Managing Foreign Exchange Risk with Derivatives

Foreign Exchange Management Committee (FXMC) provides more control ….. In short, it seems unlikely that the program management of the exchange rate risk can be ….

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Contents:

  • 1 Introduction
  • 2 HDG and Risk Management Operations
    2.1 The Structure of Foreign Exchange Risk Management
    2.2 The Practice of Foreign Exchange Risk Management
  • 3 Motivations for Foreign Exchange Risk Management
    3.1 Hedging or Speculating?
    3.2 Traditional Motivations
    3.3 Earnings Smoothing
    3.4 Competitive Impacts
    3.5 Facilitation of Internal Contracting
  • 4 The Structure of Derivative Portfolios
    4.1 Characteristics of Hedge Portfolios
    4.2 Determinants of Hedging Strategies
  • 5 Financial Risk and Firm Value
    5.1 Risk Management and Stock Returns
    5.2 Unanswered Questions6 Conclusions

I estimate a set of fixed-effect panel regressions using the hedge portfolio deltas and gammas as the dependent variables. As explanatory variables, I use three types of factors:
1. Current foreign-exchange market factors

  • Exchange rate implied volatility, labeled FX Volatility, is used to capture the effect of price risk.
  • The difference between the 6-month forward exchange rate and the spot exchange rate in percent, labeled Forward Points (%), is a measure of the current forward point spread.

2. An underlying exposure factor

  • The absolute difference between the exposure forecast and the actual exposure, labeled Exposure Volatility, is used as a crude proxy for quantity risk.

3. Factors that proxy for market views and possible behavioral influences

  • The percentage difference between the current spot exchange rate and the highest (lowest) level of the spot exchange rate in the previous 12 months, labeled Spot % Below (Above) 12 Month High (Low), are used as proxies for market views since these technical variables are employed by HDG analysts to estimate market tops and bottoms.
  • The percentage change in the spot exchange rate over the previous 60 trading days, labeled 3 Month Change in Spot, is used to capture trend-following behavior.
  • The actual profit or loss on the hedge in the previous quarter (relative to the forecast horizon) as a percent of exposure, labeled Derivative P&L (t-1), is included to measure the impact of recent hedging results. This variable may capture the effect of regret from under-hedging or over-hedging in the most recent completed quarter.
Download Managing Foreign Exchange Risk with Derivatives pdf from public.kenan-flagler.unc.edu, 59 pages, -KB.
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