Impact of exchange rate derivatives on stocks in emerging markets
Abstract
This paper investigates the effect of derivatives on the relationship between the foreign exchange rate and the stock market. A theoretical model is used to extend the understanding of that relationship. Also, the model is tested with an empirical analysis using the GMM strategy for the Mexican and Brazilian stock markets for the period 2007 to 2019. Findings reveal that in addition to the spot exchange rate, exchange rate futures explain the currency exposure, wherein the derivative effect is the most prominent. The result implies that both risk sources should be considered in the implementation of risk management or macroeconomic policy. The theoretical results are extended by applying them to international portfolio management, proposing a strategy to mitigate foreign exchange exposure with derivatives. This study contributes to the literature by explaining why the minimum variance hedge ratio plays an essential role in the foreign exchange rate and stock market nexus.
Keyword : dynamic stochastic programming, portfolio, risk hedging, derivatives, futures market, foreign assets, foreign exchange markets
How to Cite
Bernal-Ponce, L. A., Castillo-Ramírez, C. E., & Venegas-Martínez, F. (2020). Impact of exchange rate derivatives on stocks in emerging markets. Journal of Business Economics and Management, 21(2), 610-626. https://doi.org/10.3846/jbem.2020.12220
This work is licensed under a Creative Commons Attribution 4.0 International License.
References
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Almudhaf, F. (2019). Pricing efficiency of exchange traded funds tracking the gulf cooperation countries. Afro-Asian Journal of Finance and Accounting, 9(2), 117–140. https://doi.org/10.1504/AAJFA.2019.099485
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Anisak, N., & Mohamad, A. (2019). Foreign exchange exposure of Indonesian listed firms. Global Business Review. https://doi.org/10.1177/0972150919843371
Aysun, U. & Guldi, M. (2011). Derivatives market activity in emerging markets and exchange rate exposure. Emerging Markets Finance and Trade, 47(6), 46–67. https://doi.org/10.2753/REE1540-496X470603
Bae, S. C., Kim, H. S., & Kwon, T. H. (2018). Currency derivatives for hedging: New evidence on determinants, firm risk, and performance. Journal of Futures Markets, 38(4), 446–467. https://doi.org/10.1002/fut.21894
Bakshi, G. S., & Chen, Z. (1997). Equilibrium valuation of foreign exchange claims. Journal of Finance, 52(2), 799–826. https://doi.org/10.2307/2329499
Bartram, S., Brown, G., & Conrad, J. (2011). The effects of derivatives on firm risk and value. Journal of Financial and Quantitative Analysis, 46(4), 967–999. https://doi.org/10.1017/S0022109011000275
Bernal, L., & Venegas-Martínez, F. (2011). Impacto de los productos derivados los objetivos de política monetaria: un modelo de equilibrio general. Estudios Económicos, 26(2), 187–216.
Bhargava, V., & Malhotra, D. K. (2007). The relationship between futures trading activity and exchange rate volatility, revisited. Journal of Multinational Financial Management, 17(2), 95–111. https://doi.org/10.1016/j.mulfin.2006.05.001
Branger, N., Muck, M., & Weisheit, S. (2019). Correlation risk and international portfolio choice. Journal of Futures Markets, 39(1), 128–146. https://doi.org/10.1002/fut.21941
Brown, C. J., & Curci, R. (2002). Mexican peso futures and exchange rate volatility. Latin American Business Review, 3(1), 75–90. https://doi.org/10.1300/J140v03n01_04
Caves, R. E. (2007). Multinational enterprise and economic analysis. Cambridge University Press. https://doi.org/10.1017/CBO9780511619113
Chen, S.-S., Lee, C.-f., & Shrestha, K. (2003). Futures hedge rations: A review. Quarterly Review of Economics and Finance, 43(3), 433–465. https://doi.org/10.1016/S1062-9769(02)00191-6
Chkili, W. (2012). The dynamic relationship between exchange rates and stock returns in emerging countries: Volatility spillover and portfolio management. International Journal of Management Science and Engineering Management, 7(4), 253–262. https://doi.org/10.1080/17509653.2012.10671230
Cox, J. C., Ingersoll, J. E., & Ross, S. A. (1985). An intertemporal general equilibrium model of asset prices. Econometrica, 53(2), 363–384. https://doi.org/10.2307/1911241
Cuthbertson, K., & Nitzsche, D. (2004). Quantitative financial economics. Wiley.
