Foreign exchange exposure in emerging markets

A study of Spanish companies in Latin America

The Authors

Gastón Fornés, University of Bristol, Bristol, UK

Guillermo Cardoza, Euro-Latin America Center, Instituto de Empresa Business School, Madrid, Spain

Acknowledgements

The authors are pleased to acknowledge the contributions from Dr Alan Butt-Philip of the University of Bath School of Management.

Abstract

Purpose – The purpose of this paper is to look at the impact that unanticipated changes in the exchange rate, specifically the currency crises that took place in Latin America between 1998 and 2004, had on the value of Spanish companies operating in this region. It also studies the strategies, decisions, measures and initiatives that these firms made to improve the effectiveness of their hedging activities. Building upon previous studies in industrialised countries, the study applies a broader perspective as it takes a cross-functional approach by including finance, strategic planning, marketing and operations management in the analysis.

Design/methodology/approach – The paper uses qualitative and quantitative analyses to reach its conclusions. The quantitative study involves a time series regression to calculate a foreign exchange exposure (FOREX) coefficient. The qualitative analysis uses a systematic approach to develop categories from the data gathered in the interviews. Finally, the conclusions from both analyses were summarised and combined. The data was collected from interviews containing structured and open-ended questions with senior managers and directors of the largest Spanish investors in Latin America.

Findings – The research results suggest that foreign companies exposed to exchange risks in emerging markets gain resilience when they take a cross-functional approach for the assessment and implementation of hedging strategies along with the decentralisation to subsidiaries of the decisions and implementation of hedging initiatives. This helps companies in: elaborating scenarios, assessing the possible impact of exchange rate variations, designing pre-emptive measures and setting alternative strategies to mitigate potential impacts. This cross-functional approach to managing risks in emerging markets seems to offer companies higher flexibility and new knowledge that can be shared among subsidiaries working in similar economic and political environments.

Originality/value – The results from this empirical study build upon previous works on FOREX and offer companies an alternative approach to minimise its impacts when operating in emerging markets.

Article Type:

Research paper

Keyword(s):

Emerging markets; Foreign exchange; Latin America; Multinational companies; Spain.

Journal:

International Journal of Emerging Markets

Volume:

Number:

Year:

2009

pp:

6-25

Copyright ©

Emerald Group Publishing Limited

ISSN:

1746-8809

Introduction

The 1990s was a decade of deep transformation for the Spanish economy, characterized by privatisation programmes, consolidation of industries and internationalisation of companies, mainly to Latin America. This wave of internationalisation began in 1991 when Telefónica won the bid in the privatisation of Entel in Argentina and reached a peak (in terms of the amount of investment) in 1999 when Repsol acquired YPF in Argentina for around 15 billion. After 1997, Spain became a net exporter of capital for the first time and Latin America received around 60 per cent of these investments (as an annual average). These investments made Latin America the first destination for Spanish companies, and Spain the second-largest international investor in the region after the USA. The investments were concentrated in a few service industries: telecommunications, banking, insurance and pension funds, electricity, gas, water and infrastructure. In fact, 85 per cent of the direct investments during the period 1995-2000 were attracted to these sectors. The majority of the investments were acquisitions of both privatised and private companies, followed by an expansion of equity interests; less than 5 per cent of the total went to new or greenfield investments (Arahuetes and Casilda, 2004, pp. 19-21). Table I shows the cumulative net investment by Spanish companies in the region.

As can be seen, ten companies are responsible for 94.5 per cent of the investments in Latin America along with 57 per cent of the country's total foreign investments. This situation is worthy of note, mainly because of the short period in which these investments took place, as well as for the particular moment in the life of the companies[1]. As a result of these investments, Latin America currently represents a high, and growing, proportion in the operations of some of these companies. Partly attributed to the success of the Latin American ventures, most of these Spanish companies have become world players in their own sectors; for instance, Telefónica has become the world's fifth largest telecommunications operator in terms of market capitalisation (Telefónica, 2007). As global players, these companies have “transformed the ownership of some economic sectors in Latin America's largest countries” (Arahuetes and Casilda, 2004), as well as modified the provision of products and services in the region. As a result, these investments have challenged international and domestic competitors and regulatory authorities, as well as the companies themselves.

