Derivatives Use In The Partial Hedging Of Currency Risk: A Firm-Specific Approach To Understanding The Exchange Rate Exposure Puzzle

Abstract

This study investigates whether firms with significant foreign exchange rate exposure change their future use of foreign exchange rate derivatives (FXDs) INTRODUCTIONhe use of derivatives has come under increased scrutiny by lawmakers, regulators, practitioners, and academics. In the U.S., "many in Congress blame such instruments for exacerbating the financial crisis," and Treasury officials are exploring regulation "to prevent another financial meltdown caused by hidden exposure to derivatives risk" (Scannell, 2009, page B1). At the practitioner level, the use of foreign exchange rate derivatives (FXDs) is being reassessed by firms attempting to effectively manage the dramatic increase in currency risk accompanying the financial crisis (Kirschner et al., 2009). Motivated by such increased scrutiny, academics are investigating the role of derivatives in understanding the surprising lack of empirical evidence of significant returns-based estimates of exchange rate exposure; aka, the "exchange rate exposure puzzle" (e.g. Bartram and Bodnar, 2007).This study employs a firm-specific approach to refining the analysis of exchange rate exposure, and investigates whether firms with significant exposure (if any) modify their future use of FXDs. To the extent firms monitor the effectiveness of their hedging strategy, we expect firms with significant returns-based estimates of foreign exchange rate exposure will change their future derivatives use accordingly. We shed light on the exchange rate exposure puzzle by taking advantage of firm-specific accounting data on currency risk and hedging strategy, and by examining changes in firms' FXDs use in relation to their past efforts to effectively hedge exchange rate exposure. Such firm-specific data allows us to identify the bilateral exchange rate to which the firm is most exposed, and whether the firm uses a partial hedging strategy; that is, whether it chooses to hedge less than 100 percent of its exposure to changing exchange rates.Employing this refined approach, we find significant returns-based estimates of exchange rate exposure for firms with high FXDs use relative to foreign sales. Of these firms, however, only partial hedgers modify their future T