Hedging operating and financing risk with financial derivatives during the global financial crisis

• Published date: 01 March 2021
• Author: Sung C. Bae,Taek Ho Kwon
• Date: 01 March 2021
• DOI: http://doi.org/10.1002/fut.22174

J Futures Markets. 2021;41:384–405.wileyonlinelibrary.com/journal/fut384

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© 2020 Wiley Periodicals LLC

Received: 15 October 2020

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Accepted: 15 October 2020

DOI: 10.1002/fut.22174

RESEARCH ARTICLE

Hedging operating and financing risk with financial

derivatives during the global financial crisis

Sung C. Bae

1

|Taek Ho Kwon

2

1

Department of Finance, Schmidthorst

College of Business, Bowling Green State

University, Bowling Green, Ohio

2

School of Business, Chungnam National

University, Daejon, Korea

Correspondence

Sung C. Bae, Department of Finance,

Schmidthorst College of Business, Bowling

Green State University, Bowling Green,

OH 43403.

Email: bae@bgsu.edu

Funding information

Ministry of Education of the

Republic of Korea and the National

Research Foundation of Korea,

Grant/Award Number:

NRF‐2018S1A5B8070344

Abstract

We investigate whether firms properly protect values from sudden exchange

rate changes using financial derivatives. Sampling Korean firms, we com-

pare firms experiencing significant changesinexchangerateexposuresto

firms experiencing no such changes surrounding the global financial crisis.

We find that the former outnumbers the latter, uses more derivatives for

hedging, and has lower firm values. We further show that the lower firm

values are more pronounced for firms hedging financing risk than firms

hedging operating risk with derivatives, indicating more difficulty of hed-

ging financing risk in the face of a sharp depreciation of local currency

during the crisis.

KEYWORDS

financial derivatives, financing risk hedging, global financial crisis, Korean firms, operating risk

hedging

JEL CLASSIFICATION

F31, G15

1|INTRODUCTION

Exchange rate changes bring in impacts on business operations, and the degree of the impact varies by firm. Firms

employ various hedging tools including derivatives products to manage their exchange risk.

1

While firms would

manage their exchange risk relatively well in the environments of stable exchange rate changes, it is questionable

whether firms perform as well in different environments of sudden exchange rate changes such as during financial

crises.

2

Among others, the following key questions on firms' exchange risk management with financial derivatives

would arise: Do firms' existing positions in derivatives continue to work and protect firm values from abrupt changes in

exchange rates during a financial crisis? If not, which type of hedging between operating risk hedging and financing

risk hedging poses more difficulty and contributes to the mismanagement of exchange rate exposures? This paper

attempts to offer new empirical insights into these questions by taking a sample of firms in Korea surrounding the

global financial crisis.

1

The literature shows that firms with greater exchange rate exposures are more likely to use derivatives products (see, e.g., Bae & Kwon, 2013; Bae,

Kim, & Kwon, 2018; Geczy, Minton, & Schrand, 1997).

2

A financial crisis is a situation where some financial assets suddenly lose a large portion of their nominal value and often accompanies a currency

crisis where a currency value depreciates at least 10% (Wikipedia: https://en.wikipedia.org/wiki/Financial_crisis).

While a large body of studies offers rich, though mixed, empirical evidence on the effectiveness of financial

derivatives in managing exchange rate exposures,

3

there is scant evidence on firms' performance in exchange risk

management during financial crises. Allayannis et al. (2003) find that East Asian firms' values declined more than the

changes in exchange rate during the 1997 Asian financial crisis mainly due to the decreased liquidity in the financial

derivatives markets during the crisis. Bae et al. (2018) also show that currency derivatives use by Korean firms carrying

high exchange rate exposures during the 2007 global financial crisis was associated with lower firm values but lower

firm risk as well. Their results imply that the reduction in firm risk resulting from hedging with currency derivatives is

not materialized into an increase in firm value, which they attribute to the excessive costs associated with hedging in

the derivatives markets during the crisis.