Demange, G., & Laroque, G. (1999). Efficiency and options on the market index. Economic Theory, 14(1), 227–235. https://doi.org/10.1007/s001990050290
Duarte, J. B., & Mascareñas, J. M. (2014). Comprobación de la eficiencia débil en los principales mercados financieros latinoamericanos. Estudios Gerenciales, 30(133), 365–375. https://doi.org/10.1016/j.estger.2014.05.005
Dwumfour, R. A., & Addy, N. A. (2019). Interest rate and exchange rate exposure of portfolio stock returns: Does the financial crisis matter? Journal of African Business, 20(3), 339–357. https://doi.org/10.1080/15228916.2019.1583977
El Abed, R. (2017). Exploring the nexus between stock prices and macroeconomic shocks: Panel VAR approach. Economics Bulletin, 37(3).
Guay, W., & Kothari, S. P. (2003). How much do firms hedge with derivatives? Journal of Financial Economics, 70(3), 423–461. https://doi.org/10.1016/S0304-405X(03)00179-X
He, J., & Ng, L. (1998). The foreign exchange exposure of Japanese multinationals corporations. The Journal of Finance, 53(2), 733–753. https://doi.org/10.1111/0022-1082.295575
Hodder, J. E. (1982). Exposure to exchange-rate movements. Journal of International Economics, 13(3– 4), 375–386. https://doi.org/10.1016/0022-1996(82)90065-4
Hodrick, R. J., & Srivastava, S. (1986). The covariation of risk premiums and expected future spot exchange rates. Journal of International Money and Finance, 5(1), S5–S21. https://doi.org/10.1016/0261-5606(86)90015-X
Inci, A. C., & Lee, B. S. (2014). Dynamic relations between stock returns and exchange rate changes. European Financial Management, 20(1), 71–106. https://doi.org/10.1111/j.1468-036X.2011.00621.x
Jorion, P. (1990). The exchange-rate exposure of U.S. Multinationals. Journal of Business, 63(3), 331–345. https://doi.org/10.1086/296510
Kambi, K., & Ali, A. I. (2016). Effects of financial risk management practices on financial performance of listed banks at the Nairobi securities exchange in Kenya. International Journal of Business and Management, 4(4), 19–36.
Lee, B., & Suh, J. (2012). Exchange rate changes and the operating performance of multinationals. European Financial Management, 18(1), 88–116. https://doi.org/10.1111/j.1468-036X.2009.00522.x
Luo, H. R., & Wang, R. (2018). Foreign currency risk hedging and firm value in china. Journal of Multinational Financial Management, 47(48), 129–143. https://doi.org/10.1016/j.mulfin.2018.11.002
Mahapatra, S., & Bhaduri, S. N. (2019). Dynamics of the impact of currency fluctuations on stock markets in india: Assessing the pricing of exchange rate risks. Borsa Istanbul Review, 19(1), 15–23. https://doi.org/10.1016/j.bir.2018.04.004
Makar, S., & Huffman, S. (2008). UK multinationals’ effective use of financial currency-hedge techniques: Estimating and explaining foreign exchange exposure using bilateral exchange rates. Journal of International Financial Management and Accounting, 19(3), 219–235. https://doi.org/10.1111/j.1467-646X.2008.01022.x
Mo, G., Tan, C., Zhang, W., & Liu, F. (2019). International portfolio of stock indices with spatiotemporal correlations: Can investors still benefit from portfolio, when and where? North American Journal of Economics and Finance, 47, 168–183. https://doi.org/10.1016/j.najef.2018.12.002
Nguyen, H., Faff, R., & Marshall, A. (2007). Exchange rate exposure, foreign currency derivatives and the introduction of the euro: French evidence. International Review of Economics and Finance, 16(4), 563–577. https://doi.org/10.1016/j.iref.2006.01.002
Ozimkovska, V. (2018). Real financial market exchange rate volatility and portfolio flows. International Economics and Economic Policy, 15(2), 281–303. https://doi.org/10.1007/s10368-017-0405-3
Pérez-González, F., & Yun, H. (2013). Risk management and firm value: Evidence from weather derivatives. The Journal of Finance, 68(5), 2143–2176. https://doi.org/10.1111/jofi.12061
Roberts, M. R., & Whited, T. (2012). Endogeneity in empirical corporate finance. In G. Constantinides, M. Harris, & R. Stulz (Eds.), Handbook of the economics of finance (Vol. 2). Elsevier.
