm with positive (negative) exposure coefficient is a firm with positive
VOL. 32, No. 4, FOURTH QUARTER, 2001

(negative) residual exposure elasticity yi. In other words, this means a firm whose total exposure elasticity is greater (less) than the market's exposure elasticity adjusted by the firm's marketbeta (see Bodnar and Wong, 2000). The sign of the firm's total exposure elasticity depends on the magnitude of the foreign currency revenues relative to its foreign currency denominated costs and their respective sensitivities to the exchange rate. 5. We also computed the exposure coefficient using the remaining alternative combinations of exchange rate index and market portfolio. The results obtained are quantitatively similar to all results presented in this paper (i.e. Tables 2 through 5 analysis). 6. Including financial subsidiaries in the HEDGE variable proxy for the MNC's ability to manage its foreign exchange exposure by devising financial strategies to complement their operational hedges. This variable may indicate the MNC's ability to engage into "naturalhedging", i.e. matching inflows and outflows of foreign currencies as is done in the case of a reinvoicing center, which is quite common in many MNCs. 7. Garmanand Klass (1980) show that this estimator has higher relative efficiency ratings than other standard estimators in their study on security price volatility. Other studies that have used this volatility estimator (see Chauvin and Hirschey, 1993, among others). This proxy combines the advantages of being very easy to compute and its proven efficiency. In addition, this volatility measure captures total risk which is appropriate for our study. 8. Due to the high correlation of -0.743 between BREADTH and DEPTH, it is necessary to analyze their effects in separate regressions to minimize problems with multicollinearity.


9. As noted in Allen and Pantzalis (1996), the MNC network spans various product markets with both domestic and international links. A flexible network is one that includes the optimum amount of links, so as to enable adjustments to absorb external shocks and exploit opportunities to a maximum net of costs. In addition, the MNC's flexibility is a function of the nature of the links (market versus technological links) and the distribution of the links across the different countries in the MNC network. In that sense, our Breadth and Depth measures capture different dimensions of the firm's degree of multinationality. A large value for Breadth indicates that the MNC network provides a large number of links between product markets located in different countries. On the other hand, a large value for Depth indicates that a large proportion of the links is concentrated within the two top countries of the MNC network. 10. As a robustness check for the specification of our models, we added an aggregate exports sales variable in the regression models. The resulting sample sizes were considerably smaller, since export sales are not reported by all firms included in our sample. However, the results obtained were qualitatively similar to the ones presented here in Tables 4 and 5.

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