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Hedging, speculating and risk diversification in international markets
International Review of Financial Analysis 17 (2008) 645–646
Contents lists available at ScienceDirect
International Review of Financial Analysis
Editorial
Hedging, speculating and risk diversification in international markets An editorial review
This special issue unifies four apparently disparate themes in financial markets both from the domestic and international perspectives. In particular one major sub-theme in the volume is the influence of asymmetry in information flow and the appropriate hedging, risk diversification strategies when the markets behave differently during period of rising and falling exchange rates. The second theme deals with the issue of how currency risk should be priced in the face of asymmetric currency exposure. Another theme has to do with the role of asymmetric incentive compensation schemes and the influence, behavioral and otherwise, that they exert on the hedging and portfolio optimization behavior of portfolio managers. The final sub-theme deals with the efficacy of diversification itself as a strategy, both in the industrial and geographic senses. These various themes are explored in the papers that follow and the authors of these papers provide compelling new evidence that new approaches to the problems can be fruitful. The first paper by Chu-sheng Tai, “Asymmetric Currency Exposure and Currency Risk Pricing” provides new perspective on the problem of currency exposure. The author shows that ignoring the possibility of asymmetric currency exposure may explain why prior studies, which focused mainly on linear exposure, have difficulty in detecting exposure. The author embeds the problem of currency exposure in a MGARCHM, framework and also tests whether exposure is priced in the stock market. Many tests for robustness are conducted and the tests apply to both weekly and monthly data. He finds evidence that many of the US industry groups display non-linear currency exposure that is also time-varying in nature. Some of the exposure may be exacerbated by firms taking one-sided bets on currency movements but may in part also be attributable to pricing-to-market behavior. The second paper by Cetin Ciner and Ahmet Karagozoglu, “Information Asymmetry, Speculation and Foreign Trading Activity: Emerging Market Evidence”, examine the role of asymmetry in access to information and its implication for trading and returns. The authors make a strong case that information asymmetry is more prevalent in emerging economies and countries with weak corporate governance. They construct three measures of foreign trading activity and show that all of them point to a positive association between foreign trades and private-information-based speculation, for the Istanbul Stock Market. Their results are also robust to several specifications. They then use information asymmetry and speculation, together with volume and return dynamics of individual stocks to examine the extent of foreign trading activity on the Istanbul Stock exchange. The authors uncover some interesting peculiarities of the market, namely that larger firms have smaller float on a relative basis, versus small firms and that speculative trading is more of a problem with large firms. This contradicts the evidence from the US market and suggests there is scope for additional work in the area. 1057-5219/$ – see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.irfa.2008.04.001
646
Editorial
The third paper Kingsley Olibe, Franklin Michello, and Jerry Thorne,” Systematic Risk and International Diversification: An Empirical Perspective” address the issue that diversification, which in the domestic context is expected to reduce systematic risk, can in the international domain lead to an increase in systematic risk. The literature is divided on the issue of whether international diversification in increasing or reducing in systematic risk, but the authors attempt to provide a definitive answer by the utilization of little-used explanatory factors such as number of foreign countries of operations and the number of business lines for example. They recognize that asymmetry of information, foreigners may have restricted access to information, and other agency cost factors may impact their results and they attempt to control for them. Consistent with their hypothesis, they find that international diversification proxies are significantly and positively associated with systematic risk. The fourth paper by Imtiaz Mazumder, Ting-Heng Chu, Edward Miller and Larry J. Prather, “International Day-of-the-Week Effects: An Empirical Investigation of iShares”, analyzes the phenomenon from the perspective of what are the strategies that could be utilized to exploit the perceived patterns. Their evidence seems to suggest that dynamic strategies outperform buy-and-hold strategies, even though their findings might have to be tempered with the introduction of transactions costs and frequency of trading. The fifth paper by Kurtay Ogunc, “Behavioral Strategic Currency Hedging for International Portfolios”, analyzes optimal hedging strategies where portfolio managers have partial job functions. In his framework, he paints a picture where, traditional portfolio managers deal with correlations among the various assets in the portfolio and try to minimize asset risk only. The residual currency risk of the entire portfolio is handed over to currency overlay managers. In this set up he shows that