This journey to Latin America has not been without difficulties. Since the start of the structural reforms in the late 1980s, the region has suffered many economic, financial, and political crises. The most important were the Tequila Crisis in Mexico in 1994, the debt and currency crisis in Brazil at the beginning of 1999, and the debt, currency, and political crisis in Argentina at the end of 2001. Other financial and political crises took place in countries like Ecuador, Bolivia, Paraguay, Uruguay, Colombia and Venezuela. The crises brought the kind of situations that companies usually try to avoid. For example, in political terms, the crises involved fallen governments, unemployment, poverty, riots, looting, violence, loss of property rights, etc. In economic terms, they entailed considerable increases in the rate of interest, substantial currency devaluations, taxation policy changes, higher inflation rates, circulation of currency (foreign and domestic) restrictions, etc. In business terms, the crises caused demand decreases, an increase in debtors in arrears, demographic variations, circulation of goods restrictions (mainly foreign), etc. In addition, there was a contagious effect in terms of instability; for example, Chile and Costa Rica, generally considered two of the more stable countries in the region, also suffered some of the economic and business effects described above.

It is in this context that this paper will first attempt to analyse the impacts (if any) that variations in the exchange rate had in the performance of the largest Spanish investors in Latin Americal second, the strategies and decisions these companies made in order to protect the value of their investments in the region.

Conceptual framework

Doherty and Smith (2001, p. 477) said that, in general, the companies' aim when managing foreign exchange exposure (FOREX) should be to avoid reductions in their operating value, that is “reductions in the present value of expected operating cash flows”. In this sense, Shapiro (2003, p. 399) proposed that a sensible objective for an exchange risk management strategy should be “to protect the dollar [home currency] earning power of the company as a whole”. To accomplish these objectives, the role of financial management should be to structure the firm's liabilities in such a way that “the reduction in asset earnings is matched by a corresponding decrease in the cost of servicing these liabilities”. However, “this approach concentrates exclusively on risk reduction rather than on cost reduction” (Shapiro, 2003).

On the other hand, Martin and Mauer (2003) argued that FOREX, also known as economic exposure[2], “typically has a longer-term time dimension as well, as it encompasses the competitive and indirect effects of exchange rate risk”. The origins of the economic exposure are changes in the sales price, sales volume, and the cost of input of the firm and its competitors due to exchange rate changes. Since these effects are often indirect, and longer-term in nature, it is unclear if financial hedging is effective (Chow et al., 1997a, b; Pringle, 1991; Pringle and Connolly, 1993).

In addition, other studies have argued that geographically positioned production facilities, sales revenues, suppliers, and funding could be effective in reducing economic exposure (Bodnar et al., 1998; Chow et al., 1997a, b; George and Schroth, 1991; Jacque, 1981; Jorion, 1990; Lessard and Lightstone, 1986; Martin et al., 1999; Martin and Mauer, 2003; Pantzalis et al., 2001; Pringle, 1995). Norton and Malindretos (1991) concurred, suggesting that hedging economic exposure requires:

diversification of production, raw materials sources, and operations; and
diversification of financing sources.

However, relocating operations to form such hedges can be expensive and difficult to reverse (Chow et al., 1997a; Hodder, 1982; Martin and Mauer, 2003; Pringle and Connolly, 1993). In other words, the costs of geographically diversified production along with its perceived net benefits sometimes are not enough to offset the economic exposure. Nevertheless, the CFOs could choose to diversify financing sources since this is relatively cheap compared with diversifying operations.