In this paper, we examine how firms manage their exchange rate risk with financial derivatives in the face of

sudden changes in exchange rates. For our study, we sample nonfinancial firms in Korea for empirical evidence.

Over the last decades, Korean firms have long engaged in international trades and resorted to foreign capital,

which makes their firm values highly sensitive to exchange rate changes. Consequently, they have been in great

need of various hedging tools including financial derivatives to manage exchange rate exposures (Jung &

Kwon, 2007).

4

Hence, Korean firms offer an ideal laboratory for the study of exchange risk management using

derivatives products surrounding the global financial crisis. We are particularly interested in uncovering empirical

evidence on two research issues.

The first research issue is whether there exist distinctive firm characteristics and valuation effects for firms

experiencing significant changes in their exchange rate exposures surrounding the global financial crisis. To this

end, we take a unique approach of first measuring exchange rate exposures of sample firms and then separating

firms experiencing significant changes in their exposures (labeled as “change firms”) from firms experiencing no

such changes (labeled as “no change firms”) over two periods surrounding the global financial crisis. The first

period is 2001–2005 when the KRW/USD exchange rates followed a stable downward trend (i.e., appreciation of

KRW relative to USD); and the second period is 2006–2010, when the KRW/USD exchange rates increased with

significant volatility, encompassing the global financial crisis. We then compare firm characteristics, determi-

nants of exchange rate exposures, and the effects of such exposures on firm values between “change firms”and

“no change firms.”

The second research issue is whether any mismanagement of risk hedging attributes to the difference in the

valuation effects of exchange rate exposures between the two groups of firms surrounding the crisis. We investigate this

issue by relating firms' operating and financing risk hedging with derivatives to firm values. The exchange risk

management by firms relying on foreign trades and foreign capital such as Korean firms typically involves derivatives

products to hedge operating risk related to the variability of foreign currency revenues from exporting activity and

financing risk associated with interest and principal payments of foreign currency debt.

The mismanagement of operating risk hedging by a Korean firm is well illustrated by the widely‐published GM

Daewoo case during the global financial crisis. Before the crisis, GM Daewoo in Korea held dollar‐forward sell contracts

for hedging exchange risk from its dollar revenues. During the crisis, GM Daewoo suffered a sharp decline in sales

including dollar revenues caused by a declining market demand, but continued to maintain its previously set dollar‐

forward contacts, which resulted in a loss of approximately USD 2.3 billion (Eiteman et al., 2016, p. 344). This mega loss

for GM Daewoo exemplifies a firm's failure to timely adjust and rebalance its previously set derivatives positions for

operating risk hedging, although the size of the hedged assets was substantially reduced.

Financing risk wise, foreign currency debt ratio of Korean firms reached a record level of 6.4% during the global

financial crisis, which was a significant increase from its precrisis level of 6.1% and a level well above their foreign

currency assets ratio of 5.3% (Bae et al., 2016). Accordingly, Korean firms were exposed to increased financing risk

through a serious liquidity mismatch between foreign currency debt and foreign currency assets, causing their

financial positions to worsen. More seriously, the rapid depreciation of local Korean won (KRW) during the crisis

magnified the size of foreign currency debt and thus increased capital costs, which in turn deteriorated business

3

Several studies (e.g., Allayannis & Weston, 2001; Carter, Rogers, & Simkins, 2006; Clark & Mefteh, 2010) report positive effects of hedging with

financial derivatives on firm values, but other studies (e.g., Bae et al., 2018; Bartram, Brown, & Fehle, 2009; Guay & Kothari, 2003; Jin & Jorion, 2006)

show negative or no hedging effects.

4

In addition, the current accounting system in Korea has also contributed to the more active management of exchange rate exposures as it requires

firms to report the translation gains and losses in asset values associated with exchange rate changes in the concurrent year's balance sheets.

BAE AND KWON

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