Hedging-Foreign-Exchange-Exposure

Journal of International Financial Management and Accounting 15:1 2004

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

e-mail: bpg@fek.su.se

Abstract

Using a sample of Swedish firms we investigate the risk reducing effect of foreign exchange

exposure hedging. Further, we investigate risk reduction from using different hedging

instruments, and particular interest is directed towards the impact of transaction exposure

hedges and translation exposure hedges respectively. We find that firms’ foreign exchange

exposure is increasing with the level of inherent exposure, measured as the difference

between revenues and costs denominated in foreign currency, and that it is decreasing with

firm size. We find a significant reduction in foreign exchange exposure from the use of

financial hedges. The evidence suggests that the usage of foreign denominated debt as well as

currency derivatives reduce firms’ foreign exchange exposure. Further, we find that

transaction exposure hedges significantly reduce exposure, and that translation exposure

hedges also reduce exposure. A possible explanation for the latter is that translation

exposure approximates the exposed value of future cash flows from operations in foreign

subsidiaries (i.e. economic exposure). If so, by hedging translation exposure, economic

exposure is reduced.

1. Introduction

The purpose of this paper is to investigate the relationship between foreign

exchange (FX) exposure and hedging activity using financial instruments.

Our study is motivated by the possibility that exposure management may

be costly, but yet ineffective in reducing total risk. Copeland and Joshi

(1996) argued that 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...