Rossi, J. L. (2011). Exchange rate exposure, foreign currency debt, and the use of derivatives: Evidence from Brazil. Emerging Markets Finance and Trade, 47(1), 67–89. https://doi.org/10.2753/REE1540-496X470104
Ryan, J., Ulrich, J., Thielen, W., Teetor, P., & Bronder, S. (2019). Quantitative Financial Modelling Framework. R package version 0.4-15. https://cran.r-project.org/web/packages/quantmod/quantmod.pdf
Salma, U., & Hussain, A. (2018). A comparative study on corporate diversification and firm performance across South Asian Countries. Journal of Accounting and Marketing, 7(1), 263–269. https://doi.org/10.4172/2168-9601.1000263
Santillán-Salgado, R. J., Núñez-Mora, J. A., Aggarwal, R., & Escobar-Saldivar, L. J. (2019). Exchange rate exposure of Latin American firms: Empirical evidence. Journal of Multinational Financial Management, 51, 80–97. https://doi.org/10.1016/j.mulfin.2019.03.001
Sikarwar, E. (2018). Exchange rate fluctuations and firm value: Impact of global financial crisis. Journal of Economic Studies, 45(6), 1145–1158. https://doi.org/10.1108/JES-02-2017-0048
Sikarwar, E., & Gupta, R. (2019). Economic exposure to exchange rate risk and financial hedging: Influence of ownership as a governance mechanism. Journal of Economic Studies, 46(4), 965–984. https://doi.org/10.1108/JES-10-2017-0286
Singh, G. (2017). Estimating optimal hedge ratio and hedging effectiveness in the NSE index futures. Jindal Journal of Business Research, 6(2), 108–131. https://doi.org/10.1177/2278682117715358
Tang, B. (2019). Does the currency exposure affect stock returns of Chinese automobile firms? Empirical Economics, 57(1), 53–77. https://doi.org/10.1007/s00181-018-1437-4
Venegas-Martínez, F. (2006). Stochastic temporary stabilization: Undiversifiable devaluation and income risks. Economic Modelling, 23(1), 157–173. https://doi.org/10.1016/j.econmod.2005.09.004
Venegas-Martínez, F. (2008). Riesgos financieros y económicos: Productos derivados y decisiones económicas bajo incertidumbre (2 ed.). Cengage Learning.
Wei, K., & Starks, L. (2013). Foreign exchange exposure elasticity and financial distress. Financial Management, 42(4), 709–735. https://doi.org/10.1111/fima.12016
Allayannis, G. & Ofek, E. (2001). Exchange rate exposure, hedging and the use of foreign currency derivatives. Journal of International Money and Finance, 2(2), 273–296. https://doi.org/10.1016/S0261-5606(00)00050-4
Almudhaf, F. (2019). Pricing efficiency of exchange traded funds tracking the gulf cooperation countries. Afro-Asian Journal of Finance and Accounting, 9(2), 117–140. https://doi.org/10.1504/AAJFA.2019.099485
Anderson, B. P., Makar, S. D., & Huffman, S. H. (2004). Exchange rate exposure and foreign exchange derivatives: Do ineffective hedgers modify future derivatives use? Research in International Business and Finance, 18(2), 205–216. https://doi.org/10.1016/j.ribaf.2004.04.001
Anisak, N., & Mohamad, A. (2019). Foreign exchange exposure of Indonesian listed firms. Global Business Review. https://doi.org/10.1177/0972150919843371
Aysun, U. & Guldi, M. (2011). Derivatives market activity in emerging markets and exchange rate exposure. Emerging Markets Finance and Trade, 47(6), 46–67. https://doi.org/10.2753/REE1540-496X470603
Bae, S. C., Kim, H. S., & Kwon, T. H. (2018). Currency derivatives for hedging: New evidence on determinants, firm risk, and performance. Journal of Futures Markets, 38(4), 446–467. https://doi.org/10.1002/fut.21894
Bakshi, G. S., & Chen, Z. (1997). Equilibrium valuation of foreign exchange claims. Journal of Finance, 52(2), 799–826. https://doi.org/10.2307/2329499
Bartram, S., Brown, G., & Conrad, J. (2011). The effects of derivatives on firm risk and value. Journal of Financial and Quantitative Analysis, 46(4), 967–999. https://doi.org/10.1017/S0022109011000275
Bernal, L., & Venegas-Martínez, F. (2011). Impacto de los productos derivados los objetivos de política monetaria: un modelo de equilibrio general. Estudios Económicos, 26(2), 187–216.
