u—p— ——-—_ , v . -1 _ p r : .; .. '-.- -’ . ,.- «ii ' .‘ ' in} - -. “~. - «I c » ”v 3:39 w This is to certify that the dissertation entitled Corporate Hedging Strategies in the Foreign Exchange Forward Markets presented by Carl H. Walther has been accepted towards fulfillment of the requirements for Ph. D. . Finance & Insurance degree in lzglgégg.zi [Cféfl4¢¢—/ M es S. Delano Av Major professor 11/11/83 Date MSU is an Affirmative Action/Equal Opportunity Institution 0-12771 a RETURNING MATERIALS: hiSU Place in book drop to ngRARJES remove this checkout from m your record. FINES will be charged if booiflis returned after the date stamped below. CORPORATE HEDGING STRATEGIES IN THE FOREIGN EXCHANGE FORWARD MARKETS By Carl H. Walther A DISSERTATION Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Finance and Insurance 1983 Copyright CARL H. NALTHER 1983 ABSTRACT CORPORATE HEDGING STRATEGIES IN THE FOREIGN EXCHANGE FORWARD MARKETS By Carl H. Halther Recent research on strategies to hedge foreign exchange risk in the foreign exchange forward markets has concentrated on the performance of hedges based on portfolio theory. This study extends previous work to examine the hedging effectiveness of portfolio hedges in the foreign exchange forward markets. The relative ability of three non-speculative hedging strategies to reduce foreign exchange risk as the result of holding a foreign currency denominated cash position is examined for British pounds and Deutsche marks for the time period following the introduction of the free-floating currency pricing system for 1974-1982. To evaluate the performance of each hedging strategy, a returns model was developed with which to measure individual hedging strategy outcomes adjusted for the transaction cost of hedging and a risk premium. Carl H. Walther These hedging outcomes were evaluated based on the assump- tion that the hedger is risk-averse and seeks to minimize the possibility of negative hedging returns. A modified version of the Fishburn alpha-t model was employed to evaluate each hedging strategy. The results of the study provide evidence for the rejection of the research hypothesis that portfolio-based hedges are more effective than either traditional or naive hedging strategies. Evidence is also provided for the rejection of a minor research hypothesis that traditional hedges are more effective than naive hedges. Portfolio hedges were found to be less effective than traditional hedges, and traditional hedges were found to be less effective than naive hedges in reducing the risk weighted likelihood that hedging returns would fall below a zero return from holding a foreign currency denominated cash position over a period of time. A direct comparison of the variances of return showed that portfolio based hedges generated greater return variances for both currencies, time periods and hedge durations than did either one of the two competing hedges. The conclusion of such findings is that the hedging methodology implied by portfolio theory, when employed in the foreign exchange forward markets, is not effective in either reducing foreign exchange risk as defined in Carl H. Nalther this study or in minimizing the variance of return of portfolio hedges. The implications of the results are twofold. 0n the microeconomic level. non-speculative corporate hedgers will be able to minimize their foreign exchange risk expo- sure by employing the naive hedging strategy. Under the assumption that the empirical findings can be generalized to other time periods and currencies, the naive hedging strategy would be the most effective hedging strategy in reducing foreign exchange risk as measured by risk- weighted returns below the return of a perfect hedge. 0n the macroeconomic level, the study lends sup- port to the proponents of a fixed currency pricing system who contend that the free floating pricing system creates future price uncertainties and, therefore, hinders the development of international trade. The results of this study show that none of the three non-speculative hedging strategies allows for the complete elimination of foreign currency price risk. The new system also has contributed additional costs to international trade activities in the form of transaction costs and risk premiums which result from implementing hedging programs. ACKNOWLEDGMENTS I wish to express my appreciation to the members of my dissertation committee, Dr. Myles S. Delano (Chair- man), Dr. Larry J. Johnson and Dr. Dennis Gilliland, for their guidance, encouragement, and aid in completing this dissertation. I am especially grateful to Dr. Delano for his valuable advice and guidance throughout my entire pro- gram and to Dr. Gilliland for his technical advice. I would like to thank Dr. Raymond Schmidgall for his advice and support which helped to obtain much needed financial assistance. Thanks are due to Mrs. Jo McKenzie for typing the final draft of this dissertation. Finally, to my parents, for their support, kindness, and encouragement, I dedicate this dissertation. iii TABLE OF CONTENTS LIST OF TABLES. Chapter I. INTRODUCTION Objectives of the Study. Importance of the Study. . The Theory of Hedging and Speculation . . Literature Review. Forecasting Foreign Exchange Rates:. Theory and Empirical Evidence Foreign Exchange Risk Management: Theory and Empirical Evidence . Summary. II. A MODEL FOR MEASURING HEDGING RETURNS. Factors Relevant to the Study. Non-Speculative Hedging Strategies Identified . A Hedging Returns Model. . . Determination of the Optimal Hedge Ratio . Summary. III. A MODEL FOR MEASURING HEDGING EFFECTIVENESS . . . . Risk and Return Preferences of Hedgers . . Hedging Effectiveness Defined. A Measure of Hedging Effectiveness Summary. . . . . . . IV. RESEARCH HYPOTHESES AND DESIGN Research Hypotheses. Research Design. iv Page vi —l .4 DON 01¢» 20 25 27 28 29 32 37 39 Chapter Sample and Data Source Time Period. . Methodology. . Estimation Procedure for the Portfolio Hedge Ratio . . Estimation Procedure for Hedging Effectiveness . . . . . . Summary. V. FORWARD MARKET HEDGING EFFECTIVENESS Period I Hedging Effectiveness . Period II Hedging Effectiveness. Effectiveness of Different Hedging Durations . . Direct Test of Portfolio Theory of Hedging. . Summary. VI. CONCLUSIONS. Summary of Findings - Portfolio Hedges. . Summary of Findings - Traditional Hedges. . Results of the Study . . Implications of the Results. . Suggestions for Future Research. APPENDIX A, An Analysis of the Hedging Effective- ness of Traditional Hedges. . B Listing of Program to Determine the Optimal Sample Size for the Initialization of 2* . C Listing of Program to Calculate the Hedging Strategy Return . . D Listing of Program to Calculate the Measure of Hedging Effectiveness e. BIBLIOGRAPHY. Page 52 54 54 57 58 60 GT 65 7O 7l 72 77 87 91 94 98 100 LIST OF TABLES Table 1 Estimates of e ratios for period I British pound forward market hedges. 2 Estimates of e ratios for period I Deutsche mark forward market hedges. 3 Estimates of e ratios for period II British pound forward market hedges. 4 Estimates of e ratios for period II Deutsche mark forward market hedges. 