In this review, the article which is being analyzed is entitled “the use of foreign currency and firm market value.” The authors of the article are George Allayannis and James P. Weston published in the journal called “The Review of Financial Studies” Volume 14, issue number 1, and from pages 243-276. The appropriate reference of the article according to APA referencing style is Allayannis G. & Weston, J. P. (2001). “The use of foreign currency derivatives and firm market value.” The Review of Financial Studies, 14(1). pp. 243-276. In this article, the authors examine how firms use Foreign Currency Derivatives (FCDs) as a risk management strategy. A sample of 720 firms in the US was surveyed in the period from 1990 to 1995. The impact of FCDs on the value of firms was identified. Tobin’s Q was used to symbolize the value of a firm. A positive correlation was found to exist between the value of a firm and the application of FCDs (Allayannis & Weston, 2001).
The hedging premium was found to be significant in firms that were exposed to exchange rates. This premium was found to form 4.8% of the total value of a firm. It was hypothesized that the process of hedging causes an increase in the value of a firm (Allayannis & Weston, 2001). Hedging has been found to improve risk management strategies by investors. Managers predict future changes in cash flows and are able to put in place proper measures to avoid making losses. As such, the interest of stockholders is protected. On the other hand, hedging has been found to increase the costs of assets. In addition, it is not possible to predict with certainty about the future market condition (Bychuk & Haughey, 2011). Despite the drawbacks encountered in hedging, the value of a firm increases after applying FCDs.
Summary of the Article
The main theme in this research was to examine how Foreign Currency Derivatives (FCDs) are used in non-financial firms in a time period of 1990 to 1995. The hypothesis of the study was that firms that are exposed to FCDs are preferred by shareholders with a high market appraisal. This implies that the value of a firm is increased by using currency derivatives; particularly to firms that are exposed to risks in exchange rate deviations (Allayannis & Weston, 2001).
The use of Foreign Currency Derivatives (FCDs) increases the value of a firm. Modigliani and Miller are of the opinion that risk management is not relevant in an organization. They suggest that shareholders can reduce risks by purchasing diversified portfolios. Hedging has been described to be a strategy that firms are using to increase the value of their assets. There has been a controversy as to whether hedging affects the value of a firm. The authors conduct research to find the relationships between derivatives and the market value of a firm (Allayannis & Weston, 2001).
In the study, 720 firms were sampled for the study. Out of this sample, firms facing exchange rate risk by selling through foreign operations were selected. The study sought to identify whether other firms with the same exposure have different values. The hedging factor was not considered for this group of firms. The authors hypothesized that the use of FCDs in these firms might be accepted by investors with a high valuation. The other firms in the sample which do not operate foreign sales were also alleged to be affected by the movement of exchange rates through export processes and competition in the importation process (Allayannis & Weston, 2001).
The use of currency derivatives was applied in this research because the authors wanted to separately discuss common risk factors found in firms and to study how currency derivatives affect firms’ value. Most hedging theories have implied that the use of foreign exchange derivatives reduces the variability of the value of a firm. However, various empirical studies have identified numerous factors that affect decisions concerning the use of currencies, interest rates and/or commodities. Currency derivatives were used in this study because most firms use currency derivatives. Firms that use other types of derivatives likewise use currency derivatives (Allayannis & Weston, 2001).
It was observed that the study had a weakness in that, in the US, data concerning exports and imports was not available to firms. Therefore, there was uncertainty as to whether the movement in exchange rates had any impact on these firms. In a case where these firms could not be affected by the movement of exchange rates, then no value would be added by hedging. In addition, it was not reasonable to value firms that were not exposed to hedging policy at a discounted rate, as compared to the firms which adopted hedging exposure. Due to this reason, the analysis was done by separating samples of the firms which had foreign sales and those which did not have (Allayannis & Weston, 2001).
Firms which use foreign currencies were found to have means and medians which were higher than those which did not use foreign currencies. It was also established that firms which had exchange rate risks had a positive and significant relationship between the value of the firm and the usage of currency derivatives. Investors using hedges were found to have a higher value than those which did not use hedges (Allayannis & Weston, 2001).
The results of the analysis confirm that using currency derivatives improves the value of the firms that experience risks in exchange rate. Therefore, the use of FCD has been found to increase the value of a firm. However, there are other derivatives, for example interest rate and commodities, which can be used to increase the value of a firm (Allayannis & Weston, 2001).
Hedging is the process of reducing the risks associated with adverse movements in the prices of assets. Shareholders usually hedge by offsetting financial positions in similar securities. For example, offsetting stocks with future contracts when the current prices are not favorable. Investors encourage hedging to reduce the risk of market fluctuations. Market uncertainty causes investors to hedge. Hedging has been found to be a good risk management strategy where investors reduce risks to almost nothing. However, there are costs accompanied by the hedging process (Cusatis & Thomas, 2005).
According to Kolb and Overdahl (2006), exchange rates affect the profitability of a firm, its value and the net cash flows. Thus, the success of a firm can be measured in terms of the profits generated, cash flows and the market value. Currency-related aspects of a firm affect its activities more than any other variable, and may have destructive effects on the earnings that are reported by a firm. The market opinion of a company is determined by the cash flows, and any change in cash flows may adversely affect a company (Coyle, 2000).
