Foreign Exchange Risk Management in German

Non-Financial Corporations: An Empirical

Analysis

Martin Glaum1
1
Professur für Internationales Management und Kommunikation,
Justus-Liebig-Universität Gießen, Licher Straße 62, 35394 Gießen, Germany

1 Introduction
By definition, all entrepreneurial activities incur risks, and coping with risk has
therefore always been an important managerial function. In recent years, however,
risk management has received increasing attention in both corporate practice and
the literature. This is particularly true for the management of financial risks, i.e.
the management of foreign exchange risk, interest rate risk and other financial
market risks. A major reason for this is the development of markets for derivative
financial instruments. Forward contracts, futures, options, swaps and other, more
complex financial instruments today allow firms to transfer risks to other
economic agents who are better able, or more willing, to bear them.
Derivatives, however, can be used not only to hedge existing risks but also to
build up additional, speculative positions in financial markets. The spectacular
losses a number of large and well-known firms have experienced in connection
with the use of derivatives have shown that these instruments themselves,
therefore, constitute a source of risk. Hence, it has to be stressed that "in financial
risk management, derivatives are only a part of the process and not the process
itself."1
A number of studies have attempted to provide insights into the practices of risk
management within the corporate sector. Reports by Price Waterhouse (1994,
1995) describe corporate practices in the wider area of treasury management.
Glaum/Roth (1993), Batten et al. (1993), Aabo (1999) and Greenwich Treasury
Advisors (1999) focus on the exchange risk management practices of multinational

1 Baldoni 1998, p. 30.

corporations. Others report on the use of derivative financial instruments by non-
financial firms (see, for example, Bodnar et al. 1995, 1996, 1998; Grant/Marshall
1997; Howton/Perfect 1998; Bodnar/Gebhardt 1999). These empirical studies are
interesting not only from an academic standpoint. In the absence of clearcut
theoretical answers to the question of how corporate risk management should be
organized, these surveys provide managers with information on the current
practices of other firms. This kind of information is valuable since it allows
managers to critically assess and analyse their own strategies. Cohen/Wiseman
(1997) explain which questions should be asked in this context: ”Companies
should use this information to assess where they stand in comparison with other
companies. The survey findings do not necessarily represent best practice, but
they should be used as a guide for a treasury to compare itself with other
organizations and ask: Where are we similar? Where are we different? Should we
be different? What should we do about it?”2
The present paper reports the findings of an empirical study on the exchange risk
management practices of large German non-financial corporations. It is based on a
questionnaire survey conducted in late 1998, early 1999. Of the 154 companies
addressed, 74 took part in the survey (response rate: 48 %). The aim of the study
was to find out how these firms measure their exchange rate exposures, which
strategies they follow, which instruments and techniques they use, and which
problems they encounter.3
The rest of the paper is organized as follows. In part 2, a brief overview over the
main theoretical concepts of foreign exchange risk management is given. In part 3,
the methodology of the empirical study is explained. The findings of the survey
are then described in part 4. The paper concludes with a brief summary.

2 Theoretical framework: Measurement and

management of foreign exchange risk
Firms are exposed to foreign exchange risk if the results of their projects depend
on future exchange rates and if exchange rate changes cannot be fully anticipated.
In order to provide a conceptual framework for corporate exchange risk
management, the following three questions have to be asked: Firstly, should firms