Another challenge when hedging economic exposure is the need for coordination among the functional areas of the company. In fact, the complexity of the information required to assess economic exposure may involve different areas. In addition, its long-term nature makes it difficult to identify and measure economic exposure so “it is possible that the perceived costs of hedging outweigh the perceived benefits or that the exposure is not recognized, and the economic exposure remains unhedged” (Martin and Mauer, 2003).

These are the main reasons to claim that economic exposure depends on the marketing and operations strategies, along with the company's suppliers and potential competitors, in addition to the corporate-level finance unit. In line with this claim, Shapiro (2003, p. 377) stated that “the most important aspect of foreign exchange risk management is to incorporate currency change expectations into all basic corporate decisions”. A similar idea was proposed by Aggarwal and Soenen (1989) in a study of US companies' FOREX. As a result, this work will take a cross-functional approach to analyse the decisions made in different functional areas within the companies aimed at protecting the value of their foreign investments.

Previous works in this field area have studied the use of hedging instruments in the protection of firms' value (Bodnar et al., 1998; Marshall, 2000) as well as the relation between variations in the exchange rate and companies' value (Bodnar and Gentry, 1993; Chow et al., 1997a; Jorion, 1990). Although most of the studies refer to US companies, this relationship has also attracted studies in other countries (Choi and Kim, 2003; De Jong et al., 2002; Doukas et al., 2001; Nguyen and Faff, 2003). Other studies tried to assess the operational hedge's effect on firms' value (Martin et al., 1999; Pantzalis et al., 2001), and to find the determinants of foreign exchange rate exposure of multinational corporations (Faff and Marshall, 2005). The current work follows this line of research and attempts to contribute to the following areas, by:

Taking a broader, cross-functional perspective; it adds marketing, operations management, and strategic planning to the traditional financial perspective for the analysis of FOREX. This is relevant, since:
- the literature suggests that these areas should participate in the assessment and hedging of FOREX; and
- most previous studies have focused their analysis on the use of financial hedging instruments.
Looking at operations in emerging markets, specifically in Latin America, where Europe is the largest foreign investor. This is another difference, in the sense that this study focuses on companies from developed countries with foreign investments in emerging economies (Choi and Kim, 2003). This is relevant as the conditions for the use of financial hedging instruments (the traditional approach) in emerging markets are different than those in developed countries and, therefore, the need emerges to study alternatives. These different conditions can be seen in that:
- currencies from emerging countries could be difficult to hedge due to the high costs or the non-existence of either forward or currency options;
- swap arrangements may be difficult to set up because there is no active market for swaps in a specific currency;
- emerging markets' currency positions may involve investments in brand development or other intangible assets;
- loans in local currencies may affect the performance and the profitability of companies trading with these currencies due to higher rates of interest in emerging economies compared to those in developed countries;
- the volatility of emerging countries' currencies makes it riskier to borrow long-term as companies could face a maturity mismatch; and
- companies borrowing in strong currencies could suffer a currency mismatch paying the capital and services of the loan with revenues in a devalued currency.
Including the analysis of qualitative data obtained from interviews with senior managers/directors in addition to the quantitative analysis. In this sense, the difference resides in the fact that most previous works gathered data through mail surveys (Faff and Marshall, 2005) or from the companies' balance sheets (Choi and Kim, 2003; Miller and Reuer, 1998) and no qualitative approach was attempted. The qualitative perspective offered the opportunity to discuss in detail the issue under study with the participants. Jones and Khanna (2006) also suggested the use of qualitative data and other rigorous methods in addition to quantitative information for future studies in International Business.
Presenting a different approach for the analysis of the business environment in Latin America. This region has been studied using different perspectives; transaction costs economics (Aulakh et al., 2000; Khanna and Palepu, 2000), institutional theory (Khanna and Palepu, 2000; Suarez and Oliva, 2002), and resource-based view of the firm (Guillen, 2000). However, these studies did not have a focus on the impacts that variations in the value of the region's currencies had on foreign companies operating in these countries. Most Latin American countries are included in the list of emerging economies (Hoskisson et al., 2000).
Studying a group of European companies. This European origin marks a difference to the current state of play as most of previous studies were focused on the USA.