Firms are exposed to foreign exchange changes through transactions, operations, translation or tax systems. Transaction exposure determines the value change of financial obligations experienced before changes in exchange rate occur. The obligations are not settled up to the time the exchange rates change. Operating exposure is a measure of the change in the present value of a firm as a result of changes in cash flows expected in the future. These exposures happen when changes in exchange rates are not expected. Translation exposures occur out of changes in the equity of owners, especially when there is need to change financial statements from foreign subsidiaries. Tax exposures occur due to changes in tax policies in different countries (Sercu, 2009).
Critique of the article
Risk management is an important aspect in any investment because it helps improve certainty in any investment. The use of hedging is important in the stock market because it provides confidence to investors. Fluctuations in currency are well catered for when hedging, and increases the value of stocks in the market. This is experienced when the firm experiences losses following the unexpected increase in interest rates for local currency securities. Hedging also complicates the operational processes in a firm (Bierman, 1999).
Investing in the international markets requires managing the risks which may affect the prices of stocks. With the increase in economic turbulence in the global scene, there is great need to come up with strategies of protecting investors’ money. This can only be achieved by hedging their funds. Firms are able to plan easily after reducing risks in their future cash flows. The chances of future cash flows falling below the necessary minimum level are reduced. Imperfections in the structural and institutional systems are eliminated after hedging out all investments (Bierman, 1999).
Hedging is important since it protects the assets of investors from losses. Firms with foreign operations are exposed to higher risks of currency fluctuations. This creates risks to investors and there is need to manage risk by creating a hedge. Foreign markets fluctuate because they are exposed to many conditions. Economic policies of various countries may affect the international market, and this exposes investors in the global markets. Domestic investors experienced less risks associated with currency fluctuations. Investing domestically reduces the risk of currency rate deviations because the domestic market is less affected by international rates (Sercu, 2009).
On the other hand, hedging has the disadvantage that investors who use hedges as a risk management tool do not gain from any value increase for the assets they hedge against. The hedging process has been criticized because managers hedge the assets of a firm for their own benefits at the expense of shareholders. In addition, the expected cash flows of a firm do not increase after managing currency risk. In most cases, resources are consumed while conducting currency risk management. The process of hedging is conducted by the management, but this creates a weakness in that shareholders have a better ability to diversify risks than the management. As such, stockholders can diversify their assets when managing risks, if they do not want to assume currency risks associated with a given firm (Koziol, 1990).
Outguessing the market by managers is not possible. There is zero expected net present value of hedging, when the market is in equilibrium regarding parity conditions. Managers use hedging when they want to escape from the accounting blame. Managers incur more costs when trying to avoid losses in exchange.
From the article, it is possible to conclude that hedging improves the continuity of a firm. A business that is able to monitor its cash flows is in a better position to monitor its performance in the global markets. In addition, managers are able to access better information in managing firms. Hedging encourages managers to keep track of the information in the global market. As such, better information is obtained to run the information.
The article has the strength that it has used a substantial number of respondents as the sample. This is indicated by the sample of 720 firms which were used as samples in the survey. In addition, the research was conducted in a period of five years, and this shows that market changes were well captured within that time. It is also notable that the research applied different methodologies to establish the relationship between the dependent and independent variables.
However, the research is weak in that it does not provide proper background to the application of hedge funds. The entire paper circulates around the importance of hedge funds in comparison to local stock assets. In addition, the time taken to conduct the research was too long. This should have complicated the survey process because most researches are shorter. Taking five years is a long period of time and it important to shorten the time so that the research can be economical.
The value of a firm increases after applying FCDs. The value of a firm is created when shareholders get a better risk management factor on their investments. The management has an obligation of ensuring that shareholders get fair returns. Hedging is important in that it protects the assets of investors from losses. Firms with foreign operations are exposed to higher risks of currency fluctuations. This creates risks to investors and there is need to manage risk by creating a hedge. Hedging may be disadvantageous especially when the opportunity costs are too high. Poor hedging strategies by management have caused huge losses to shareholders. This has caused shareholders in various firms to become suspicious about hedging. It is important that managers should involve shareholders in decision making process during the hedging process. This will reduce speculations of misuse of funds. In this journal article, there is need for more studies to establish the effect of currency deviations to non hedgers.
Allayannis, G. & Weston, J. P. (2001).The use of foreign currency derivatives and firm market value. The Review of Financial Studies, 14(1). pp. 243-276.
Bierman, H. (1999). Corporate financial strategy and decision making to increase shareholder value. New York: John Wiley and Sons.
Bychuk, O. V. & Haughey, B. (2011). Hedging Market Exposures: Identifying and Managing Market Risks. New Jersey: John Wiley and Sons.
Coyle, B. (2000). Hedging Currency Exposures: Currency Risk Management. London: Global Professional Publishing.
Cusatis, P. & Thomas, M. R. (2005).Hedging instruments and risk management. New York: McGraw-Hill Professional.
Kolb, R. W. & Overdahl, J. A. (2006).Understanding futures markets. Australia: Wiley-Blackwell.
Koziol, J. D. (1990). Hedging: principles, practices, and strategies for the financial markets. New Jersey: Wiley.
Sercu, P. (2009). International finance: theory into practice. New Jersey: Princeton University Press.