2 Cohen/Wiseman 1997, p. 25; also see Phillips 1997, p. 80.

3 The study actually addressed a broader range of questions on corporate risk
management (strategic risk management, use of derivatives, management of exchange
rate risk and interest rate risk, accounting for financial instruments and risk
disclosure). However, only the results on exchange rate risk management are reported
here. For an overview over the results in general, see Glaum 2000.
be concerned about exchange risk at all, that is, should firms attempt to manage
this type of risk? Secondly, if the firm decides to take an active stand towards
exchange rate risk, how should the firm's exposure to this risk be measured?
Thirdly, after the firm has identified and measured the risks it faces, it then has to
decide how its exchange risk management should be organized, which strategy it
should adopt and which instruments it should use.
In the traditional, more practically oriented literature, it was generally assumed
that firms should adopt a strictly risk averse attitude to financial risks. Therefore,
it was argued that firms engaged in exporting or importing activites as well as
multinational corporations with foreign subsidiaries should hedge their exposed
positions. The authors then described the various instruments and techniques that
enable firms to achieve this goal.
A very different attitude was taken up by theoreticians belonging to the
neoclassical school of thought. Pointing out to equilibrium relationships in
international financial markets they argued that the management of financial risks
is unnecessary and potentially even harmful. In an influential article,
Dufey/Srinivasulu (1984) pointedly paraphrased this attitude with respect to
exchange risk management: "Foreign exchange risk does not exist; even if it
exists, it need not be hedged; even it it is to be hedged, corporations need not
hedge it."4 Dufey/Srinivasulu then went on to critically assess each of these
contentions. They showed that the underlying neoclassical assumptions do not
hold in the real world and that, therefore, a case for corporate risk management
can be made.
In recent years, a more detailed discussion of the arguments for and against
corporate hedging activies has developed. Several papers have shown under which
conditions corporate hedging of exchange risk and other financial risks may add to
firm value (see, for instance, Smith/Stulz 1985; Nance et al. 1993; Froot et al.
1993).5 The conditions are based on market imperfections which are neglected in
neoclassical capital market theory. Examples are the costs of financial distress, the
problems of synchronizing investments and financing activities coupled with the
costs of external funding, agency conflicts between managers and shareholders,
and the convexity of the tax function.
The second component of the theoretical framework for corporate exchange risk
management concerns the measurement of exchange risk. The academic literature
generally distinguishes three concepts for measuring the effects of exchange rate
changes on the firm. The accounting exposure concept (translation or book expo-
sure) measures the impact parity changes have on accounting profits and on
owners' equity. However, accounting exposure is based on historical book values

4 Dufey/Srinivasulu 1984, p. 54.

5 For further references, also see the literature review by Hommel/Pritsch 1997.
and it is a function of the accounting methods applied in the translation of foreign
currency denominated balance-sheet and profit-and-loss account items.
Furthermore, the accounting effects of exchange rate changes do not have any
direct impact on the firm's cash flows (unless the firm has committed itself to
maintaining certain accounting ratios). Consequently, it has long been argued that
firms should not actively manage their accounting exposures (see Dufey 1972).
What should concern management is cash flow exposure. The transaction
exposure concept concentrates on contractual commitments which involve the
actual conversion of currencies. A firm's transaction exposure thus consists of its
foreign currency accounts receivables and payables, its longer-term foreign
currency investments and debt, as well as those of its foreign currency cash
positions which are to be exchanged into other currencies. Until these positions
are settled, their home currency value may be impaired by unfavorable parity
changes.
Transaction exposure can be neutralized ("hedged") fairly easily by setting up
counterbalancing positions. For example, a German firm expecting a US-dollar
inflow at a known future date can sell these dollars today in the forward markets.
The effects of exchange rate changes on the receivable and on the forward market
position will now cancel each other out, the home currency value of the future
cash flow is fixed (US-dollar amount times the forward rate). Instead of using the
forward markets, the firm can achieve the same effect by borrowing US dollars
and converting them into Deutschmarks today; the future dollar revenues will then
be used to repay the dollar loan ("money market hedge"). Alternatively, the firm
can buy a put option which will give it the right to sell the incoming dollars at a
prearranged rate. In contrast to the forward hedge, the option does not oblige the
firm to use this rate for the conversion. If at the time of maturity the spot market
offers a more favorable rate, the firm will let the option expire and sell its dollars
at the spot rate. The currency option, in other words, provides the firm with
protection against foreign exchange losses while leaving open the possibility to
participate in favorable exchange rate changes.6
Previous empirical studies have shown that the management of transaction
exposure is the centrepiece of corporate exchange risk management (see
Glaum/Roth 1993; Aabo 1999). For a number of years, however, the academic
literature has pointed out that this exposure concept also has its shortcomings.
Numerous empiricial studies have shown that the theory of purchasing power
parity does not hold over the short and medium run (see, for instance, Taylor
1995). This means that exchange rate changes can lead to changes in the relative

6 For a detailed discussion on the use of currency options in corporate exchange risk
management, see Dufey/Giddy 1995; Dufey/Hommel 1999. For a general overview
over transaction exposure management instruments and techniques, see Dufey/Giddy
1997; Stapleton/Subrahmanyam 1997; Eun/Resnick 1997; Shapiro 1999.
prices of the firm's inputs and outputs. The relative price changes can affect the
firm's competitive market position leading to changes in cash flows and,
ultimately, in firm value. An exchange risk management approach which limits
itself to transaction exposure, i.e. to those foreign currency cash flows which are
contracted at any given point in time, ignores these fundamental, longer-term
effects of exchange rate changes.
The economic exposure concept intends to capture these effects. Economic
exposure is defined as the sensitivity of the firm's future cash flows to unexpected
exchange rate changes. The exposure encompasses all cash flows, no matter
whether a currency conversion is involved and regardless of their timing. The
firm's economic exposure thus includes its transaction exposure, but it also
comprises the expected cash flows of future periods which are not contracted yet.
The exposure can be measured by sensitivity analysis, simulation or by regressing
the firm's cash flows on the foreign exchange rates.7
Although the above-mentioned studies provide answers to the question of whether
firms should manage financial risks at all, they do not, however, supply managers
with a guide as to how exactly their firms' risk management should be organized,
that is, which objectives they should follow, which strategies they should
implement, or which instruments and techniques they should use. As has already
been pointed out, this lack of clearcut theoretical guidelines means that survey
studies of current corporate practice contain valuable information for managers.

