1. Resolving the Exposure Puzzle: The Many Facets of Exchange Rate Exposure FDIC October 27, 2006 Söhnke M. Bartram Lancaster University Gregory W. Brown University of North Carolina Bernadette A. Minton Ohio State University

2. 2Motivation FX risk is a major financial risk to nonfinancial firms “FX Exposure Puzzle” –Theoretical models predict exposure Bodnar, Dumas and Marston 2002; Marston 2001; Adler and Dumas 1984; Shapiro 1975 –Empirical studies find weak evidence Allayannis and Ihrig 2001; Dominguez and Tesar 2001a,b; Griffin and Stulz 2001; Williamson 2001

3. 3 How to Resolve the Puzzle? General idea/hypothesis of this paper –Firms do have potentially large FX risk –Pricing and financial policies reduce exposures Analysis –Use structural models to analyze different facets of FX exposure and hedging Gross (or pre-hedging) exposure Net (or post-hedging) exposure

4. 4 What We Do Motivating Example: Global Automotive Industry –Bodnar and Marston (2002) model –Detailed firm-level data Enhanced Bodnar, Dumas and Marston (BDM, 2002) model –Firm selling and producing in local and foreign market –Exposure is a function of: market share product substitutability, sales and cost in foreign currency –Use model to analyze a large sample of global manufacturing firms around the world

5. 5Contribution Resolving the Exposure Puzzle –Model predicts that firms should have large gross FX exposures –Firms reduce these exposures via three channels: Pass-through (10%-15%) Operational hedging (10%-15%) Financial hedging (45%-50%) –Residual FX exposures (as estimated in the prior literature) are economically and statistically small

6. 6 Automotive Industry Industry study to motivate main analysis –16 auto manufacturers from 6 countries –Mature and competitive industry –Important FX risk (Williamson 2001) –Bodnar and Marston (2002) h 1 : percent foreign sales h 2 : percent foreign cost r : profit margin

7. 7 Automotive Companies Volkswagen Foreign Sales0.52 Margin0.16 Gross Exposure (h 2 =0)3.29

8. 8 Automotive Companies Volkswagen Foreign Sales0.52 Margin0.16 Gross Exposure (h 2 =0)3.29 Foreign Production0.42 Model Exposure1.02

9. 9 Automotive Companies Volkswagen Foreign Sales0.52 Margin0.16 Gross Exposure (h 2 =0)3.29 Foreign Production0.42 Model Exposure1.02 FX-Derivatives0.46 Foreign Currency Debt0.18 Residual Exposure0.38

10. 10 Automotive Companies Volkswagen Foreign Sales0.52 Margin0.16 Gross Exposure (h 2 =0)3.29 Foreign Production0.42 Model Exposure1.02 FX-Derivatives0.46 Foreign Currency Debt0.18 Residual Exposure0.38 Actual Exposure0.16 p-value[0.270]

11. 11 Automotive Companies VolkswagenMean Foreign Sales0.520.55 Margin0.160.22 Gross Exposure (h 2 =0)3.292.70 Foreign Production0.420.38 Model Exposure1.021.26 FX-Derivatives0.460.41 Foreign Currency Debt0.180.09 Residual Exposure0.380.76 Actual Exposure0.160.18 p-value[0.270][0.291]

12. 12 BDM Model FX exposure of exporter Exposure depends on –Product market competition => pass-through  : degree of product substitutability  : market share of exporting firm in foreign market –Operational Hedging  : fraction of marginal cost due to foreign currency-based inputs

13. 13 Enhanced BDM Model Two extensions of BDM model –Both firms can have cost in local and foreign currency –Firm sells globally Global firm is sales-weighted average of foreign and domestic operations (  is percent of foreign sales). Model is more broadly applicable –Captures global firms in global markets –Allows for broader set of exposures and pass-through –BDM model is a special case of enhanced model

14. 14 Enhanced BDM Model Foreign Exchange Rate Exposure Foreign Exchange Rate Pass-Through

15. 15Parameters DescriptionEmpirical Counterpart  Percent foreign sales  Percent domestic sales1-Percent foreign sales Exporting firm γ f1 Firm’s fraction of marginal costs in foreign currency Percentage of foreign assets of firm  f2 Import competing firms’ fraction of marginal costs in the foreign market, also foreign currency costs of other exporting firms Weighted average of the percentage of domestic assets of foreign firms and percentage of foreign assets of other domestic firms f Market share of firm in foreign markets Rest-of-world GDP-weighted average of import penetration ratio