5 Standard deviations of return for British pound and Deutsche mark non-speculative forward market hedges in periods I and II vi Page 62 63 66 67 73 CHAPTER I INTRODUCTION A firm is exposed to foreign exchange risk if it makes or receives payments in a currency different from its own functional currency. This risk is the result of two factors: First, financial decisions and the resulting payment flows are generally separated by a period of time. Second, the price of the underlying foreign currency is likely to change during that time. During past periods of fixed or pegged exchange rates (such as the Bretton Woods period from 1944-l973), firms faced very little foreign exchange risk. Prices of foreign currencies maintained a fixed relationship to each other. Price changes occurred relatively infrequently and were predictable to a useful degree of accuracy. The environment in which most firms made their decisions featured national governments pledging to maintain exchange rates within small margins around a target rate or par value through agreements within the International Monetary Fund (I.M.F.). This par value could be changed whenever a country's balance of payments moved into disequilibrium and when it became clear that alternative policies (such 2 as internal deflation and/or controls) were ineffective or politically infeasible. Such a disequilibrium condition was then defined as being “fundamental" by the I.M.F., and the country was exempted from its obligation to defend its par value. The country, after negotiating with its major trading partners, then revalued or devalued its currency and declared a new par value. Forecasts of price changes under the fixed parity system were fairly easy and accurate. They were based on a) the pressure on a currency price as a result of balance of payment difficulties; b) the amount of foreign exchange reserves the country held; and, c) the policy (such as ex- change controls or devaluation) the country chose to return its currency to equilibrium. The fixed parity system also significantly reduced the downside risk of a price change forecast, since the price either did or did not change in the predicted direction. With the advent of an exchange rate system of continuously floating rates in l973, the need for foreign exchange price change forecasts increased significantly. Simultaneously, the ability to forecast price changes was strongly reduced, since the variables used under the Bretton Woods system to forecast price changes had lost their predictive power. Monetary authorities relied more strongly on the equilibrating process, which was facilitated by freely floating rates. While a devaluation was formerly considered bad, it became a desirable means by which to return to a balanced payment account. The phenomenon of freely floating exchange rates, the movement of which seems characterized by a random walk, has raised such questions as: Can future price changes be forecasted accurately? How should a firm manage its exposure to foreign exchange risk if forecasts are not possible? These questions have led to numerous studies on forecasting foreign exchange prices and foreign exchange risk management, with conflict- ing results. In general, the results tend to support the view that foreign exchange rates cannot be forecasted accu- rately. However, market participants often behave as if they possess accurate forecasts. Disagreement also con- tinues to exist regarding the optimal form of risk exposure management. Objectives of the Study This research will examine the effectiveness of different strategies of foreign exchange risk management under the assumption that foreign exchange rates cannot be predicted accurately enough to eliminate foreign ex- change risk. The effectiveness of non-speculative hedging strategies such as naive or traditional hedging, which are widely practiced by American corporate executives (Rodriguez and Carter, 1978, 1979; Jilling, l978), is hypothesized to be higher than for hedges based on portfolio theory. This hypothesis is contrary to the findings of Dale (1981), Naidu and Shin (1981) and Hill and Schneeweis (1982a, 1982b), who found the hedging effectiveness of variance— minimizing portfolio hedges to be superior to naive hedges. This study, however, will not necessarily present support for or refute earlier findings of hedging effective- ness. In contrast to previous studies, the current study will employ a measure of hedging effectiveness that attempts to incorporate hedger's risk and return preferences as well as the cost of hedging. The reduction of variance of port- folio return was interpreted as hedging effectiveness which, in this study, is seen as minimizing the likelihood that hedging returns will fall below a target return. Furthermore, this study examines the performance of different non-speculative hedging strategies using the foreign exchange forward market. Dale (1981), Naidu and Shin (1981), and Hill and Schneeweis (1982a, 1982b) tested the hedging performance of different hedging strategies in the foreign exchange futures market. The forward and futures markets differ in two significant practical trading aspects. The futures market is easily accessible to anyone, but unit contract sizes for each foreign currency are rela- tively large and indivisible. In addition, forward markets are only accessible to trustworthy bank customers, but the unit contract sizes for each currency are negotiable and may be fit to the needs of the foreign exchange risk manager. Finally, the current research will contribute in- formation on the risk component introduced with free- floating foreign exchange rates. With the abandonment of the Bretton Woods system in 1973, foreign exchange rates have started to fluctuate widely relative to each other. The loss of stability and forecasting ability has led to successful introduction of the foreign currencies futures markets and increased use of foreign currency forward mar- kets. Both markets are employed frequently by corporate executives in their attempt to hedge the value of foreign currency cash positions. The proponents of the Bretton Woods system contended that the introduction of floating exchange rates, as a new risk component-foreign exchange risk, would represent a major barrier to international trade. A significant increase of both international trade and employment of the forward and futures markets by cor- porate hedgers has been observed since changing to the new system. Three non-speculative hedging strategies are identi- fied that are available to risk-averse hedgers. Any evi- dence that applying such non-speculative hedging strate— gies does not lead to the elimination of foreign exchange risk will support the arguments of those advocating that a system such as Bretton Woods facilitates international trade. Chapter II presents a model for measuring hedging returns and the relevant theories and concepts. Specifi- cally, three non-speculative hedging strategies will be discussed and the cost of hedging will be incorporated in the return measure. Chapter III presents a model for measuring hedging effectiveness under specific assumptions of risk and return preferences of non-speculative hedgers. Chapter IV outlines the research hypotheses and procedures to be applied in the testing of the hypotheses. Chapter V discusses and evaluates the results of the tests performed for short- and intermediate-term hedging durations. Finally, Chapter VI presents the summary of find- ings, conclusions and implications, and suggestions for future research. Importance of the Study The importance of the study is twofold. On the microeconomic level, the non-speculative hedger is interested in identifying the one hedging strategy with the greatest potential for protection against a loss in value of the cash position held. As Kenyon (1981) points out, foreign exchange risk follows a life cycle from con- ception to birth and finally death. During this life cycle, the business firm is exposed to foreign exchange risk in that the value of underlying currency of trade will likely change from conception to death. On the macroeconomic level, the research findings may provide information about the increase in foreign ex- change risk since the introduction of the free-floating system. Findings regarding the inability of all non- speculative hedging strategies to reduce or eliminate risk may help to provide information about the adequacy of the current system with respect to trade practices. The Theory of Hedging and Speculation According to Ederington (1979), the classic eco- nomic rationale of forward or futures markets is to facili- tate hedging. The hedger is one whose primary business activity is to receive compensation for the storage of a commodity. Since the hedger is exposed to the risk that the price of the commodity will change during the holding period, he is likely to use the forward or futures market to transfer this risk to speculators. The hedger is generally described as an unsophisticated commodity market participant who, in the words of Hawtrey (1940), "regards the making of price as a wholetime occupation for experts [speculators?] and in general will not pit his fragmented information against the systematic study at the disposal of professional dealers." The speculator is a person whose primary business activity is to assume the risk rejected by the hedger, for which he is compensated. Despite such clear-cut descriptions and definitions of roles, Working (1953) observed that hedgers are part of the time speculators and vice versa. Such a mixed role play apparently seems possible in commodity markets. Traders in such markets are assumed to have gained suffi- cient understanding of the pricing mechanism from their active market participation such that they are able to predict price changes with above-average success. Although the literature does not agree as to what hedging is or why it is undertaken (Working 1962), three hedging theories have evolved: the traditional theory, the theories of Holbrook Working, and the portfolio theory. The traditional theory (which predates Working's theory) visualizes the hedger as a primary market commodity dealer who desires insurance against the price risk from holding this commodity. According to this theory, the hedger is assumed to protect himself against price changes by selling a sufficient number of futures/forward contracts to cover his inventory position. At maturity, he simultaneously liquidates both his inventory and futures or forward market position. Any loss (gain) from inventory position would be exactly offset by a gain (loss) realized in the futures market, leaving the hedger with normal compensation for storage of the commodity. The perfect hedge, one in which gains in one market are exactly offset by losses in the second market, is only possible if the exact price rela- tionship between the spot future prices is maintained over the hedging period. The perfect hedge requires that the change in the basis is zero: AB = ABasis = O (l) where: B = Pj,t - P1,t AB ‘ (Pj,t+l Pi,t+l) "(Pj,t ‘ Pi,t) Pi,t’Pj,t = spot, forward rate at period t P P = spot, forward rate at period t+l. i,t+l’ j,t+l The assumption necessary for (l) to hold true is that the correlation coefficient between the spot price changes and the forward price changes is equal to 1. Working (1953) pointed out, "A major source of mistaken notions of hedging is the conventional practice of illus- trating hedging with a hypothetical example in which the price of the future bought or sold as a hedge is supposed to rise or fall by the same amount that the spot price lO rises or falls." He challenged the traditional view that hedgers are pure risk minimizers, and envisioned hedgers as being part-time speculators who selectively hedge only those positions which, in their Opinion, show a potential loss. Hedgers thus base their decision on the expected value of the change of the basis, and take short or long positions in the futures markets to either hedge or specu- late on price changes accordingly. Hedgers do not pri- marily seek to avoid risk, but make their decision based on expected returns arising from anticipation of favorable relative price movements in the spot and forward markets. As Working (1953) suggested, "The effectiveness of hedging intelligently used with commodity storage, depends on in- equalities between the movement of spot and futures prices and on reasonable predictability of such inequalities." The critical assumption of Working's speculative theory of hedging is that inequalities between the move- ment of spot and futures prices are predictable. This assumption appears to have been satisfied during the Bretton Woods system where directions of foreign currency price changes were reasonably predictable. The change to a floating system of foreign currency prices in 1973 seems to have altered the pricing mechanism of foreign currencies dramatically. The question is to which degree Working's critical assumption-that price changes are predictable- 11 holds under the new system of floating exchange rates.1 A major reformulation of the theory of hedging is offered by Johnson (1960) and Stein (1961). The authors showed that both the risk avoidance approach of tradi- tional hedging theory and the profit maximization approach of Working's theory could be combined in an adjusted form of Markowitz's portfolio theory of holding securities. A hedger could hold a position in the spot market (the pri— mary market) and a certain percentage of his spot market holding in the futures or forward market. Price risk is then seen as the variance of the subjective probability distribution of returns of such a two-assets portfolio from period t to t+l. The minimization of variance of return of such a two-assets portfolio is assumed to be the primary objective of hedging. In mathematical terms, the variance of return of such a portfolio would be minimized by holding 2* percent of the spot market position in the futures or forward market where 2* = Cov1 . (2) Varj and Covi. = subjective covariance between 3 the future futures or forward market price changes and the spot market price changes and 1See theory and empirical evidence on forecasting foreign exchange prices in the following literature review. 12 Var. = subjective variance of the future futures or forward market price changes. Traditional hedging theory assumed (1): AB = O + Covi’j = Varj (3) and Cov. . 2*: ..._?_LJ. :1 Varj ’ whereas portfolio theory allows for a change in the basis from period t to t+1 and assumes as; 0+C—%1;1, (4) J but is the portfolio variance-minimizing hedge ratio. Thus, traditional hedging theory is a special case of port- folio theory. Therefore, a hedger who naively sets the hedging ratio 2 = 1 according to traditional hedging theory would, according to portfolio theory, either overhedge (if the variance minimizing ratio 2* < 1) or underhedge (if 2* > 1), and thus not minimize the variance of return of his two-assets portfolio. 13 Literature Review Studies on the management of foreign exchange risk have focused on several related areas. Of foremost impor- tance is the question whether, how, and to what degree of accuracy foreign currency price changes can be forecasted in a managed float system. If it is found that price changes cannot be forecasted accurately, the question arises: how should corporate executives manage the foreign exchange risk to which they are exposed? The remaining parts of this section provide a discussion of the theory and the empirical research undertaken. Forecastigg Foreign Exchange Rates: Theory and Empirical Evidence Dufey and Mirus (1981) provide an overview of the various forecasting techniques and their underlying models and assumptions. The models are divided according to their assumptions and techniques into informal and formal models. 1. Informal models, generally unspecified, are engrained in the minds of long-term observers of the process that generates price changes. The forecaster develops a "gut feel" for the implications of new economic and political information on the future spot rate. Informal models are very complex and often indescrib- able to the outsider. 