3 Methodology of the empirical study

The results presented in this paper are based on a questionnaire study undertaken
in late 1998, early 1999. The questionnaires were sent to the Chief Financial
Officers of major German public corporations („börsennotierte Aktiengesellschaf-
ten“). We addressed all listed German corporations that were not subsidiaries of
other companies and had revenues of at least DM 400 million in 1997. Excluded
from the survey were banks and insurance companies. This left us with a total
sample of 154 companies. Of these, 74 sent us responses. The resulting response
rate of 48.1% is high for a survey of this type. One may assume that the high
participation rate was due to the strong interest the companies take in the problem
discussed. This is also reflected by the hierarchical positions of the respondents:
about a quarter of the questionnaires were filled out by a member of the board;
almost all questionnaires were answered by senior managers.

7 See Stulz/Williamson 1997 For a practical application of the economic exposure

concept to the case of the Swedish automobile producer Volvo, see
Oxelheim/Wihlborg 1995.
In Table 1, the corporations that were addressed are characterized by important
economic indicators. The figures show that the willingness to participate in the
study was correlated to the size of the corporations: the responding corporations
recorded average annual sales (in 1996) of about DM 12.5 bn, whereas for the
non-responding enterprises, the corresponding figure amounted to only DM 6.1
bn. The responding corporations employed an average of almost 37,000 workers
compared with 18,000 for the non-responding ones.8 Thus, taking into account
that we approached all listed German companies that fulfilled the above-
mentioned requirements, and the response rate of roughly 50%, the results of this
survey can be said to be representative for the largest German corporations.
An analysis of the industry pattern of the corporations included in the study
showed that all major industrial segments are represented in the survey. In
accordance with the industrial structure of the German economy as a whole,
chemical and pharmaceutical companies, companies engaged in construction,
mechanical and electrical engineering and service firms are represented most
strongly.

Table 3.1 Characteristics of responding and non-responding corporations

Responding Non-responding
Corporations (n = 74) Corporations (n= 80)

mean standard- mean standard-

deviation deviation

Revenues (million DM) 12,492,7 23,845.2 6,111.7 12,243.0

– percentage abroad 44.36% 31.30% 38.89% 26.65%
Employees 36,762 72,237 17,906 30,298
– percentage abroad 38.77% 23.01% 32.32% 26.19%
Market Value (million DM) 7,352.6 15,282.9 2,441.8 5,054.3

Notes: (i) Figures for sales revenues and employees are for the calendar year 1996. (ii) The
number of employees is the average for 1996. (iii) Market capitalization figures are based
on the prices of common and preferred shares as of December 31, 1997. Sources of data: (i)
Revenues and employees: annual reports and telephone inquiries; (ii) Market value: Börse
online, No. 52, 1997.

8 The significance of the differences in turnover, number of employees and market

capitalisation was tested with a two-tailed t-test; the test statistics are: t = 2.05, p =
0.043 (turnover); t = 2.07, p = 0.041 (number of employees) and t = 2.59, p = 0.011
(market capitalisation).
4 Results of the empirical study

4.1 Exposure concepts

Given the results of previous studies, it comes as no surprise that the risk
management of the German firms focuses on the management of transaction
exposure. As can be seen in Table 4.1, almost two thirds of the respondents
explain that their firms actively manage their transaction exposure. 27% of the
firms restrict themselves to periodic and systematic assessments, and the
remaining 9% indicate that they have little or no concern about their transaction
exposure. The other two types of exposure, accounting and economic, are of
similar importance: 16% of the respondents actively manage their accounting
exposure and 15% do the same for their economic exposure. About half of the
respondents perform periodic and systematic assessments of each type of exposure
and the remainder indicate that they have little or no concern about them.

