RDP 2006-09: Limiting Foreign Exchange Exposure through Hedging: The Australian Experience 3. Hedging Practices in Australia

While Australian firms generally appear to be in a good position to deal with currency fluctuations (see below), outside the banking sector this has not always been the case, and even within the banking sector hedging practices have evolved considerably.

Hereafter, we consider data up to March 2005 in line with the latest available hedging survey for Australia.

3.1 Adapting to Exchange Rate Fluctuations

From past work and survey evidence we know that the banking sector has always been well-insulated against adverse exchange rate fluctuations. Banks had little foreign currency exposure in the immediate period following the floating of the Australian dollar, due to regulations prohibiting many international transactions (RBA 1986). However, as these restrictions were removed with banking system deregulation, banks increasingly financed their domestic assets by raising short-term liabilities abroad. Nonetheless, prudential oversight continued to ensure that banks matched foreign currency liabilities with assets to limit net exposures. This has been facilitated by a greater use of derivatives to hedge exchange rate risk. Under the current market risk guidelines, authorised deposit-taking institutions are required to calculate their foreign currency exposure daily and comply with capital adequacy requirements on both their traded and non-traded currency positions.^[14] As a result, currency fluctuations remain of little direct consequence to the banking books of the major Australian banks.

In contrast, non-financial firms have at times found it difficult to adapt to movements in the Australian dollar. With no direct prudential guidance and little experience with foreign exchange risk management, there have been episodes when sizable currency movements imposed considerable losses.

Following capital market opening in the 1980s, foreign currency loans, commonly denominated in Swiss francs, became easily accessible to a wide range of borrowers. It is estimated that there were up to 3,000 foreign currency loans made by 1986,^[15] with many of the smaller borrowers believed to have had little understanding of the foreign exchange risks associated with these loans. These loans were appealing to many borrowers given the relatively low interest rates in countries such as Switzerland. As the Australian dollar fell by more than 50 per cent against the Swiss franc between 1985 and the middle of 1986, large foreign exchange losses substantially exceeding interest savings were incurred by unhedged borrowers.

A Riethmuller and Phillips (1986) survey showed that a relatively high proportion of importers and manufacturers were not hedged, despite some large movements in the Australian dollar prior to the float.^[16] Table 1 indicates that more than half of respondents had less than 5 per cent of their foreign exchange exposure hedged in 1984. Between 1984 and 1986 there appears to have been an increase in hedging, driven in part by losses stemming from exchange rate depreciation. However, relatively little is known about the nature of the foreign exchange exposures themselves around this time. It may well be that exposure to exchange rate changes was much shorter-term and that the remaining risks were offset through natural hedging, so that explicit use of derivatives was less crucial than it is today.

Providing further evidence of increased hedging in the early post-float period, the BIE (1991) found that the average proportion of exchange rate exposure hedged by exporters rose from around 50 per cent in 1984/85, to 60 per cent in 1985/86, and then to 70 per cent in 1989/90. Respondents indicated that the two most important factors behind this increase in their hedging were greater underlying exposure to exchange rate risk and uncertainty over future currency movements.

This rise in hedging activity in the early post-float period was also supported by the formulation of explicit hedging policies. Teoh and Er (1988) found that relative to foreign-owned firms operating in Australia, domestic firms tended to report less established hedging policies prior to the float. However, in the post-float period this difference was no longer significant, with Australian companies developing more comprehensive hedging policies. This then also led to greater demand for the necessary instruments, which saw the markets for derivative products grow over time.

Improvements in the management of currency risk continued in the early 1990s. In a survey of Australian firms, Naughton and Teoh (1995) found that five years prior, larger firms and firms with substantial international operations and exposures tended to be increasing resources devoted to risk management. Specifically, over this period, larger firms tended to develop formal policies, increase staff in foreign exchange risk management, implement forecasting, and improve reporting systems – perhaps taking advantage of economies of scale in currency risk management relative to smaller firms.

