Hedging foreign exchange exposure: risk reduction from transaction and translation hedging

Abstract

We investigate, for a sample of Swedish firms, the risk reducing effect from foreign exchange exposure hedging, using financial hedges. Further, we investigate the risk reduction from using different hedging instruments, and particular interest is directed towards the impact from transaction exposure hedges and translation exposure hedges respectively. We find that firms' FX exposure is increasing with the level of foreign activity, and a significant reduction in foreign exchange exposure from the use of financial hedges. The evidence suggests that currency derivatives hedging as well as money market hedges reduce firms' foreign exchange exposure. Further, we find that transaction exposure hedges significantly reduce exposure, and that translation exposure hedges also reduce exposure. A possible explanation for the latter is that translation exposure approximates the exposed value of future cash flows from operations in foreign subsidiaries (i.e. economic exposure). If so, by hedging translation exposure, economic exposure is reduced.