Objectives and research propositions

The first objective of this paper is to analyse if the variations in the exchange rate in Latin American countries during the period of economic, political, and financial crisis (1998-2001) and its aftermath (2001-2004) have impacted on the value of the largest Spanish investors in the region. In this context, the first research proposition is:

RP1. Variations in the exchange rate have impacted on the value of the largest Spanish investors in Latin America and this impact has been negative.

The second objective is to study the decisions/strategies used by these companies to protect their value against fluctuations in the value of currencies using the cross-functional approach described in the previous section. Thus, the second research proposition is:

RP2. The largest Spanish investors in Latin America have used a cross-functional set of tools and techniques, including decisions about their strategy, operations, marketing and finance, to hedge their FOREX as the availability and effectiveness of financial instruments is limited in the emerging markets under study.

Sample and data collection

This research work focuses on investments from a developed country (Spain) in emerging markets (Latin America). The European origin of the sample differentiates this work, as most previous studies have analysed firms in the USA; the same applies to the destination of the investments since research in this field on emerging markets has been scarce.

A non-probabilistic sample was applied and the participation of seven of the ten largest investors was secured. These companies account for over 90 per cent of the Spanish investments in Latin America as well as over 50 per cent of the total European funds invested in the region. Table II shows the operating income weighted by origin in the companies that constitute the sample of this work. As all the companies in the sample had international operations at the time of the research, the work also overcomes some criticism of previous studies (Bartov and Bodnar, 1994) claiming that they did not consider whether the firms had international operations and/or attempted to manage their exposures. The findings were analysed on a case-by-case basis; however, for reporting purposes, some of them are presented as aggregate.

The data collection process was based mainly on interviews containing structured and open-ended questions with senior managers, directors, and/or members of the Board of the seven companies participating in the study in addition to the collection of second-hand information from the companies, national governments, and multinational organisations. The interviews were carried out in Spanish between February and March 2005 in Madrid, Spain. The structure of the interviews as well as the sought information was based on the key themes identified in the analysis of the literature, as shown below:

Measurement and assessment of economic/operating exposure difficulty (Lees and Mauer, 2002; Martin and Mauer, 2003).
Stage of the planning process when economic exposure is incorporated (Miller and Reuer, 1998).
Investments abroad/multinational production networks/geographic diversification as hedging tools (Bodnar et al., 1998; Chow et al., 1997a, b; George and Schroth, 1991; Jacque, 1981; Jorion, 1990; Lessard and Lightstone, 1986; Martin et al., 1999; Martin and Mauer, 2003; Pantzalis et al., 2001; Pringle, 1995).
Ownership structure policy for foreign investments/reasons to decide to place investments overseas (Kennedy, 1984).
Relation (if any) between geographic diversification and degree of exposure (Allayannis and Ofek, 2001; Chow et al., 1997a; Hodder, 1982; Martin and Mauer, 2003; Pringle and Connolly, 1993).
Strategies of competing firms/Intercountry rivalry in industry (Hodder, 1982; Marston, 2001; Miller and Reuer, 1998; Porter, 1990; Pringle, 1995; Shapiro, 1975; von Ungerm-Sternberg and von Weizssacker, 1990).
Degree of product differentiation and price elasticity of customer demand (Porter, 1990; Sundaram and Black, 1992; Sundaram and Mishra, 1991).
Development of formal policies against FOREX (Hakkarainen et al., 1998).
Relation among the development of formal policies with the time since companies started their internationalisation process with the intended degree of hedging and with the companies' exposure level (Hakkarainen et al., 1998).
Participation of finance, marketing, operations management, and strategic planning when making decisions about hedging against foreign exchange risk (Lees and Mauer, 2002; Martin and Mauer, 2003).
Generation of relevant information within the company, and relation between the different units responsible for generating this information (Lees and Mauer, 2002).
Centralisation/decentralisation of decision-making and implementation of hedging activities (Sundaram and Black, 1992).
Relative use of financial hedging tools/effectiveness of these tools against FOREX is unclear (Chow et al., 1997a, b; Pringle, 1991; Pringle and Connolly, 1993).