Table 4.1 Exposure concepts in foreign exchange risk management

no regular regular active

Effects of exchange rate changes assessment or assessment management
on ... management (hedging)

... accounting profits and owners'

35 % 49 % 16 %
equity (accounting exposure)
... home currency values of
foreign currency receivables and 9% 27 % 64 %
payables (transaction exposure)
... competitive position of the
firm and on the expected future 33 % 52 % 15 %
operational cash flows (economic
exposure)

In order to get a more precise understanding of the firms' practices and to prevent
conceptual misunderstandings, the respondents were also asked how the positions
which are actually hedged against exchange risk are made up. In 50% of those
firms which actively manage their exchange risk (see below), the position that is
subject to hedging decisions is made up of both contracted foreign currency
receivables and payables as well as of expected future foreign currency
transactions (the time horizon of the hedging activities is discussed below). 23%
of the firms hedge only booked transactions, and 27% claimed that only expected
future cash flows are considered for hedging. 7% of the respondents explained that
the position that is being hedged comprises the net investments in foreign
subsidiaries. However, in all of these firms, booked foreign currency contracts or
expected currency transactions are also included in the hedging activities.
Firms that aim to reduce or eliminate exchange risk can hedge individual foreign
exchange positions, such as accounts receivable resulting from export transactions
or accounts payable resulting from importing activities. Each position can be
neutralized with a counterbalancing transaction in the forward markets, with a
currency option or with another hedging instrument ("micro hedge approach").
Alternatively, the firm can first identify its net position in a given currency by
subtracting expected cash outflows ("short positions") from expected cash inflows
("long positions") of the same time horizon. Since the effects exchange rate
changes have on long and short positions cancel each other out, only the net
position is effectively exposed to exchange risk, and hence only this net exposure
needs to be considered for hedging ("macro hedge approach").
Compared to the micro hedge approach, the macro hedge approach reduces the
number and volume of the hedging transactions. Especially multinational
corporations with intensive two-way cross-border activities (e.g. with exporting
and importing activities) can realize substantial savings of transaction costs if their
exchange risk management is conducted on a net exposure basis. The approach,
however, requires a centralized treasury management and an efficient information
system.
44% of those firms in our sample which actively manage their exchange risk (see
below) do so on the basis of the micro hedge approach, that is, they hedge
individual open currency positions with individual hedge transactions. 48% of the
firms follow the macro hedge approach, that is, the firms identify their net
exposure for each currency and this position is then subject to hedging decisions.
The remaining 8% explained that they follow both approaches, meaning that as a
matter of routine, they follow a macro hedge approach whereas certain positions
(large transactions, unusual currencies) are hedged individually.
The above observations can be commented as follows.
(a) In practice, the majority of firms (65% in our sample) include foreign
exchange transactions which are expected over a certain time horizon (e.g., over
the forthcoming 12 months) in their hedging activities. This form of exposure
management is not covered adequately by the usual taxonomy of international
financial management textbooks. The expected transactions are neither part of
transaction exposure since they are not contracted yet, nor do they make up the
firm's economic exposure (the time horizon is limited, only foreign currency
transactions are considered, and the firms do not apply any form of sensitivity
analysis). At best, the approach can be interpreted as an "extended transaction
exposure management".
(b) The second comment concerns the practical relevance (or irrelevance) of the
(true) economic exposure concept. The fact that most firms do not attempt to
manage their economic exposure can be explained by the complexity of this
concept. In order to measure a firm's economic exposure one needs to analyze the
elasticity of demand in its markets for inputs and outputs, the flexibility of its
production processes and the strategies of its competitors. The tools which are
available for altering a firm's economic exposure are the choice of its products and
markets, the restructuring of its sourcing, production and marketing processes, and
changes in its longer-term financial policies. Obviously, such policies cannot be
implemented easily as they require time and are expensive. Furthermore, an
economic-exposure oriented exchange risk management requires a strategic, top
management approach; it cannot be seen as the responsibility of financial
managers alone (see Glaum 1990).
(c) Considering that academics have been pointing out for many years that the
accounting concept of exchange exposure is not an appropriate concept to be used
in foreign exchange risk management, it is surprising that a number of firms still
aim to hedge this type of exposure. By eliminating their translation exposure, the
firms may actually create additional transaction exposure. The former has no
direct cash flow implications, the latter involves real cash flows. The firms, in
other words, hedge against "paper losses" while at the same time incurring the risk
of real losses from their hedging transactions (see, for instance, Eun/Resnick
1997).
(d) Finally, it is astonishing that almost half of the firms (44%) base their hedging
activities on individual currency positions. Further analysis of the data reveals that
there is a tendency for larger firms to follow a macro hedge approach (net
exposure hedging). However, among those who do not net their currency inflows
and outflows, there are also some very large multinational corporations. One
would expect these firms to be able to realize substantial savings by restructuring
their exchange risk management.