2. Formal models can be further subdivided into 14 extrinsic and intrinsic models. Extrinsic models are based on causal relationships be- tween two or more exogenous variables, whereas intrinsic models rely on statistical relation- ships between the variables to be forecast and past values of the same series. Extrinsic models are further subdivided into categories of exogenous variables employed in forecasting exchange rates: models based on the balance of payments analysis, models of the national economy focusing on changes in aggregate demand, and models based on the aggregate supply of money to the economy. One model has gained significant recognition and has been tested extensively according to Morgan (1981). This model depicts the expected rate of change of the spot exchange rate as a result of the expected inflation rate differential between the two countries, the forward exchange premium or discount of the foreign currency, and the difference in interest rates between the two countries. Five theories underly these relationships: 1. The Purchasing Power Parity (PPP) theory states that the rate of change in the exchange rate between two countries tends 15 over time to equal the differential inflation rate between the two countries' currencies. The Fisher Closed Effect states that nominal interest rates in both countries are equal to the required rate of return to the investor plus the expected rate of inflation in each country. The Fisher Open Proposition postulates that differences in nominal interest rates on similar assets denominated in several currencies reflect the antici- pated rates of change in the exchange rates. The Theorygof Interest Rate Parity (IRP) relates the forward exchange rate to the nominal interest rate differentials on similar assets denominated in different currencies. The forward exchange rate is at 'interest rate parity' when the interest rate differential is equal to the forward rate discount or premium. The Forward rate as an unbiased predictor of the future spot rate assumes that foreign exchange markets are reasonably 16 efficient and all new relevant infor- mation is quickly and completely reflected in both forward and spot exchange rates. Further, this theory holds that these rates are always an adequate reflection of the equilibrium position of supply and demand. All extrinsic models depict the future exchange rate as the dependent variable and a series of exogenous and endogenous variables as the independent variables. These econometric models were very successful in predicting future price changes during the Bretton Woods system, since government action created a predictable lag effect. Intrinsic models attempt to use information from past price changes to predict future changes. The challenge is to identify the underlying processes that generate new data. These models range in sophistication from charting trend analysis to various time series models (such as moving averages, Box Jenkins forecasting techniques, and momentum models). The problems of intrinsic models lay in the presumption that past relationships will prevail in the future and in the lack of cause and effect understanding. Morgan (1981) provides an overview of the tests to which various theories have been exposed and summarizes the conclusions drawn. The ability of these theories to explain exchange rate changes is limited in the short run, but tends 17 to increase with the length of the forecasting horizon. Particularly, the forward rate appears to be a fairly good predictor of spot rates at one to three months ahead but rather a poor predictor thereafter, whereas the forward rate is an unbiased predictor of the future spot rate in the very long run. Thus, in this case, an equal chance exists for the future spot rate to be above or below the forward rate. Different tests are available for measuring the performance of currency price change forecasts. In assess- ing forecasting accuracy, a distinction is made between two types of forecasting errors: dimensional and directional. Dimensional forecasting errors (errors in point estimation) miscalculate the magnitude of the deviation between the prediction and the actual spot rate. Directional fore- casting errors occur when the directional prediction is on the wrong side of both the forward rate and the actual spot rate. Also, different scales of measurement (such as returns from a buy and hold strategy or the performance of the forward rate) can be adopted when measuring performance. Levich and Wihlborg (1980) analyzed the accuracy of a wide range of foreign exchange forecasts prepared by thirteen U.S. advisory services. They neglect to describe the theoretical models used by different services. One-, three-, six-, and twelve-month forecasts were analyzed according to accuracy of the forecast, and speculative 18 profits based on these forecasts were calculated. Based on the analysis of mean squared forecast errors, their re- sults suggest that most forecasts were not as accurate as the forward rate. Their analysis of speculative returns, however, seems to suggest that some advisory serVices did better than the forward rate. Levich and Wihlborg raise the question of whether these abnormal returns would per- sist after adjusting them for risk. King (1978) aggregated forecasts of nine advisory services to form an average "professional" forecast. He found that during the period 1976-1 to 1977-111, his pro- fessional average was superior to the forward rate forecast only for the Deutsche mark. King suggested that this was a surprising result, since the market for Deutsche mark is considered very active and speculators would be expected to act such that the information in the forecast would quickly be reflected in the forward rate. Goodman (1979) analyzed six medium-term advisory services that built their forecasts on extrinsic (econo- metric) models, as well as four short-term technical advisory services that built their forecast on intrinsic (technically oriented decision rules derived from past behavior) models. The ten services were evaluated on the basis of their predictive accuracy for six frequently traded currencies against the dollar for forecasts of three and six months. Goodman found that, while the economically 19 oriented services appeared no more accurate than the for- ward rate, the technical services performed remarkably well on the average, although not consistently for all six currencies or different time periods. Goodman neglected to adjust the returns for risk. Ensor and Clarke (1979) tested the forecasting per- formances of fourteen major currency advisory services. Point estimates for three major currencies for a twelve- month period (July 1978 - July 1979) were compared. Their findings indicate the general inability of the average service to outperform the forward rate. They conclude, "If adjusted for the cost of information of the various ser- vices, only two services would have paid for their keep." Also, no attempt has been made to adjust returns for risk. Euromoney (l978a, l978b) conducted a major survey of international treasurers of more than 250 of the world's largest companies in order to evaluate the quality of fore- casting services purchased from foreign exchange advisory businesses. In summarizing the results from these surveys, they indicated that most treasurers felt they could not rely to any reasonable degree on the forecasts that were purchased as part of a package of advisory services. Many complained that their in-house forecasts were more reliable than those of the advisory services. The majority indicated that they implemented the forecasts provided about 50 percent of the time, whereas the remaining 20 minority stated that the provided forecasts were used only 20 percent of the time. Bilik (1982) compared the relative accuracy of pre- dictions made by a group of foreign exchange services to the forecasts implied by the forward rate from 1974 to 1980. His empirical findings suggest that forward rates do as well as or better than professional