16. 16Parameters DescriptionEmpirical Counterpart Import-competing firm γ d1 Exporters’ fraction of marginal costs in the domestic market, also domestic currency costs of other domestic, import-competing firms Weighted average of the percentage of foreign assets of foreign firms and percentage of domestic assets of other domestic firms  d2 (=1- γ f1 ) Firm’s fraction of marginal costs in the domestic currency 1-Percentage of foreign assets of firm d Market share of import competing firm in domestic market 1-Domestic market import penetration ratio  f,  d Degree of product substitutability in the foreign (f) and domestic (d) markets Specified exogenously

17. 17 BDM vs. Enhanced BDM

18. 18 Automakers Again…

19. 19 Sample and Data 1,161 manufacturing firms from 16 countries Accounting data (USD) (Thomson) Market data (LC) (Datastream) Import penetration (UNIDO, SSIS) Herfindahl indices to measure industry competition (complete Worldscope universe) Collect data from annual reports for FX derivatives and foreign currency debt

20. 20 Sample Statistics MeanStdev25 th Perc.75 th Perc. Actual FX Exposure0.0711.945-0.8061.058 Foreign Sales34.5%27.2%11.6%53.5% Foreign Assets19.1%21.7%2.2%27.7% Foreign Debt Dummy0.871 FX Derivatives Dummy0.659 Import Penetration24.1%17.3%11.9%32.8%

21. 21 Model Exposures & Pass-Through MeanStdev Model Exposure  f =  d =0.5 0.4280.296  f =  d =0.7 0.4770.316  f =  d =0.9 0.5490.355

22. 22 Model Exposures & Pass-Through MeanStdev Model Exposure  f =  d =0.5 0.4280.296  f =  d =0.7 0.4770.316  f =  d =0.9 0.5490.355 Model Pass-Through  f =  d =0.5 -0.0880.215  f =  d =0.7 -0.0610.218  f =  d =0.9 -0.0350.223

23. 23 Level of Model Exposure HighLowp-value Actual FX Exposure0.128-0.091 0.033

24. 24 Level of Model Exposure HighLowp-value Actual FX Exposure0.128-0.091 0.033 Foreign Debt0.9780.764<0.001 FX Derivatives0.7990.519<0.001

25. 25 Level of Model Exposure HighLowp-value Actual FX Exposure0.128-0.091 0.033 Foreign Debt0.9780.764<0.001 FX Derivatives0.7990.519<0.001 Import Penetration0.2890.193<0.001 Foreign Import Penetration0.2950.293 0.474 Industry Herfindahl0.1520.140 0.151 Country-Industry Herfindahl0.4780.355<0.001

26. 26 Level of Model Exposure HighLowp-value Actual FX Exposure0.128-0.091 0.033 Foreign Debt0.9780.764<0.001 FX Derivatives0.7990.519<0.001 Import Penetration0.2890.193<0.001 Foreign Import Penetration0.2950.293 0.474 Industry Herfindahl0.1520.140 0.151 Country-Industry Herfindahl0.4780.355<0.001 Model Pass-through-0.2110.088<0.001

27. 27 Hedging Effects (1) Intercept-0.37*** FC Debt FX-Derivatives

28. 28 Hedging Effects (1)(2) Intercept-0.37*** -0.10 FC Debt-0.31*** FX-Derivatives

29. 29 Hedging Effects (1)(2)(3) Intercept-0.37*** -0.10-0.30*** FC Debt-0.31*** FX-Derivatives -0.10

30. 30 Hedging Effects (1)(2)(3)(4) Intercept-0.37*** -0.10-0.30*** -0.10 FC Debt-0.31***-0.30*** FX-Derivatives -0.10 -0.01

31. 31 Hedging Effects Coef.p-value Intercept-0.15[0.156] FC Debt only-0.22[0.086] FX Derivatives only0.42[0.156] Both-0.27[0.019]

32. 32 Importance of Hedging Channels Gross FX exposure = 0.674 –no market share, no foreign assets, no financial hedging –values at sample means,  f =  d =0.7 Firms reduce FX exposure via 3 channels (1) Pass-through (10%-16%) - Market shares at sample average (2) Operational hedging (9%-16%) - Foreign assets at sample average (3) Financial hedging (46% - 50%) - FC Debt (45%) - FX Derivatives (1%) Consistent with Guay and Kothari (2003), derivatives have limited impact on risk profile of the firm

33. 33 Industry Portfolios

34. 34Summary Comprehensive analysis of FX exposure Resolving the “Exposure Puzzle” –Firms have large gross FX exposures –Firms reduce these exposures via pass-through, operating and financial hedging –Residual FX exposures are economically and statistically small –FX risk management is effective, and companies can stop whining about FX risk