Managing Foreign Exchange Risk with Derivatives

This study investigates the foreign exchange risk management program of HDG Inc. (pseudonym), an industry leading manufacturer of durable equipment with sales in more than 50 countries. The analysis relies primarily on a three month field study in the treasury of HDG. Precise examination of factors affecting why and how the firm manages its foreign exchange exposure are explored through the use of internal firm documents, discussions with managers, and data on 3110 foreign-exchange derivative transactions over a three and a half year period. Results indicate that several commonly cited reasons for corporate hedging are probably not the primary motivation for why HDG undertakes a risk management program. Instead, informational asymmetries, facilitation of internal contracting, and competitive pricing concerns seem to motivate hedging. How HDG hedges depends on accounting treatment, derivative market liquidity, foreign exchange volatility, exposure volatility, technical factors, and recent hedging outcomes. * Department of Finance, Kenan-Flagler Business School, The University of North Carolina at Chapel Hill, CB 3490 – McColl Building, Chapel Hill, NC 27599-3490. Voice: (919) 962-9250, Fax: (919) 962-2068, Email: [email protected]. A more recent version of this document may be available from my web page: http://itr.bschool.unc.edu/faculty/browngr. I gratefully acknowledge the assistance of the treasury staff of HDG in providing data and for allocating time to this endeavor. This study also benefited from the advice and comments of John Graham, David Haushalter, Jay Hartzell, John Hund, Bernadette Minton, Daniel Rogers, Laura Starks, René Stulz, Klaus Toft, Jeremy Stein, and especially Peter Tufano. Furthermore, many improvements have been made due to the suggestions of seminar participants at the Harvard Business School– Journal of Financial Economics Conference on Complementary Research Methodologies, the University of Texas at Dallas, Duke University, the 2000 meetings of the American Finance Association, and the 1999 annual meetings of the Financial Management Association and the International Association of Financial Engineers. I also thank the Bank of America Faculty Development Fund for its financial support.