4.2. Exchange risk management strategies

Ultimately, the most important part of a firm's exchange risk management in

practice is its hedging strategy. Based on an earlier interview-based empirical
study (see Glaum/Roth 1993), the respondents were given descriptions of
alternative hedging strategies; they were then asked to indicate which of them best
describes the rules and procedures of their own firm's foreign exchange risk
management. The results are depicted in Figure 4.1.

• 11% of the firms taking part in the study (or, in absolute numbers: eight firms)
do not hedge their foreign exchange rate risk at all. Of these eight firms, five
explained further that they are not (significantly) exposed to foreign exchange
risk.
• 22% of the firms follow the strategy to hedge all open positions immediately.
• 12% of the firms follow a fixed rule according to which they always hedge a
certain portion of their exposure with forward and/or option contracts, while
leaving the remainder exposed. For example, some firms always hedge half of
their exposure, others always hedge a third of their position with forward
contracts, another third with currency options and leave the remaining third
unhedged.

Figure 4.1 Hedging strategies

60%

50%

40%

30% 54%

20%
22%
10% 12%
11%
1%
0%
no hedging immediately hedge use a fixed rule hedge create additional
all exposure for partial hedging selectively exposure to profit from
exchange rate changes

• The majority of firms (54%) follow a so-called selective hedging strategy. This
means that the firms hedge only those positions for which they expect a
currency loss while leaving open positions for which they expect a currency
gain. Obviously, such a strategy is based on forecasts of future exchange rate
changes. The managers must predict which foreign currencies will appreciate
and which will depreciate over the time horizon of the open positions. About a
third of the firms in this category always hedge a certain minimum percentage
of their exposures; the remainder may then be left unhedged depending on the
exchange rate forecast. In the other two thirds of the firms, the managers have
full discretion to leave up to 100% of the positions unhedged.
• Finally, one of the respondent firms indicated that, based on exchange rate
forecasts, it is willing to create exchange risk exposure beyond that arising
from its business activities in order to profit from exchange rate movements.
The participants were also asked about the time horizon of their firms' hedging
activities. As is shown graphically in Figure 4.2, 39% of the firms do not have a
fixed rule concerning the time horizon of their hedging activities. 19% of the firms
regularly hedge open positions over a horizon of three months; this is equal to the
usual terms of payments in many industries. 39% of the firms hedge over a
horizon of 12 months; this time frame corresponds with the budget period of most
firms. Only a small minority of firms regularly hedged over longer periods of
time.

Figure 4.2 Time horizon of hedging activities

three months 19%

twelve months 39%

three years 2%

longer than
2%
three years

39%
no fixed rule

0% 10% 20% 30% 40% 50%

In order to get a deeper insight into the exchange risk management practices of the
firms, we asked the participants further detailled questions about their strategy
towards their firms' US-dollar exposures. Firstly we asked whether the firms have
a significant exposure towards the US-dollar and, if so, whether this exposure
consists of a "long position" (net inflows in US-dollars) or a "short position" (net
outflows in US-dollars). Given the traditional export orientation of German firms,
it was not surprising that the majority of the firms (55%) reported that their
operations typically generated net inflows in US-dollars. In 19% of the cases, the
exposure had the opposite sign, that is, these firms typically generated net
outflows in US-dollars. The remaining 26% do not have significant US-dollar
exposures.
The firms' hedging strategies towards the US-dollar are summarized in Figure 4.3.
13% of the firms that replied to this question9 explained that they had not hedged
their US-dollar position at all. However, with one exception all of these firms have
no significant US-dollar exposure. 10% of the firms had hedged up to 25% of their
exposure, and another 10% had realized a hedge ratio between 25 and 50%. 23%

9 Six firms decided not to respond to this question.

of the firms had hedged between 51% and 75%, and 29% had hedged between
76% und 99 % of their exposure. A minority of 16% was fully hedged. Firms with
long positions had a tendency to choose relatively high hedge ratios while firms
with short positions tended to have rather low hedge ratios.

