Ebook The Term Structure of Currency Hedge Ratios
There is evidence that hedging strategies of non-financial firms strongly depend on the hedge horizon. One indication is survey results by Bodnar et al. (1996, 1998), who show that the percentage of firms using foreign currency derivatives decreases with the time to maturity of the contracts. Of all firms using derivatives, 82% hold at least some contracts with maturities less than 90 days, whereas only 12% hold any contracts with maturities greater than three years. In this sense, we can speak of a decreasing term structure of hedging activity that might well translate into a corresponding term structure of hedge ratios.
One can imagine different reasons why financial hedging activity declines with the hedge horizon. One important aspect is that operational hedges can be used instead of financial hedges to manage long-term exposure, as suggested by Brealey and Kaplanis (1995) and Chowdhry and Howe (1999). In addition, long-term exposure might be hedged using dynamic strategies that employ short-term financial contracts. For example, Brennan and Crew (1997), Neuberger (1999), and Bühler et al. (2004) analyze different model-based strategies to hedge long-term commodity price exposure with short-term futures contracts.
We must also consider that the uncertainty of a firm’s cash flows is likely to increase with the time horizon. For example, an exporting firm’s revenues in foreign currency are probably better known for the next year than for the next five years. The theoretical literature on corporate risk management has shown that such revenue risk can cause underhedging of exchange rate risk, which could explain a downward sloping term structure of currency hedge ratios. For example, Benninga et al. (1985) and Adam-Müller (1997) analyze hedging strategies with forward contracts. They show that if revenues and exchange rates are uncorrelated and forward markets are unbiased, underhedging occurs for utility functions with positive prudence.
A further explanation for underhedging of exchange rate risk at longer hedge horizons lies in certain imperfections in derivatives contracts, which become more relevant when the hedge horizon increases. One example are different forms of basis risk, as analyzed by Briys et al. (1993) and Adam-Müller (2006). Another example is provided by increasing liquidity needs of long-term hedging strategies with futures contracts, as analyzed by Zhou (1998), Mello and Parsons (2000), and Deep (2002). Finally, Cummins and Mahul (2003) demonstrate that a possible default of OTC derivatives can lead to underhedging. Since default risk usually increases with the time to maturity, the extent of underhedging should increase with the hedge horizon.
In this paper, we look at still another aspect of the interplay between different sources of risk, the potential “natural hedging” of exchange rate risk by offsetting changes in a firm’s revenues and costs. In the extreme case, if revenues move in parallel with the general price level, and prices and exchange rates always follow the predictions of Purchasing Power Parity (PPP) theory, there will be a perfect natural hedge and the firm faces no exchange rate risk in real terms. However, this extreme case is surely not realistic, since a large body of literature has shown that PPP does not hold in the short run. Nevertheless, there is evidence for some movement towards PPP in the very long run. These findings suggest that the characteristics of exchange rate risk and hedge ratios depend on the hedge horizon. Even if PPP relations do not play any role, there might still be interactions between revenues, costs, and exchange rates which lead to hedge ratios that differ across hedge horizons.
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