forecasters. Paired t-tests showed that only 16 percent of the significant statistics favor directional industry forecasts, while 84 percent favor using forward rates. The analysis also revealed no statistically significant performance differ- ences existed across services. The forecasting performance of dimensional accuracy increased with the forecasting horizon, while directional accuracy decreased. In summary, the empirical evidence seems to indi- cate that professionally provided forecasts based on the various theories and models do not seem, and are not per- ceived by their users, to perform better than simple market-based forecasts such as a buy and hold strategy or the foreign exchange forward rate. Foreingxchapge Risk Mana ement: Theory and Empirical Ev ence The objective of this research is to explore the effectiveness of different non-speculative hedging strate- gies in reducing a firm's transaction exposure. Wihlborg (1980) defines transaction exposure as the uncertain 21 domestic currency value of an open position denominated in a foreign currency with respect to a known transaction; that is, a future foreign currency-denominated cash flow. The traditional insurance theory of forward ex- change argues that the appropriate level to cover such a transaction exposure is the full amount of the exposure. This strategy is generally referred to as "naive" hedging; its usefulness has been challenged on theoretical grounds by several authors. Folks (1973) suggests that the optimal level of coverage for such a transaction exposure can be found by psotulating a utility function as describing the risk preferences of the decision maker. Each possible level of corporate earnings resulting from different preojected ex- change rates and coverage levels is assigned a utility value. The expected utility (the result of multiplying exchange price probabilities and utility values) is used then as the decision rule for the optimal level to cover the exposure. Wheelwright (1975) discusses the practical trans- action exposure problem faced by an occasional large order exporter. Using decision analysis, he suggests establish- ing a decision tree. The knowledge of the decision maker's personal preference curve allows the conversion of expected outcomes into certainty equivalents, which build the basis for the hedge decision. 22 A refinement of the decision analysis approach is used by Kohlhagen (1978) and Makin (1978). Kohlhagen assumes that the firm holds a portfolio of foreign cur- rencies transaction exposures. For the management of such a vector of transaction exposures, he develops a decision- 1-1 x Ni-l theoretic payoff matrix of profits of N outcomes over all sets of possible exchange rates (where each cur- rency can take N different values) and over all strategies (each of which is optimal for one set of future exchange rates). The firm would then use a decision rule (such as a maximax or maximin strategy) in order to select the optimal level of coverage. This approach is based only on reasonable ranges of future exchange rates. Kohlhagen's model appears theoretically inferior since it does not formally treat risk preferences or account for the statis- tical relationships among different foreign exchange rates. It seems, however, to appeal from a managerial point of view because of the limited information input required. Similar to Kohlhagen, Makin (1978) sees the firm as holding a portfolio of transaction exposures in the form of accounts receivables and payables denoted in different cur- rencies. He makes the assumption that changes of foreign exchange rates are normally distributed and that the matrix of variances and covariances of all future exchange rates is stable and known at the outset. Using portfolio theory, Makin then derives an efficient frontier of optimal 23 portfolios of shares of exposures based on the firm's mean profit and variance of profit. Although theoretically strong, the practical application of his model is limited due to the rather constraining assumptions that price changes of foreign exchange rates are normally distributed and that the variances matrix is known 35 EELS and stable. Levi (1979) shows that in a world in which the matrix of cross-elasticities between exchange rates is fully known at the outset of the exposure horizon, it is possible to fully cover the entire portfolio of transaction exposures through only one forward contract. Since cross- elasticities between foreign currency movements are stoch- astic rather than deterministic, the operational value of this approach is limited. All of the above decision theories designed to determine the optimal coverage level make rather limiting assumptions: that forecasts are available on price ranges, variances of price changes, currency prices, or cross- elasticities; and that investors' preferences are not con- sidered, or their utility functions are quadratic, or exchange price changes are normally distributed. Recent approaches, which do not depend on currency forecasts, have been suggested and empirically tested by Dale (1981), Naidu and Shin (1981) and Hill and Schneeweis (1982a, 1982b). All approaches assume a portfolio consisting of two cash assets, including the actual exposure held in the spot 24 market and an offsetting transaction held in the forward or futures market. The coverage hedge ratio that minimizes the variance of return of such a two-assets portfolio is considered optimal. Hedging effectiveness of this cover- age strategy was measured by comparing the reduction in variance of return 01’ such a portfolio to the variance of return of’ an unhedged position. All authors found that for different currencies and time periods, a significant reduction in variance could generally be obtained by employ- ing the portfolio-generated coverage ratio. Although strong from the viewpoint of practical usefulness (since no currency forecasts are necessary), the portfolio approach fails to provide a theoretical framework within which to determine the sample size for the optimal hedge ratio. Furthermore, the reduction in variance of returns is assumed to be the only objective or preference of hedgers. The reduction in variance may or may not be a good measure of hedging effectiveness, since it ignores actual return levels and the cost of hedging. Rather, it assumes that hedgers either have quadratic utility func- tions or that exchange rates are normally distributed. Empirical evidence on the risk and return prefer- ences of corporate treasurers and their practices of managing their transaction exposure is rather limited. Rodriguez (1978) surveyed risk and return prefer- ences of financial officers of seventy-five U.S. 25 multinational corporations, and found asymetrical atti- tudes toward foreign exchange risk. Under varying assump- tions about future currency devaluations, managers indi- cated that their decision would be either not to cover at all or to cover fully their transaction exposure, depend- ing on the likelihood of devaluation. Jilling (1978) interviewed financial officers of 102 U.S. multinational corporations to obtain empirical evidence of foreign exchange risk management practices. His findings showed that 36 percent of the respondents covered their foreign exchange exposure fully all the time, 37 percent covered a portion of the total exposure (various levels), and 12 percent covered more than 100 percent. Summary Foreign exchange risk appears to have become a sig- nificant additional risk component since the advent of free-floating exchange rates. The forecastability of foreign exchange rates for the purposes of eliminating this new risk component appears to be rather limited, a conclusion that is supported by empirical evidence. Even sophisticated professional forecasting services that use a variety of different forecasting models do not show better