Figure 4.3 Current hedge ratio of US-dollar position

30%

25%

20%

15% 29%

23%
10%
16%
13%
10% 10%
5%

0%

0% 1 bis 25% 26 bis 50% 51 bis 75% 76 bis 99% 100%

Another observation can be made. As was shown earlier, 22% of the respondents
(or, in absolute numbers, 16 firms) claimed that their firms always fully hedge
open currency positions (see Figure 4.1). However, of these 16 firms, only seven
had a fully hedged US-dollar position at the time of our survey. Of the other nine
firms, one did not respond to the question about the US-dollar position; five firms
had hedged between 75% and 99% of their dollar positions, two had hedged
between 51% and 75%, and one firm had hedged only between 1% and 25%. Each
of these nine firms had, according to their own answers in the study, significant
US-dollar exposures.
Overall, the above results are in line with previous empirical studies on corporate
exchange risk management (see Glaum/Roth 1993; Batten et al. 1993; Aabo 1999;
Greenwich Treasury Advisors 1999). They show that only a very small minority
of firms do not hedge their foreign exchange risks at all. However, they also show
that only a small minority of firms fully hedge their risks. What may be the most
surprising result from an academic point of view is the fact that a majority of firms
follow profit-oriented, selective hedging strategies.10 The managers of these firms
obviously believe that, in comparison to a strategy of always fully hedging their
positions, they can increase the firms' cash flows. In order to achieve this goal,
they willingly accept the risk of currency losses due to the open positions. The
speculative nature of the selective hedging strategy has been pointed our very
sharply by Lessard/Nohria (1990, p. 198/199): "In fact, to the extent that it
includes a speculative element by factoring possible gains into the hedging
decision, [selective hedging] differs little from staking the assistant treasurer with
a sum of money to be used to speculate on stock options, pork bellies or gold."
The selective hedging strategy is based on the managers' ability to forecast
appreciations and depreciations of the relevant currencies over the planning
horizon. The managers thus implicitly reject one of the foundations of modern
finance theory, namely, the efficient market hypothesis. According to this
hypothesis (in its semi-strong version), financial market prices always reflect all
publicly avaible information. Therefore, it is impossible for individual market
participants to generate abnormal returns by forecasting future market prices. A
strict interpretation of the efficiency hypothesis is not very plausible because in
this case nobody would have an incentive to invest in the production or analysis of
new information. Instead, one can argue that financial markets in reality display a
high degree of information efficiency precisely because so many private and
professional market participants are continuously striving to gain access to new
and better information and to analyze the available information most carefully.
The efficiency of the foreign exchange markets was subject to numerous empirical
tests. The results of some studies show that it would have been possible to make
speculative gains in certain markets over certain periods of time. However, these
studies analyze historical exchange rate time series. Economists are extremely
doubtful about the possibilities of making predictions of future exchange rate
changes (see Frankel/Rose 1995; Lewis 1995; Taylor 1995). To conclude, unless
financial markets are seriously distorted by government restrictions or
interventions (including fixed exchange rate regimes), it appears to be very
difficult indeed to generate profits on the basis of exchange rate forecasts.
Therefore, financial managers should analyze very (self-) critically whether their
firms have access to privileged information or whether they possess superior
abilities to analyze the publicly available information. If this is not the case, it is
unlikely that speculative activities, including selective hedging, will systematically
increase the value of the firm (see Glaum 1994; Dufey/Giddy 1997 on this point).

10 Empirical evidence seems to suggest that European firms are more inclined than US
firms to accept open foreign exchange positions based on exchange rate forecasts; see
Bodnar/Gebhardt 1999; Greenwich Treasury Advisors 1999.
4.3 The use of foreign exchange rate forecasts
Despite the critical attitude of the academic literature, exchange rate forecasts
appear to be very popular in practice. As was shown in the previous section, this is
also true for the current study. In order to gain further insights into the use of
exchange rate forecasts, we directly asked the survey participants whether they use
forecasts in connection with hedging decisions. As is shown graphically in Figure
4.4, exchange rate forecasts are employed in 73% of firms. This means that the
financial executives of almost three quarters of the largest German firms do not
believe that currency markets are information efficient and that they are able to
profit systematically from exchange rate forecasts.

Figure 4.4 Use of foreign exchange forecasts

80%

60%

73%
40%

20% 27%

0%

In connection with hedging In connection with hedging

decisions, we regularly use decisions, we generally do
exchange rate forecasts. not use exchange rate forecast.

We were also interested in the techniques and the sources of information used in
the preparation of the exchange rate forecasts. Our results indicate that costfree
forecasts provided by banks or consultants are the most important source of
information. On a scale of 0 (= no importance) to 4 (= very important), these
forecasts received an average score of 2.9. With an average rating of 2.7, forecasts
based on the fundamental analysis of macroeconomic data also play an important
role. Third come the managers' subjective, personal views on the future
development of the parity rates (2.1), followed by technical analysis of the
exchange rate history (1.9). Commercial forecasts which have to be purchased by
the firms play only a very minor role (average rating: 0.8).
4.4 Organization of exchange rate management