Bhargava, V., & Malhotra, D. K. (2007). The relationship between futures trading activity and exchange rate volatility, revisited. Journal of Multinational Financial Management, 17(2), 95–111. https://doi.org/10.1016/j.mulfin.2006.05.001
Branger, N., Muck, M., & Weisheit, S. (2019). Correlation risk and international portfolio choice. Journal of Futures Markets, 39(1), 128–146. https://doi.org/10.1002/fut.21941
Brown, C. J., & Curci, R. (2002). Mexican peso futures and exchange rate volatility. Latin American Business Review, 3(1), 75–90. https://doi.org/10.1300/J140v03n01_04
Caves, R. E. (2007). Multinational enterprise and economic analysis. Cambridge University Press. https://doi.org/10.1017/CBO9780511619113
Chen, S.-S., Lee, C.-f., & Shrestha, K. (2003). Futures hedge rations: A review. Quarterly Review of Economics and Finance, 43(3), 433–465. https://doi.org/10.1016/S1062-9769(02)00191-6
Chkili, W. (2012). The dynamic relationship between exchange rates and stock returns in emerging countries: Volatility spillover and portfolio management. International Journal of Management Science and Engineering Management, 7(4), 253–262. https://doi.org/10.1080/17509653.2012.10671230
Cox, J. C., Ingersoll, J. E., & Ross, S. A. (1985). An intertemporal general equilibrium model of asset prices. Econometrica, 53(2), 363–384. https://doi.org/10.2307/1911241
Cuthbertson, K., & Nitzsche, D. (2004). Quantitative financial economics. Wiley.
Demange, G., & Laroque, G. (1999). Efficiency and options on the market index. Economic Theory, 14(1), 227–235. https://doi.org/10.1007/s001990050290
Duarte, J. B., & Mascareñas, J. M. (2014). Comprobación de la eficiencia débil en los principales mercados financieros latinoamericanos. Estudios Gerenciales, 30(133), 365–375. https://doi.org/10.1016/j.estger.2014.05.005
Dwumfour, R. A., & Addy, N. A. (2019). Interest rate and exchange rate exposure of portfolio stock returns: Does the financial crisis matter? Journal of African Business, 20(3), 339–357. https://doi.org/10.1080/15228916.2019.1583977
El Abed, R. (2017). Exploring the nexus between stock prices and macroeconomic shocks: Panel VAR approach. Economics Bulletin, 37(3).
Guay, W., & Kothari, S. P. (2003). How much do firms hedge with derivatives? Journal of Financial Economics, 70(3), 423–461. https://doi.org/10.1016/S0304-405X(03)00179-X
He, J., & Ng, L. (1998). The foreign exchange exposure of Japanese multinationals corporations. The Journal of Finance, 53(2), 733–753. https://doi.org/10.1111/0022-1082.295575
Hodder, J. E. (1982). Exposure to exchange-rate movements. Journal of International Economics, 13(3– 4), 375–386. https://doi.org/10.1016/0022-1996(82)90065-4
Hodrick, R. J., & Srivastava, S. (1986). The covariation of risk premiums and expected future spot exchange rates. Journal of International Money and Finance, 5(1), S5–S21. https://doi.org/10.1016/0261-5606(86)90015-X
Inci, A. C., & Lee, B. S. (2014). Dynamic relations between stock returns and exchange rate changes. European Financial Management, 20(1), 71–106. https://doi.org/10.1111/j.1468-036X.2011.00621.x
Jorion, P. (1990). The exchange-rate exposure of U.S. Multinationals. Journal of Business, 63(3), 331–345. https://doi.org/10.1086/296510
Kambi, K., & Ali, A. I. (2016). Effects of financial risk management practices on financial performance of listed banks at the Nairobi securities exchange in Kenya. International Journal of Business and Management, 4(4), 19–36.