different risk profiles of the managers and the incentive compensation structures affect the optimal currency hedge allocations. This paper gets at the issue of how management structures and behavioral factors affect the final currency hedging levels. The sixth paper by Anna Vygodina and Thomas Zorn, “Asymmetry in the Effects of Economic Fundamentals on Rising and Falling Exchange Rates”, provides an interesting link with the exposure dialogue. The model in based on market participants who have access to limited information, that differs across participant type, i.e., there is heterogeneity in their information sets. The authors analyze data from eight countries, covering 308 events of extreme fluctuations over three months (and 140 events over one year) for the time period from 1972–2000. They find that exchange rates show overreaction to changes in economic fundamentals outlined by Traditional Flow, Money Sector, and Quantitative Theory of Money Models. What is also an interesting result is they show strong evidence of asymmetry in the effects of economic fundamentals on exchange rates during time periods of rising and falling exchange rates: the probability of extreme fluctuation is greater during time periods of rising exchange rates as compared to falling. This supports the hypothesis of (Tai, 2008) in this volume that there is asymmetry in exposure, even if corporations do not alter their cash flows by hedging or taking one sided bets. The seventh paper by Ike Mathur and Young Sang Kim, “The Impact of Geographic Diversification on Firm Performance”, makes a similar point to the paper by Olibe et al. In this case corporate industrial and geographical diversification rather than international diversification specifically may be associated with significant agency costs. The costs of such diversification may outweigh its benefits. They find evidence that diversification reduces firm value. This of course is consistent with the Olibe et al. findings that increases in diversification increase firm systematic risk. Increases in firm beta, increase cost of capital and would tend to be reducing in firm value. Mathur and Kim also find that the relatedness of the business segments and the degree of foreign involvement also play a role in firm value. Unrelated segment diversification and higher foreign involvement reduce firm value, thus once again confirming the findings of Olibe et al. in this volume. These papers in their totality present clear and compelling new ideas and results in the investigations of troublesome issues like currency exposure, benefits of diversification and hedging. The authors point the way for future research and it is hoped that some of these ideas would be explored more thoroughly in future research. Lloyd P. Blenman University of North Carolina-Charlotte, United States E-mail address: [email protected].
Contents lists available at ScienceDirect
International Review of Financial Analysis
Editorial
Hedging, speculating and risk diversification in international markets An editorial review
This special issue unifies four apparently disparate themes in financial markets both from the domestic and international perspectives. In particular one major sub-theme in the volume is the influence of asymmetry in information flow and the appropriate hedging, risk diversification strategies when the markets behave differently during period of rising and falling exchange rates. The second theme deals with the issue of how currency risk should be priced in the face of asymmetric currency exposure. Another theme has to do with the role of asymmetric incentive compensation schemes and the influence, behavioral and otherwise, that they exert on the hedging and portfolio optimization behavior of portfolio managers. The final sub-theme deals with the efficacy of diversification itself as a strategy, both in the industrial and geographic senses. These various themes are explored in the papers that follow and the authors of these papers provide compelling new evidence that new approaches to the problems can be fruitful. The first paper by Chu-sheng Tai, “Asymmetric Currency Exposure and Currency Risk Pricing” provides new perspective on the problem of currency exposure. The author shows that ignoring the possibility of asymmetric currency exposure may explain why prior studies, which focused mainly on linear exposure, have difficulty in detecting exposure. The author embeds the problem of currency exposure in a MGARCHM, framework and also tests whether exposure is priced in the stock market. Many tests for robustness are conducted and the tests apply to both weekly and monthly data. He finds evidence that many of the US industry groups display non-linear currency exposure that is also time-varying in nature. Some of the exposure may be exacerbated by firms taking one-sided bets on currency movements but may in part also be attributable to pricing-to-market behavior. The second paper by Cetin Ciner and Ahmet Karagozoglu, “Information Asymmetry, Speculation and Foreign Trading Activity: Emerging Market Evidence”, examine the role of asymmetry in access to information and its implication for trading and returns. The authors make a strong case that information asymmetry is more prevalent in emerging economies and countries with weak corporate governance. They construct three measures of foreign trading activity and show that all of them point to a positive association between foreign trades and private-information-based speculation, for the Istanbul Stock Market. Their results are also robust to several specifications. They then use information asymmetry and speculation, together with volume and return dynamics of individual stocks to examine the extent of foreign trading activity on the Istanbul Stock exchange. The authors uncover some interesting peculiarities of the market, namely that larger firms have smaller float on a relative basis, versus small firms and that speculative trading is more of a problem with large firms. This contradicts the evidence from the US market and suggests there is scope for additional work in the area. 1057-5219/$ – see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.irfa.2008.04.001