Multinational corporations have to decide on the degree of centralization of their

exchange risk management function. In a totally decentralized system, each
corporate unit is responsible for managing its own exposure. In a fully centralized
system, risk management is the sole responsibility of the corporate center. As has
already been mentioned, centralized risk management offers certain advantages. It
is possible to balance out long and short positions and to calculate the group-wide
net position for each currency. Only these net exposures need to be hedged in the
derivatives markets. Furthermore, centralization allows the firm to benefit from
economies of scale (larger overall positions, employment of specialized know
how, access to international financial markets). On the other hand, the introduction
of a centralized risk management system may be costly, and it may meet with
resistance by the management of the local subsidiaries. In addition, the firms have
to take into account capital controls and other legal restrictions which in some
countries may impose limitations on the centralization of exchange risk
management.
Previous surveys in the US indicate that the risk management of US firms tends to
be highly centralized (see Bodnar et al. 1998; Greenwich Treasury Advisors
1999). In an earlier study, Glaum/Roth (1993) showed that German multinationals
had developed very heterogeneous organizational forms in the area of financial
risk management. On the whole, however, they also displayed a high degree of
centralization.
The current study distinguishes between the centralization of risk management
decisions and the centralization of the actual implementation of these decisions.
With respect to decision making, we supplied the participants with three
alternative categories and asked them which of these best describes the
organization of their firms' risk management function: (i) all hedging decisions are
taken by the corporate center or are determined by rules which are administered
by the center (high degree of centralization); (ii) within guidelines set by the head
office, the subsidiaries may decide on their own about hedging financial risks
(medium degree of centralization); (iii) the subsidiaries are totally free to make
hedging decisions independently of the headquarters (low degree of
centralization).
Interestingly, not a single corporation relies on a low degree of centralization. 47%
of the respondents indicate that a high level of centralization best describes the
decision making process for financial risk management in their firms while the
medium level of centralization is the best descriptor for the remaining 53%.
The implementation of risk management activities are even more strongly
centralized. Again, we presented the participants with three possible anwers: (i)
the subsidiaries are obliged to conduct all hedging transactions with the corporate
center (high degree of centralization); (ii) subsidiaries can, within guidelines set
by the head office, carry out their own hedging transactions with independent
market partners (medium degree of centralization); and (iii) the subsidiaries are
totally free to conduct hedging transactions with independent market partners
without interference by the corporate center (low degree of centralization).
Again, there is not a single case where the subsidiaries are fully autonomous with
respect to the implementation of hedging decisions. 47% of the firms are
characterized by a medium degree of centralization and in 53 % of the firms the
local financial managers are obliged to settle all hedging transactions with the
head office.

