RDP 2006-09: Limiting Foreign Exchange Exposure through Hedging: The Australian Experience 1. Introduction

Exchange rate variations over time are a potential source of risk to cross-border financial obligations and trade-related transactions. Concern about the potentially disruptive financial and real consequences of such variations are reflected in the policy of some countries to explicitly limit the nominal variability of their currency vis-à-vis that of others. While this ‘fear of floating’ is the result of a complicated array of competing considerations, it nonetheless illustrates that limiting exchange rate variability ranks well ahead of other policy objectives in some countries.^[1]

Since the Australian dollar was floated in December 1983, the economy has proven to be resilient to substantial exchange rate fluctuations. Arguably, this resilience has strengthened over time, as firms have learned to adapt to exchange rate variability, including through the development of the hedging practices of financial institutions and non-financial firms.

This paper examines foreign exchange hedging of direct balance sheet and transaction exposures and assesses their broader implications for the Australian economy. We draw on the quantitative results of Australian Bureau of Statistics (ABS) surveys in 2001 and 2005.^[2] These surveys provide comprehensive data on foreign currency exposures and hedging practices and indicate that both financial and non-financial firms use derivatives markets extensively to hedge their foreign exchange exposures back into Australian dollars.

A substantial body of literature deals with estimating the usual linkages between the exchange rate and the macroeconomy over time.^[3] However, here we focus on the more readily quantifiable and direct financial gains or losses due to exchange rate changes, often referred to as transaction and balance sheet exposures.^[4]

Transaction exposures typically arise for non-financial firms as a result of international trade. Since receipts and payments are often denominated in foreign currencies, the local currency value of these amounts varies with exchange rate movements. This type of exposure may pose an array of potential problems for firms. Take, for example, an exporter whose costs are largely denominated in local currency terms, but who sells output into world markets in foreign currencies. Exchange rate fluctuations directly affect revenue streams and profit margins as a result of lags between production and sales. Many firms in the Australian resources sector are in such a position. Importers face a similar transaction exposure, albeit for different reasons, since costs are typically denominated in foreign currency and revenues in Australian dollars.

For financial firms, balance sheet (or translation) exposure that arises from holding assets and liabilities denominated in foreign currencies is likely to be more important than transaction exposure. In addition to the financial sector, non-financial firms such as multinationals with offshore operations may acquire an exposure to valuation effects through the translation of foreign currency assets or liabilities held on their balance sheet into Australian dollar terms. A substantial portion of this paper is devoted to examining balance sheet exposures where much of the perceived vulnerabilities appear to lie.

The remainder of the paper is arranged as follows. Section 2 discusses methods and instruments used to hedge exchange rate risk. Section 3 tracks the evolution of hedging and risk management practices since the floating of the Australian dollar, and provides quantitative evidence on resident firms' current hedging practices. Section 4 provides a detailed examination of foreign currency exposure underlying the overall net foreign liability position. It discusses why often-cited vulnerabilities are overstated, and how hedging contributes to a transfer of wealth from the rest of the world to Australian residents in the event of an exchange rate depreciation. Appendix A provides a useful benchmark by doing a similar exercise for the United States. Finally, Section 5 offers some concluding remarks.

Footnotes

Hausmann, Panizza and Stein (2002) provide a detailed discussion of the fear of floating among emerging economies. [1]

See ABS (2002, 2005). [2]

Exchange rate pass-through in a broader Australian macroeconomic framework is addressed in a recent paper by Stone, Wheatley and Wilkinson (2005). [3]

A common way of estimating the total impact of exchange rate movements on firms is to model individual share prices using the exchange rate as an explanatory variable. However, these models generally perform poorly. A number of past studies have estimated the impact of exchange rates on share prices as a proxy for the degree of foreign exchange exposure. See, for example, Bartov, Bodnar and Kaul (1995), Allayannis and Ofek (2001), Dominguez and Tesar (2001), and Nguyen and Faff (2003). [4]