646
Editorial
The third paper Kingsley Olibe, Franklin Michello, and Jerry Thorne,” Systematic Risk and International Diversification: An Empirical Perspective” address the issue that diversification, which in the domestic context is expected to reduce systematic risk, can in the international domain lead to an increase in systematic risk. The literature is divided on the issue of whether international diversification in increasing or reducing in systematic risk, but the authors attempt to provide a definitive answer by the utilization of little-used explanatory factors such as number of foreign countries of operations and the number of business lines for example. They recognize that asymmetry of information, foreigners may have restricted access to information, and other agency cost factors may impact their results and they attempt to control for them. Consistent with their hypothesis, they find that international diversification proxies are significantly and positively associated with systematic risk. The fourth paper by Imtiaz Mazumder, Ting-Heng Chu, Edward Miller and Larry J. Prather, “International Day-of-the-Week Effects: An Empirical Investigation of iShares”, analyzes the phenomenon from the perspective of what are the strategies that could be utilized to exploit the perceived patterns. Their evidence seems to suggest that dynamic strategies outperform buy-and-hold strategies, even though their findings might have to be tempered with the introduction of transactions costs and frequency of trading. The fifth paper by Kurtay Ogunc, “Behavioral Strategic Currency Hedging for International Portfolios”, analyzes optimal hedging strategies where portfolio managers have partial job functions. In his framework, he paints a picture where, traditional portfolio managers deal with correlations among the various assets in the portfolio and try to minimize asset risk only. The residual currency risk of the entire portfolio is handed over to currency overlay managers. In this set up he shows that different risk profiles of the managers and the incentive compensation structures affect the optimal currency hedge allocations. This paper gets at the issue of how management structures and behavioral factors affect the final currency hedging levels. The sixth paper by Anna Vygodina and Thomas Zorn, “Asymmetry in the Effects of Economic Fundamentals on Rising and Falling Exchange Rates”, provides an interesting link with the exposure dialogue. The model in based on market participants who have access to limited information, that differs across participant type, i.e., there is heterogeneity in their information sets. The authors analyze data from eight countries, covering 308 events of extreme fluctuations over three months (and 140 events over one year) for the time period from 1972–2000. They find that exchange rates show overreaction to changes in economic fundamentals outlined by Traditional Flow, Money Sector, and Quantitative Theory of Money Models. What is also an interesting result is they show strong evidence of asymmetry in the effects of economic fundamentals on exchange rates during time periods of rising and falling exchange rates: the probability of extreme fluctuation is greater during time periods of rising exchange rates as compared to falling. This supports the hypothesis of (Tai, 2008) in this volume that there is asymmetry in exposure, even if corporations do not alter their cash flows by hedging or taking one sided bets. The seventh paper by Ike Mathur and Young Sang Kim, “The Impact of Geographic Diversification on Firm Performance”, makes a similar point to the paper by Olibe et al. In this case corporate industrial and geographical diversification rather than international diversification specifically may be associated with significant agency costs. The costs of such diversification may outweigh its benefits. They find evidence that diversification reduces firm value. This of course is consistent with the Olibe et al. findings that increases in diversification increase firm systematic risk. Increases in firm beta, increase cost of capital and would tend to be reducing in firm value. Mathur and Kim also find that the relatedness of the business segments and the degree of foreign involvement also play a role in firm value. Unrelated segment diversification and higher foreign involvement reduce firm value, thus once again confirming the findings of Olibe et al. in this volume. These papers in their totality present clear and compelling new ideas and results in the investigations of troublesome issues like currency exposure, benefits of diversification and hedging. The authors point the way for future research and it is hoped that some of these ideas would be explored more thoroughly in future research. Lloyd P. Blenman University of North Carolina-Charlotte, United States E-mail address: [email protected].