Lee, B., & Suh, J. (2012). Exchange rate changes and the operating performance of multinationals. European Financial Management, 18(1), 88–116. https://doi.org/10.1111/j.1468-036X.2009.00522.x
Luo, H. R., & Wang, R. (2018). Foreign currency risk hedging and firm value in china. Journal of Multinational Financial Management, 47(48), 129–143. https://doi.org/10.1016/j.mulfin.2018.11.002
Mahapatra, S., & Bhaduri, S. N. (2019). Dynamics of the impact of currency fluctuations on stock markets in india: Assessing the pricing of exchange rate risks. Borsa Istanbul Review, 19(1), 15–23. https://doi.org/10.1016/j.bir.2018.04.004
Makar, S., & Huffman, S. (2008). UK multinationals’ effective use of financial currency-hedge techniques: Estimating and explaining foreign exchange exposure using bilateral exchange rates. Journal of International Financial Management and Accounting, 19(3), 219–235. https://doi.org/10.1111/j.1467-646X.2008.01022.x
Mo, G., Tan, C., Zhang, W., & Liu, F. (2019). International portfolio of stock indices with spatiotemporal correlations: Can investors still benefit from portfolio, when and where? North American Journal of Economics and Finance, 47, 168–183. https://doi.org/10.1016/j.najef.2018.12.002
Nguyen, H., Faff, R., & Marshall, A. (2007). Exchange rate exposure, foreign currency derivatives and the introduction of the euro: French evidence. International Review of Economics and Finance, 16(4), 563–577. https://doi.org/10.1016/j.iref.2006.01.002
Ozimkovska, V. (2018). Real financial market exchange rate volatility and portfolio flows. International Economics and Economic Policy, 15(2), 281–303. https://doi.org/10.1007/s10368-017-0405-3
Pérez-González, F., & Yun, H. (2013). Risk management and firm value: Evidence from weather derivatives. The Journal of Finance, 68(5), 2143–2176. https://doi.org/10.1111/jofi.12061
Roberts, M. R., & Whited, T. (2012). Endogeneity in empirical corporate finance. In G. Constantinides, M. Harris, & R. Stulz (Eds.), Handbook of the economics of finance (Vol. 2). Elsevier.
Rossi, J. L. (2011). Exchange rate exposure, foreign currency debt, and the use of derivatives: Evidence from Brazil. Emerging Markets Finance and Trade, 47(1), 67–89. https://doi.org/10.2753/REE1540-496X470104
Ryan, J., Ulrich, J., Thielen, W., Teetor, P., & Bronder, S. (2019). Quantitative Financial Modelling Framework. R package version 0.4-15. https://cran.r-project.org/web/packages/quantmod/quantmod.pdf
Salma, U., & Hussain, A. (2018). A comparative study on corporate diversification and firm performance across South Asian Countries. Journal of Accounting and Marketing, 7(1), 263–269. https://doi.org/10.4172/2168-9601.1000263
Santillán-Salgado, R. J., Núñez-Mora, J. A., Aggarwal, R., & Escobar-Saldivar, L. J. (2019). Exchange rate exposure of Latin American firms: Empirical evidence. Journal of Multinational Financial Management, 51, 80–97. https://doi.org/10.1016/j.mulfin.2019.03.001
Sikarwar, E. (2018). Exchange rate fluctuations and firm value: Impact of global financial crisis. Journal of Economic Studies, 45(6), 1145–1158. https://doi.org/10.1108/JES-02-2017-0048
Sikarwar, E., & Gupta, R. (2019). Economic exposure to exchange rate risk and financial hedging: Influence of ownership as a governance mechanism. Journal of Economic Studies, 46(4), 965–984. https://doi.org/10.1108/JES-10-2017-0286
Singh, G. (2017). Estimating optimal hedge ratio and hedging effectiveness in the NSE index futures. Jindal Journal of Business Research, 6(2), 108–131. https://doi.org/10.1177/2278682117715358
Tang, B. (2019). Does the currency exposure affect stock returns of Chinese automobile firms? Empirical Economics, 57(1), 53–77. https://doi.org/10.1007/s00181-018-1437-4
Venegas-Martínez, F. (2006). Stochastic temporary stabilization: Undiversifiable devaluation and income risks. Economic Modelling, 23(1), 157–173. https://doi.org/10.1016/j.econmod.2005.09.004
Venegas-Martínez, F. (2008). Riesgos financieros y económicos: Productos derivados y decisiones económicas bajo incertidumbre (2 ed.). Cengage Learning.
Wei, K., & Starks, L. (2013). Foreign exchange exposure elasticity and financial distress. Financial Management, 42(4), 709–735. https://doi.org/10.1111/fima.12016