Linear and Nonlinear Foreign Exchange Rate Exposures of German Nonfinancial Corporations

It has been viewed as an unsolved puzzle that only for a small number of firms a significant impact of foreign exchange rate risk on firm value could be detected empirically. This paper investigates whether the results of previous studies can be explained by the fact that only the linear exposure component has been estimated or that exchange rate indices were used. For a comprehensive sample of German firms, empirical evidence is presented for the existence of significant linear and nonlinear exposures, which can be identified for bilateral as well as multilateral foreign exchange rates. The percentage of foreign sales, measures of firm liquidity and industry sectors are significant determinants of the exposure.foreign exchange rates, exposure, corporate finance, risk management, derivatives

The Interest Rate Exposure of Nonfinancial Corporations

Many interest rates are as volatile as exchange rates and thus represent an equally important source of risk for corporations. While this is true not only for financial institutions, but for other corporations as well, little is known about the interest rate exposure of nonfinancial firms. Consequently, this paper investigates the impact of interest rate risk on a large sample of nonfinancial corporations. It presents empirical evidence for the existence of linear and nonlinear exposures with regard to movements in various interest rate variables. The interest rate exposure is empirically determined by measures of firm liquidity, but not by financial leverage.Interest rates, exposure, derivatives, risk management, corporate finance, capital markets

The Impact of the Introduction of the Euro on Foreign Exchange Rate Risk Exposures

This paper examines whether the introduction of the Euro in 1999 was associated with lower stock return volatility, market risk exposures and foreign exchange rate risk exposures for 12,821 nonfinancial firms in Europe, the United States, and Japan. We show that though the Euro led to a significant decrease in the volatility of trade-weighted exchange rates of European countries, stock return variances of nonfinancial firms increased after its introduction. However, the Euro was also accompanied by significant reductions in market risk exposures for nonfinancial firms in and outside of Europe. We show that the reduction in market risk was not as a result of changes in financial leverage, and that it is concentrated in firms with a high fraction of foreign sales in Europe, a high fraction of total foreign sales and larger market capitalizations. In addition to its impact on market betas, the Euro has a positive effect on the incremental foreign exchange rate exposures, particularly for multinationals.Foreign exchange rates, exposure, Euro, corporate finance, risk management, derivatives

Alternative Market Structures for Derivatives

In this paper, we compare option contracts from a traditional derivatives exchange to bank-issued options, also referred to as covered warrants, whose markets have grown rapidly around the world in recent years. While bank-issued option markets and traditional derivatives exchanges exhibit significant structural differences such as the absence of a central counterparty for bank-issued options, they frequently exist side-by-side, and the empirical evidence shows that there is significant overlap in their product offerings. We examine trading costs and liquidity in both markets and find that bank-issued options have smaller quoted percentage bid-ask spreads than traditional option contracts by an average of 4.3%. The bid-ask spread difference manifests itself in a highly regular fashion in that ask (bid) prices for bank-issued options are consistently higher than comparable ask (bid) prices for traditional option contracts. The difference of the bid prices is larger than the difference of the ask prices resulting in smaller bid-ask spreads for bank-issued options. The empirical analysis also indicates that bid-ask spreads in either market are lowered by competition from the other market. We present a potential explanation for the co-existence of the two market structures which suggests that the bank-issued option market caters more towards retail investors with predominantly speculative motives while traditional derivatives exchanges may cater more towards institutional investors with predominantly hedging motives.Options, Market Design, Microstructure, Bid-Ask Spreads

Competition among Alternative Option Market Structures: Evidence from Eurex vs. Euwax

We study option market design by providing a theoretical motivation and comprehensive empirical analysis of two fundamentally different option market structures, the Eurex derivatives exchange and Euwax, the world’s largest market for bank-issued options. These markets exist side-by- side, offering many options with identical or similar characteristics. We motivate the two market structures based on option investor clienteles which differ with respect to the probability of selling the option back to the dealer/issuer before maturity, which in turn affects the investors expected transaction costs. As suggested by the clientele argument, the most important empirical finding is that Euwax ask prices and bid prices are consistently higher than comparable Eurex ask prices and bid prices. The difference of the bid prices is larger, resulting in smaller Euwax bid-ask spreads, which makes Euwax preferable for investors with a high probability of early liquidation. We find that competition from one market reduces bid-ask spreads in the other market.Options, Market Design, Microstructure, Bid-Ask Spreads

Corporate Risk Management as a Lever for Shareholder Value Creation

Firm value is influenced in many direct and indirect ways by financial risks, which consist of unexpected changes of foreign exchange rates, interest rates and commodity prices. The fact that a significant number of corporations are committing resources to risk management activi-ties is, however, only an indication of the potential of corporate risk management to increase firm value. This paper presents a comprehensive review of positive theories and their empiri-cal evidence regarding the contribution of corporate risk management to shareholder value. It is argued that because of realistic capital market imperfections, such as agency costs, transac-tion costs, taxes, and increasing costs of external financing, risk management at the firm level (as opposed to risk management by stock owners) represents a means to increase firm value to the benefit of the shareholders.risk management, agency cost, hedging, shareholder value, taxes, transaction cost, derivatives

The Impact of the Introduction of the Euro on Foreign Exchange Rate Risk Exposures

This paper examines whether the introduction of the Euro was associated with lower stock return volatility, market risk exposures and foreign exchange rate risk exposures for 3,921 nonfinancial firms from 18 European countries, the United States and Japan. While the Euro led to a significant decrease in the volatility of trade-weighted exchange rates of European countries, stock market volatility generally increased, but less in the Euro area and Non-Euro Europe than outside of Europe. At the same time, the Euro was accompanied by significant reductions in market risk exposures for nonfinancial firms in and outside of Europe. We show that the reduction in market risk was not the result of changes in financial leverage, and that it is concentrated in firms with a high fraction of foreign sales or assets in Europe. Moreover, the Euro led to a net absolute decrease in the foreign exchange rate exposure of nonfinancial firms. Consistent with economic theory, the changes of market and foreign exchange rate betas of multinationals are shown to be a function of firm characteristics (sales, the percentage of foreign sales in general and in Europe in particular), regional factors (geography, strength of currency) and industry characteristics (competition, traded goods).