Quantitative and qualitative analyses

Quantitative analysis

This was carried out in a similar way to that in previous papers (Allayannis and Ofek, 2001; Choi and Kim, 2003; Chow and Chen, 1998; Faff and Marshall, 2005; Guay, 1999) where a coefficient of FOREX of the sampled companies is calculated through a time series regression of the companies' stock returns on market and foreign exchange returns. In this context, foreign exchange risk was defined as changes in the value of the firm as a consequence of changes in the value of the currency. However, there is a difference in the use of real exchange rates rather than nominal exchange rates used by most of those papers. This is because “the random walk and the market efficiency hypotheses might make both nominal and exchange rates acceptable for advanced industrialised countries” but for emerging economies like the ones under study the “same degree of market efficiency cannot be expected” (Choi and Kim, 2003). This coefficient was calculated using contemporaneous exchange rates as the evidence between contemporaneous and lagged is mixed and there is no theory to say what length of lag is appropriate. The equation used can be seen below: Equation 1 where R _it is the return of company i in period t, R _mt is the return for the market index in period t, and R _fxt is the return on real exchange rate in period t.

This market-based model attempts to analyse the effects of variations in the exchange rate on stock returns (Allayannis et al., 2001; Bartov and Bodnar, 1994; Choi and Prasad, 1995; Faff and Marshall, 2005; He and Ng, 1998; Jorion, 1990; Martin et al., 1999). The election of this model was based on:

the possibility to of assessing the overall impact of changes in the currency price on the value of the firm;
its flexibility; and
its forward-looking nature.

However, this model has some weaknesses when assessing exchange rate exposure.

First, “by using the capital market to assess exposure, there is heavy reliance upon the market to accurately use available information” (Martin and Mauer, 2003). For example, Bartov and Bodnar (1994) said that investors might not use all available information to evaluate the impact of exchange rate changes on firm value. In addition, Chow et al. (1997b) stated that investors are unable to assess the impact on firm value from current exchange rate changes because they found great frequency of significant exposure using long-horizon returns. Furthermore, Marshall and Weetman (2002) as well as Roulstone (1999) argued that inadequate financial statement disclosures on the extent of exposure contribute to impeding the capital market in its efforts to assess exposure.

Second, the market-based model “does not provide a sense of the time profile of exchange rate effects. Whether such effects impact company operations in the short-term or in a longer-term time frame is a major issue for many analysts, investors, and managers” (Martin and Mauer, 2003).

Third, another weakness of this model is that it only measures net impacts, i.e. the remaining exposure after the company's hedging activities:

As a result, it is difficult to empirically detect exchange rate exposure using [this] approach. In other words, sensitivity of stock returns […] to exchange rate risk may not be significant for firms that have ex ante exposures but that are proficiently managing these exposures (Martin and Mauer, 2003).

By taking a cross-functional approach and including qualitative data, this work attempts to overcome the weaknesses, described above, of this widely used method of FOREX assessment.

Qualitative analysis

The qualitative data collected from the interviews was analysed and coded using the systematic approach described by Glaser and Strauss (1967) [3]. The first “natural” coding was done by the structured questions in the survey. Subsequently, the objective was the development of new categories, hypotheses, and interrelated hypotheses. The unit of analysis for the qualitative study was the different incidents (which varied from a single phrase or sentence, to an entire comment consisting of two or three sentences, Titscher et al., 2000) reported by the participants. These incidents were sorted under the categories that were emerging as the review of the data went on. During this continuous process, the categories and their incidents were compared, which generated properties that were then integrated with the categories. As the process of comparison started to produce fewer new results, the next step saw the consolidation of the categories and their properties. Finally, the conclusions were summarised and combined with the quantitative analysis.