3.2 What Hedges are in Place?

Comprehensive information about net foreign currency exposures of Australian firms was lacking until the inaugural ABS survey of hedging practices in 2001. The findings of that survey showed that every sector of the economy with foreign currency exposures, either through trade or balance sheets, hedged some part of this exposure back into Australian dollars by making extensive use of foreign exchange derivatives. Given the importance of the findings in 2001, the Reserve Bank asked the ABS to conduct a second survey in 2005.^[17] The results, outlined in Table 2, were broadly in line with the findings of the earlier survey. Australian residents in aggregate held a net foreign currency asset position amounting to $218 billion as at 31 March 2005. And while the banking sector had a large net foreign currency liability position, this was fully hedged by derivatives. All of the other major sectors also had a long (or net asset) foreign currency position after taking into account the notional value of existing derivative contracts employed to hedge against exchange rate fluctuations.^[18]

Respondents reiterated their intention reported in the 2001 survey to hedge a high proportion (78.9 per cent) of exchange rate risk arising from foreign debt exposures, but only a small proportion (20.9 per cent) of the exchange rate risk pertaining to equity investments abroad. Hedging was again mainly undertaken through the use of forward foreign exchange contracts and cross-currency interest rate swaps.

Perhaps the most important result was that the counterparties to the net position in derivatives were non-residents, thereby insulating residents as a whole against unfavourable exchange rate fluctuations by exporting foreign currency risk abroad.^[19] Under these contracts, non-residents have effectively guaranteed to supply Australian residents, at some point in the future, with foreign currency in return for Australian dollars at predetermined exchange rates. These contracts are only possible because non-residents are prepared to hold a proportion of Australian dollars in their portfolios.

3.3 Time Horizon of Firms' Hedging

Another notable feature of hedging is that, for most firms, hedges tend to cover transactions for a relatively near-term horizon of less than one year.^[20] These results most likely reflect the uncertainty many firms face in determining the extent of their exposure beyond short horizons. A firm would typically only hedge those foreign currency transactions it can anticipate with a considerable degree of certainty, because if the underlying transaction were not to eventuate, then the hedge itself would create an exposure. Another factor may be that longer-term derivatives are seen by banks as a higher credit risk, which may limit the ability of firms lacking a strong credit rating (that is, typically smaller firms) to obtain long-term forward cover.

Exporters typically tend to hold longer hedging contracts compared with importers (Figure 5). That this is especially true of the mining sector is likely to be a result of the long-term supply contracts that mining companies tend to engage in and the durability and homogeneous nature of some commodities.

3.4 Foreign Currency Exposure is Predominantly to the US Dollar

Since 1997, around 70 per cent of Australia's trade has been invoiced in foreign currencies (Figure 6). Most of this has been in US dollars, reflecting the importance of commodities in Australia's exports (which are usually quoted in US dollars) and the general importance of the US dollar as an international medium of exchange.

Foreign currency balance-sheet exposures are also mainly denominated in US dollars. The 2005 ABS survey on hedging practices showed that the US dollar made up at least 50 per cent of the private sector's exposure. The euro is also an important currency denominator, accounting for around 15 per cent of total exposures; the other currencies explicitly enumerated in the survey (the British pound, Japanese yen, and Swiss franc) play a relatively minor role.

Further evidence that the main exposures are denominated in US dollars can be drawn from turnover in derivatives markets, where around 85 per cent of Australian dollar trading in forwards and options is against the US dollar.

Footnotes

Refer also to APRA (2000). Prior to these arrangements, the Reserve Bank imposed strict limits on the foreign currency positions of foreign exchange dealers, which limited exposures. [14]

See Martin (1991). [15]

For example, the Australian dollar fell by 17 per cent against the US dollar in the year to October 1982. [16]

For results of the hedging survey refer to Becker et al (2005) and ABS (2005). [17]

The government sector is somewhat different. The state governments continue to borrow offshore but hedge all of these borrowings back into Australian dollars. The remaining small foreign currency exposure of this sector is the result of international transactions, on which the Australian Government has a ‘no hedging’ policy. [18]

This must be true since the net long position in derivatives held by banks, other resident sectors, and the government is much larger than the combined short position of the other sectors. That is, the economy's overall net long position of $122 billion in derivatives must be matched by a short position held by non-residents. [19]

Australian practices appear to be in line with international norms. See, for example, Bodnar et al (1996, 1998), Bodnar and Gebhardt (1998), Brookes et al (2000), Loderer and Pichler (2000), Sheedy (2001), Bodnar et al (2002) and Pramborg (2005). [20]