4.5 Further Arguments and Hypotheses on Exchange Risk

Management
Finally, we confronted the participants with several arguments and hypotheses
related to the management of foreign exchange rate risk and asked them to
indicate whether they agree or disagree with them on a scale of 0 (= do not agree
at all) to 3 (= fully agree).
(a) Our first statement held that during “good times” (i.e., in periods with
relatively high profits), firms protect themselves less intensively against
unexpected exchange rate changes than they usually do. Most respondents
disagreed strongly with this statement; the average score on our scale of 0 to 3 is
0.5.
(b) One of the determinants of hedging which are discussed in the more recent
academic literature is the firm's tax function. If the tax function is convex, firms
can reduce taxes by smoothing taxable income. Furthermore, reducing the
volatility of the firm's cash flows enables the firm to take on more debt which
again leads to tax advantages (see Ross 1996; Graham/Smith 1998). We therefore
asked the survey participants whether they agree with the statement that reducing
taxes is an important goal in foreign exchange risk management. Our results show
that the managers do not agree with this argument at all (average consent rating:
0.5).
(c) The contention that the (perceived) risk management practices of the firms'
most important competitors exert an influence on the firms’ own hedging
decisions also received a very low level of support. The average consent rating of
0.4 is the lowest of all the arguments and hypotheses in our list (similar results
were obtained by Aabo 1999).
(d) From a theoretical perspective, exchange rate risk matters only in so far as it
contributes to the firm's overall risk. In the case of less than perfect positive
correlation between different categories of risk, there are diversification effects;
and if exchange risk happens to be negatively correlated to the firm's other risk
factors, the hedging of exchange risk could actually increase the overall volatility
of the firm's cash flows. About half of the respondents explained that the
correlation to other business risks does influence their firms' exchange risk
management decisions whereas this is not the case in the other half. The almost
even distribution of answers resulted in an average consent rating of 1.6.
(e) In a previous part of the study it was shown that the majority of firms include
expected future cash flows in their hedging decisions. It has already been
suggested that this might be interpreted as an "extended transaction exposure
management" rather than as an approximation to management of economic
exposure. In another section of the study, numerous managers had indicated that
they regularly assess their firms' economic exposure (52 %) or even actively
manage it (15 %). One of our statements was directly related to the economic
exposure concept. The statement held that the managers systematically examine
the influence of exchange rate changes on the stock prices of their firms. The
responses we received to this statements reveal that the central idea of the
economic exposure concept has no support in corporate practice: 91% of the
respondents do not agree with the statement; only 8% indicate some support and
only one participant "fully agreed" with the statement (average consent rating:
0.6).
(f) Next, we confronted the managers with the notion that because of the
informational efficiency of the exchange markets, forward rates are the most
reliable source of information for risk management decisions. The hypothesis that
the forward rates are unbiased predictors of future foreign exchange rates
("forward market efficiency") is the subject of an intensive debate in the literature
(see Frenkel 1994; Lewis 1995 for details). Over recent years, several empirical
studies have shown that the forward rate does not predict future spot rates without
bias. The deviations may be the result of systematic expectational errors or they
are due to a risk premium (or both). Whatever the explanation, the deviations
appear to be highly volatile and their sign changes over time. Futhermore, so far
no adequate model exists which would make it possible to forecast the prediction
error of the forward rates. For these reasons, the deviations may be largely
irrelevant for practical purposes. In the words of Shapiro (1999): "However, the
premium appears to change signs – being positive at some times and negative at
others – and averages near zero. ... In effect, we wind up with the same
conclusion: ... That is, on average, the forward rate is unbiased."11
The hedging strategies followed by the firms, in particular the widespread use of
exchange rate forecasts, has already shown that the managers do not believe in the
validity of the forward market efficiency hypothesis. This is also reflected in the
responses we received to the above statement. Only a minority of 6% of the
respondents fully agreed with the statements that forward rates are the most
reliable sources of information for risk management decisions. 22%, on the other
hand, strongly disagreed. The remaining participants indicated either moderage
agreement or disagreement (overall average consent rating: 1.3).

11 Shapiro 1999, p. 233; similarly Dufey/Giddy 1997, p. 8.

(g) The last two statements focused on the performance of the managers' hedging
decisions. The first of the two statements postulated that the firms periodically
measure the success of their exchange rate management policy. This statement
met with strong support; 80% of the participants either fully or at least moderately
agreed with the statement (average consent rating: 2.1). The second statement held
that in recent years the firms had usually been correct with their exchange rate
forecasts and that, therefore, they had earned high profits through their selective
hedging strategy (compared to a full hedging strategy). Looking at only those
firms which do follow a selective hedging strategy, the average consent rating is
1.4. Interestingly, not a single firm totally agrees with the statement. One half of
the firms moderately agreed, the others disagreed; 42% of the firms "somewhat
disagreed", the 8% totally disagreed.

5. Conclusion

The paper reports the results of an empirical study into the foreign exchange risk
management of large German non-financial corporations. Of the 154 firms that
were addressed, a total of 74 took part in the study. The managers of theses firms
were asked about the measurement of exchange risk, about their management
strategies, and about organizational issues. The results can be summarized as
follows. The majority of the firms are concerned about managing their transaction
exposure. Most firms adopted a selective hedging strategy based on exchange rate
forecasts. Only a small minority of firms do not hedge foreign exchange risk at all,
and only few companies hedge their transaction exposure completely. Looking in
more detail at the management of the firms' exposure to the US-dollar, we found
that only 16% of the firms were fully hedged. The majority of firms had realized
hedge ratios between 50 and 99%.
The survey found a number of interesting discrepancies between the positions of
the academic literature and corporate practice. For instance, numerous firms are
concerned about their accounting exposure and some firms are actively managing
it. The exposure concept favored by the academic literature, that is, economic
exposure, is of little importance in practice. Further, we found that almost half of
the firms manage their exchange positions on the basis of the micro hedge
approach. In other words, they forego the possibility to establish the firm's net
exposure by balancing out cash outflows and inflows first. The most interesting
finding from an academic point of view, however, is the widespread use of
exchange rate forecasts and of exhange risk management strategies based on
forecasts (selective hedging). By adopting such strategies, the managers indicate
that they do not believe that the foreign exchange markets are information
efficient and they are able to beat the market with their own forecasts. The
academic literature, on the other hand, emphasizes that it is very difficult indeed to
make systematically successful exchange rate forecasts. Further research is
required in order to analyze whether the firms' current practices in this area are ill-
conceived or whether they really do have access to privileged information or
possess superior abilities which allow them to generate profits in the foreign
exchange markets.

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