The Market Premium of Foreign Exchange Exposure in the Use of Derivatives

Existing methods of measuring firms’ foreign exchange exposure can explain the mechanism of foreign exchange exposure, but there is still a limitation on answering how much foreign exchange exposure is appropriate to individual firms. Thus, this study derived the market premium of foreign exchange exposure, an indicator for the degree of foreign exchange exposure, by the ratio of foreign exchange exposure of companies recognized in the market about the sensitivity of the operating profit to the exchange rate that the company inherently possesses. Based on this, we defined and categorized companies with low foreign exchange exposure ratio as companies with under-identified, while companies with the high ratio as companies with over-identified to exchange exposure. Then we examined whether major financial exposure management tools like foreign currency assets(or debts) and derivatives assets(or debts) work effectively in each categorized firm groups. Main result is that for firms over-identified to exchange exposure, increase in foreign currency denominated debts lowers the market premium , while increase in foreign currency denominated assets increases the market premium due to the increased anxiety of investors about the liquidity. Second, unlike the conclusion of the previous studies that derivatives are appropriate tools for foreign exchange control, for companies with under-identified to exchange rate exposure, it rather provides false signals to the market and increase the market. Finally, the effect of the natural hedge which comes from firm size is not applied to over-identified firms, but it lowers the market premium only to the companies with under-identified.