forecasting performance than "naive" forecasts such as the forward rate. On theoretical grounds, a variety of decision- making approaches has been suggested to determine the 26 optimal coverage level of a firm's transaction exposure. From limited empirical evidence, it seems that corporate treasurers belong to one of two schools of thought: those who believe that foreign exchange forecasts are possible and the coverage decision is a function of the forecast; and those who do not believe that sufficiently reliable forecasts are available and who, therefore, fully cover their transaction exposure to foreign exchange risk. The current study will make the assumption that foreign exchange rates cannot be forecasted sufficiently accurately to provide useful information for the management of risk exposure. Different hedging strategies are evalu- ated using a measure of hedging effectiveness that appears to incorporate risk and return preferences of non- speculative hedgers. CHAPTER II A MODEL FOR MEASURING HEDGING RETURNS This study examines the hedging effectiveness of non-speculative hedging strategies. If it is found that the hedging strategies differ in degree of hedging effec- tiveness, then such information may be used by non-specu- lative corporate treasurers to develop hedging programs for their foreign exchange risk exposure. The method of measuring hedging effectiveness employed in this study will differ in two ways from that used by Dale (1981), Naidu and Shin (1981), and Hill and Schneeweis (1982a, 1982b). First, a model for measuring hedging returns will be developed which, contrary to the analysis of the above authors, will explicitly measure the rate of return from a hedging strategy and adjust the rate of return to account for the cost of hedging. In the next chapter, a measure of hedging effectiveness will be derived based on the returns model that will be employed to determine the effectiveness of different non-speculative hedging strategies. This second measure of hedging effec- tiveness will incorporate hedging returns, transaction costs, and risk and return preferences of corporate non- speculative hedgers. 27 28 Factors Relevant to the Study The term "non-speculative hedging" is employed in this study to refer to the activity of reducing or possibly eliminating the foreign exchange risk resulting from a transaction exposure. Kenyon (1981) identifies the three stages of the life cycle of such a transaction exposure as: Conception: when the firm commits itself to a currency mismatch, such as through a tender for a contract or a price offer or price list denominated in a foreign currency. 81535: when the commitment becomes a com- mercial or contractual reality. Eggtp: the end of the exposure, when the firm is free to convert the receipt or payment into the other currency and can measure the final cash gain or loss. Kenyon points out that the firm faces the problem of identifying at what point in the life cycle the cover- age or hedge for the transaction exposure should begin. This difficulty is the result of rising hedging costs, which the firm views as the price for being relieved of foreign exchange risk. However, if the firm decides to hedge the exposure at conception, it will incur hedging costs for an expected transaction exposure, which may or 29 may not materialize. The final hedging cost per actual transaction exposure thus rises above the level that would have resulted from only hedging already existing transac- tion exposures. If, on the other hand, the firm decides to wait with the hedge until birth of the transaction expo— sure, it is exposed to a possible currency price change and cash loss. For the purpose of developing a model with which to measure hedging returns, it is assumed either that the time period between conception and birth is small enough to minimize the likelihood of price change, or that prices are quoted conditionally until the birth of the transaction exposure. Non-Speculative Hedging Strategies Identified Whenever a firm receives (or has to make) payment in a foreign currency due to international trade activity, it is exposed to foreign exchange risk. A cash position, therefore, is established in period t (the birth of the transaction exposure), which consists of XFc units of foreign currency to be received/paid in period t + l (the death of the transaction exposure). The price value of this foreign currency cash position denominated in domestic currency will change from period t to period t + l as the result of a price change of the underlying foreign currency during the same period. A non-speculative firm will con- sider a transaction exposure management program having the 30 potential to preserve the value of this cash position denominated in domestic currency over the exposure life cycle. Using the foreign exchange forward market, the firm can employ one of the following three alternative hedging strategies, which are not based on speculative price fore- casts: Stratpgy A: At period t, the amount of the cash position, XFC’ is sold/bought forward to period t + 1. At period t + l, the cash position is liquidated and employed to settle the forward contract. Strategy 8: At period t, the amount of the cash position, XFC’ is sold/bought forward to period t + 2. At period t + l (the maturity date of the cash position), an equal amount, XFC’ is bought/ sold forward to period t + 2. A translation gain/ loss is realized from holding the cash position in the spot market from period 't to period t + 1, which is equal to: translation gain/loss = XFCISPi,t+l'SPi,t] (5) where sP1 t ' spot sell exchange ’ rate of the foreign currency at period t sPi t+l = spot sell exchange ’ rate of the foreign currency at period t + 1. 31 At the same time, a hedging gain/loss is realized from holding XFc units of foreign currency in the forward marekt from period t to period t + 1, which is equal to ~ hedging gain/loss = XFCISPj,t'ij,t+l] (6) where sP. t = forward sell exchange 3’ rate of the foreign currency at period t ij,“1 = forward buy exchange rate of the foreign currency at period t + 1. Since the movement of spot and forward exchange rates tends to coincide, the gain/loss from holding the cash position in the spot market tends to offset the loss/ gain from simultaneously holding an equal amount in the forward market. If both spot and forward rate were per- fectly correlated, strategy 8 would be ideal in the sense that the value of the cash position denominated in domestic currency would not change from period t to period t + l. Stratggy C: At period t, a portion, 2*, of the amount of the underlying cash position, 2*XFC, is sold/bought forward to period t + 2, where 2* is the variance-minimizing hedge ratio of a two- cash-assets portfolio consisting of a spot market and a forward market position. 