An investigation into the effects of the use of financial and operational hedges on Australian corporate foreign currency risk exposure

The purpose of this thesis is to investigate the effects of the use of financial and operational hedging on foreign exchange rate exposure among Australian multinational corporations. Since the flotation of the Australian dollar at the end of 1983, Australian firms have become increasingly exposed to foreign exchange rate risk. To eliminate this risk, Australian firms have undertaken substantial corporate hedging programs, which are both financial and operational in nature. It is notable that there has been an increase in financial hedging techniques such as derivatives and foreign-currency denominated debt, and operational hedging such as diversifying and spreading subsidiaries across foreign countries. Despite the substantial involvement in corporate hedging strategies, there is a paucity of Australian research studies examining the relationship between the use of financial and operational hedging by firms and their levels of foreign exchange rate exposure. A two-stage market model was used to investigate the main research problem using a sample of 62 Australian multinational corporations. The first-stage model - Jorion’s (1991) model – was adopted, to test the first hypothesis of whether there exists a relationship between stock returns and changes in exchange rates, by estimating the exposure coefficients to foreign currency risk during the period from January 2000 to December 2004. Next, the second-stage model utilised cross-sectional regression models to examine the effects of the use of financial hedging, separately and/or in combination with, operational hedging on foreign exchange risk exposure. This second-stage model was estimated for the 2004 financial year data to test seven hypotheses. These seven hypotheses were related to whether the use of financial separately, or in combination with, operational hedging effectively reduced exposure. Therefore, eight main research hypotheses were tested in the study. Findings of the study were that there is only weak evidence to support the hypothesis that stock returns were sensitive to changes in value of the Australian dollar. It was found that the use of foreign currency derivatives was significantly related to exposure reduction. The use of foreign debt was also found to be significantly related to exposure reduction, indicating that foreign debt is used for hedging purposes. Furthermore, the combined use of these two financial hedging strategies was found to be significantly associated with the exposure reduction. By the same token, these two financial hedging strategies were found to be substitutive to each other in reducing exposure. Operational hedging proxies were also significantly associated with the exposure reduction. This latter finding indicates that, for the purposes of hedging, firms diversify and disperse foreign operations and subsidiaries across countries and geographical regions. In addition, the combined use of financial and operational hedging was found to be negatively associated with exposure. Finally, the use of financial hedging was found to complement operational hedging in reducing exposure. The models used in this study could be applied to further research into the relationship between the use of financial and operational hedging and exposure. This could be achieved by using different time spans, different markets (countries) data, and larger samples, together with other measures. As Australian firms are greatly exposed to foreign exchange rate risk and consequently are heavily involved with financial and operational hedging activities, the results of this study could be beneficial to corporate managers, individual and corporate investors, researchers, derivatives designers and regulators.