32 At period t + 1, an equal amount, z*XFc, is bought/sold forward to period t + 2. Similar to hedging strategy B, a translation gain/loss is realized from holding the cash position XFc in the spot market, which is equal to translation gain/loss = XFCISPi,t+l'SPi,t] (7) At the same time, a hedging gain/loss if realized from holding z*XFc units of foreign currency in the forward market, which is equal to ~ hedging gain/loss = XFC[SPJ,t'ij,t+1][z*]' (8) A Hedging Returns Model The model for measuring hedging strategy returns is based on the proposition that the objective of non- speculative hedging activity is to preserve the value of the cash position denominated in domestic currency. This research attempts to identify the hedging strategy(s) that, under the stated assumptions, can best accomplish this objective. The variables of the returns model are defined as follows: Let XFc = Net cash position denominated in a foreign currency established in period t and maturing in period t + l t+n v(ch)t V(XFC)t+1 Y% Y% 33 the portion of xFC hedged in the forward market from period t to period t + l sell spot rates, where all foreign currency prices (spot and forward) are quoted in units of foreign currency per U.S. dollar sell, buy forward rates subscripts to spot and forward market subscripts to time period dollar value of the cash position at period t = XFCIPi t] dollar value of the cash position at period t+l change in the dollar value of the cash position XFc from period to to period t+1 v(ch)t+]-v(ch)t percent change in the dollar value of the cash position XFC from period t to period t+1 v leFc’t 34 With all variables of the returns model thus defined, the returns can now be measured for each hedging strategy. Return for Hedging StratggyA: v(x v(x Fc)t+l Fc)j,t XFCISPj,t] Y ‘ XFCISPj,t]'xFC[5Pi,t] = XFCISPj,t'SPi,t] X [sP -sP ] Y% = FC j,t i,t XFCISPi,t] sP. y% = __143 _ 1 (g) SPi,t Return for Hedging Strategy 8: Translation + Hedging = v(XFC)i,t + Gain/Loss Gain/Loss = XFCISPi,tJ + XFCISPi,t+1'SPi,t] +[Spj,t ~ ‘ bpj,t+l]xFC 35 v(ch)t+] = xFCISPi,t+l + st’t-ij’t+]] Y = XFC[SPi,t+l * spj,t'bpj,t+l] ' chlspi.t] xrc spi,t ~ sP. + sP. - bP. Y% = glgt+l j,t j,t+l _ 1 (10) SPi,t Return for Hedging Strategy C: Translation V(XFC)t+l = v(XFc)i,t + Gain/Loss ‘ XFCISPi,t] l chlspi,t+l ~ 1 hedge ratio from equation (2). 1 Hedging + (2*) Gain/Loss - SPi,t] + Where 2* is the portfolio variance-minimizing 36 V(XFC)t+1 [sP1.,t+.I + (z*)st’t - (2*)bpj,t+l][xFC] XFC[SPi,t] = XFCISPi,t+l + (2*)Spj,t ' (2*)bpj,t+i ' SPi,t] i% = xFC[SPi,t+1 * (2*)Spi.t ' (2*)bpj.t+l ' split] ch SPi,t - sP + (z*)sP. - (2*)bP Y% = 19t+1 Jot j4t+1 - 1 (1]) SP1,t Equations (9), (10), and (11) measure the returns of hedging strategies A, B, and C respectively. The cost of hedging for each hedging strategy is accounted for in the terms P1 and Pj in the above return equations, since they are market quotations and no additional transaction costs will be incurred. 37 Determination of the Optimal HegggRatio Using the basic assumptions and principles of port- folio theory, Johnson (1960) and Stein (1961) have shown that the optimal hedge ratio, 2*, is related to the co- variance between the spot and the futures (forward) price changes. A portfolio is established consisting of two cash assets. The cash position is held in the spot market and a portion of the spot market holding is held in the forward market. The portfolio return variance is deter- mined by the variability of returns from the spot market, the variability of returns from the forward market, and the correlation coefficient between the spot market and the forward market. The spot market and forward market variability is determined by the random variables 55i,t+1 and DP. respectively. The variance of return of such j t+l a portfolio (H) is V(H) = xizoiz + x 20 2 + ZXiijOVi‘j where xi = fixed spot market holding x. = portion of x; that is hedged J in the forward market -x. 71 = z, the percentage of the fixed 1 spot market position held in the forward market 38 012 = subjective variance of future spot market sell price changes 0.2 = subjective variance of future 3 forward market buy price changes Covi. = subjective covariance between 3 future spot and forward market price changes. _ 2 2 2 2 Minimize Var (H) - xi Oi + xj °j + inijovU -x. substitute 2 for Y—1 i _ 2 2 2 Var (H) - xi (Oi + z o. - 22°1,j) differentiate Var (H) with respect to z um . x12<22°jz 2., , d2 - in]. set the derivative equal to zero and solve for z _ 2 2 J 39 where z* is the variance minimizing hedge ratio for the portion of the cash position held in the forward market. Summary In this chapter, theoretical considerations for the development of a hedging returns model were set forth. The term "non-speculative hedging" is defined as the hedging objective of preserving the value of a foreign currency cash position denominated in domestic currency. Three non-speculative hedging strategies were identified as being available for corporate hedgers using the foreign exchange forward market. A model was deVeloped for measuring the hedging returns of each strategy. The theory for the derivation of the optimal hedge ratio for portfolio hedges was discussed. In the following chapter, the returns model will be employed to develop a measure of hedging effectiveness, which will specifically take risk and return preferences of non-speculative hedgers into account. This measure will help determine the effectiveness of the different hedging strategies identified. CHAPTER III A MODEL FOR MEASURING HEDGING EFFECTIVENESS This chapter sets forth a model with which to mea- sure the effectiveness of different hedging strategies. The outcomes of these strategies are evaluated with respect to risk and return preferences of corporate hedgers. The objective of this chapter is twofold: to identify risk and return preferences characteristic to non-speculative foreign exchange risk managers, and to develop a measure of preference that allows for the comparison of outcomes from different hedging strategies. Risk and Return Preferences of Hegggrs Making decisions regarding hedging appears to be similar to the general framework of investment decision making with respect to the valuation of outcomes. Under conditions of uncertainty, such outcomes take the form of probability distributions of return. The outcomes are evaluated with the help of decision models or rules that attempt to reflect the decision maker's preferences for risk and return as imbedded in his utility function. In the past, the results of investment decisions often were evaluated based on the mean-variance framework 40 41 developed by Markowitz in 1959. Although convenient to apply, the mean-variance rule is generally found to be too restrictive in its assumptions: either the underlying probability distribution must be normal or the decision maker's utility function must be quadratic. Markowitz discussed the possibility of substituting semivariance of return for variance as a measure of risk. Semivariance depends only on those returns that fall below a target level or mean return. Mao (1970) provided empirical evidence that, as a measure of risk, semivariance is more consistent with risk (as seen by financial managers) than is variance. Semi- variance has the advantage of capturing the financial manager's intuitive notion of risk as the failure to meet some minimum return. Unlike variance, semivariance is in- fluenced only by returns below a target rate. Bawa (1975) provided the theoretical support for the semivariance measure of risk. He showed the congru- ence of the mean-semivariance rule with the rules of stochastic dominance. The mean-semivariance rule can be derived from the stochastic dominance selection rules under very general assumptions regarding distributions of returns and utility functions. Bawa concluded, therefore, that on theoretical grounds the mean-semivariance rule is preferred to the more widely used mean-variance rule. Empirical evidence supporting semivariance as the 42 appropriate risk measure (particularly for foreign ex- change risk) is provided by several authors. Jilling (1978) surveyed corporate executives of 107 U.S. multi- national corporations. In most companies, the fear of loss from foreign exchange fluctuations greatly exceeded the hope for gain. Fifty-four percent of the respondents stated that their foreign exchange risk management objec- tive was to have neither an exchange gain nor loss. Thirty-eight percent stated that their objective was plainly the minimization of exchange losses. Rodriguez (1979) interviewed the financial officers of 70 U.S. multinational firms selected from the Fortune 500 list. She found that management did not appear to analyze the hedging decision in terms of the average expected gain or loss. Instead, management showed a particular aversion to reporting exchange losses. Similar asymetrical risk and return preferences of corporate treasurers were found during a Euromoney survey (1978b). Managers perceived the pay-off matrix of outcomes from different hedging strategies and currency movements to be as follows: hedged exposure followed by an adverse currency movement was considered "expected performance," a hedged exposure followed by a favorable currency movement was considered tolerable, an unhedged exposure followed by a favorable currency movement (a windfall gain) was considered (undesirable) speculation, 43 and an unhedged exposure followed by an unfavorable cur- rency movement potentially jeopardized the manager's position. Such skewed valuation of hedging outcomes seems to indicate possible differences in risk and return objec- tives and preferences between hedging decisions and invest- ment decisions. Hedgers do not appear to value returns above a target return, and strongly dislike returns below the target returns. Hedging Effectiveness Defined Hedging effectiveness in this study is defined to be the potential of a hedging strategy to preserve the domestic currency value of a future foreign currency cash flow over the exposure horizon. The benchmark of perfor- mance against which to measure hedging effectiveness is the hedging performance of a perfect hedge. A perfect hedge, by definition, implies the certain preservation of the foreign currency cash flow value. This definition differs from the one employed by Dale (1981), Naidu and Shin (1981), and Hill and Schneeweis (1982a, 1982b). These authors defined hedging effectiveness as the potential of a hedging strategy to reduce the variance of its returns relative to the vari- ance of return of an unhedged position. Both benchmark measures of performance appear to be equally adequate to 44 measure the effectiveness of different hedging strategies relative to each other. The measure employed in this study, however, seems to be conceptually more appealing for the analysis of non-speculative hedging strategies. First, in addition to risk aspects, it explicitly incorpo- rates return aspects in the comparative analysis. Second, it allows for a comparison between the non-speculative hedging strategies available to the corporate treasurers and a riskless perfect hedge. Such a comparison may pro- vide information on the magnitude of unavoidable foreign exchange risk present in the current system of floating exchange rates. A Measure of Hepging Effectiveness The benchmark measure for hedging effectiveness in this study'is the outcome from a perfect hedge. Hedging strategies generating returns below those of a perfect hedge are considered less effective than the perfect hedge. The return deviations of different non-speculative hedging strategies from the return of the perfect hedge are evaluated from the viewpoint of the hedger's risk preferences. Fishburn (1977) suggested a two-parameter model to establish preference rules for investment return distribu- tions. His model is a generalized version of the mean- semivariance rule. It measures the semi-alpha moment below a target return 45 t Fa(t) = (t-Y)“dF(Y) a > o, (12) where F (t) = risk-weighted probability a that returns will fall below t Y = return observation where b goes from zero to n and n is the total number of return observations below t t = target return a = measure of risk aversion for returns below t O < a < l = risk-seeking attitude a = l = risk-neutral attitude a > 1 = risk-averse attitude, where small a = high concern for not meeting the target return, but little concern about the absolute value of the return below t large a = little concern about small deviations below t, but high concern about large deviations below t F(Y) = probability distribution func- tion of Y. 46 Under the assumption that the perfect hedge is the appropriate benchmark measure of performance, hedging strategy F is preferred to hedging strategy G if N Fa(t) < Ga(t)’ (13) where ra(t).sa¢ouooo >¢ouoo oooaoo oooion n.~_~o 1 omm.ou ozaeo soup—co omu2u>~houuuo ozooowz .Axpm>opuonmmg .mmmcm; oopooueoa use .pmcoououmeu .m>oo= op Looms u can .m .ouuwammt .mmmum; oopooueoa one Pacoopoomgo .m>om: op Looms u ucm .m . SPi,t+1 + spj,t,360'bpjgt+l,180 _ 1 (20) SPi,t SP1.t where sP. 180-day bid forward rate at J’t’180 period t sP. t 360 = 360-day bid forward rate at 3’ ’ period t (to open the hedge) bP. = 180-day ask forward rate at J’t+]’180 period t+l (to close the hedge position). From equation (20) it follows that whenever “ ” 1 (Pj,t,180 ' Pj,t,360) > (Pi,t+l Pj,t+l,180) . (211 1The subscripts s and b (indicating bid and ask quotations) were eliminated for the purpose of this analysis. 89 then the inequality indicated in equation (20) holds and the naive hedge is more effective than the traditional hedge. Since forward exchange rates are the market con- sensus of the future spot rate value, the left-hand ex- pression of inequality (21) at period t is equal to the expected change of the exchange rate from period t+l to period t+2. The right-hand expression of inequality (21) at period t+l is equal to the expected change of the ex- change rate, also from period t+l to period t+2. The right-hand expression, therefore, is the short-term expectation of the price change from period t+l to period t+2, whereas the left-hand expression is the long-term expectation of the price change during the same period. The empirical evidence seems to support the statement that the short-term expectation of the future price change (as defined by the right-hand term of inequality in equation 21) was on the average smaller than the longer-term expec- tation of the future price change (as defined by the left- hand term of inequality in equation 21) during the test period from 1974-1982. Since the Fishburn alpha-t model employed in this study measures only return deviations below a target return of zero, the tests of hedging effectiveness per- formed provide evidence only for a bias in the pricing process of foreign exchange in the case where the foreign currency sold at a discount. The interpretation of such 9O findings appears to be that whenever a foreign currency sold at a discount, the long-term predictions of future price changes of British pounds and Deutsche marks (as expressed by the differences in the forward rates) were on average lower (more pessimistic) than the short-term predictions for the same period. Such findings of bias in the pricing process of foreign exchange rates are, however, not necessarily contradictory to the widely held view that foreign exchange rates behave as if generated by a random- walk process. Since the advent of floating exchange rates, the currency pricing process is based on supply and demand equilibria similar to the pricing process of other commodities. The classic economic rationale for the existence of foreign exchange forward markets is that they facilitate hedging. That is, they allow those who deal in a foreign currency to transfer the risk of price changes of this foreign currency to speculators who are more willing to assume such risk. Speculators, however, expect to be compensated for their risk exposure and may, in the case of a discount, bid foreign exchange forward prices low enough to assure adequate compensation. The fact that uncertainty and the corresponding risk involved in a future currency spot price increase with time might represent an explanation for the inequalities observed on average in equations (20) and (21) and the more pessimistic pricing of longer-term forward contracts than shorter-term forward contracts. APPENDIX B LISTING OF PROGRAM TO DETERMINE THE OPTIMAL SAMPLE SIZE FOR THE INITIALIZATION OF 2* 91 APPENDIX B Listing of Program to Determine the Optimal Sample Size for the Initialization of 2* IMMUNMNQNmflfiaduodenmoodno uaamuumuoo.euua «grave i «seen». 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