Quantitative analysis results

The first step in this quantitative analysis was the calculation of a coefficient of FOREX using equation (1). This coefficient attempts to show the sensitivity of the companies' value to changes in the exchange rate of the countries under study using the return on market index (IBEX 35 in this case) as statistical control[4]. Monthly data from 1 January 1998 to 31 December 2004 was used[5], a period covering the start, development, and aftermath of the latest currency crises in Latin America. The calculations were carried out using SPSS 12.0 for Windows. The outcome of these calculations can be seen in Table III, which shows the estimates for market risk and FOREX.

In this table it is possible to see that the mean market risk (β _m) across the sample is 0.0011, with a minimum of 0.0001 and a maximum of 0.0014. All the companies have a positive beta estimate, and the vast majority of these positive betas are statistically significant (|β _m/S _b|>t _n−3;0.975). It is also possible to see that the mean foreign exchange risk (β _fx) is 0.0068, with a minimum of −0.2024 and a maximum of 0.1397. In this case, the majority of these estimates are statistically significant (|β _fx/S _b|>t _n−3;0.975). This was expected as the companies in the sample had FOREX due to their operations overseas. The non-statistically significant estimates as well as the negative ones could be explained by the companies' hedging activities or the offsetting impact of their operations in multiple currencies (Allayannis and Ofek, 2001; Faff and Marshall, 2005). The mean of the absolute value of the FOREX is 0.0847.

In Table III, the analysis of every company's situation shows three tiers of FOREX:

low (Co1);
medium (Co2, Co5 and Co6); and
high (Co3, Co4 and Co7).

In this context, Co3, Co4 and Co7 present the relatively highest exposure, meaning that for every 1 per cent movement in the weighted exchange rate index for each company, the value of these three companies have been affected by around −20 per cent, 14 per cent and 13 per cent, respectively, controlling for independent variables in the equation (the situation of these three companies will be studied in more detail in the following section).

Considering the medium and high tiers as having an impact on companies' value, it is possible to accept the first research proposition that the variations in the value of the currency during the crises and their aftermath have affected the price of these firms' shares. It is also possible to say that this impact has been negative in the sense that these companies were not successful in convincing the market of the strength of their hedging strategies. The latter is relevant in the context of this work as all the companies said that they were using some kind of financial hedging instrument to protect the value of their investments in Latin America. Although this supports the idea of the limited effectiveness and availability of these instruments in emerging markets and therefore the need for alternative hedging strategies, a further study of the companies' earning power (Shapiro, 2003) or using a cash flow-based model (rather the market-based model used in this work) would be necessary to make a more conclusive assessment of the effectiveness of their hedging activities.

Qualitative analysis results

Using the methodology described in the previous section, the results of the qualitative analysis of the data collected in the interviews can be seen below. The analysis was focused on studying the hedging strategies of the companies in the sample.

Foreign exchange exposure assessment and hedging difficulty

Companies in the sample recognised that the extent of the currency crises in Latin American countries and their consequences were difficult to anticipate (this has also been found by Lees and Mauer (2002) and Martin and Mauer (2003) in industrialised countries). As a result, the performance and the daily operations of their subsidiaries operating in these countries was affected in different ways, even considering that their overseas operations were hedged with financial instruments. This is in line with the conclusions of previous studies in developed countries (Chow et al., 1997a, b; Pringle, 1991; Pringle and Connolly, 1993) in the sense that the effectiveness of financial tools against FOREX is unclear.

Non-financial mechanisms

Companies in the sample applied non-financial mechanisms to protect the value of their investments in Latin America before the crises. All the companies employed a policy of majority control in their foreign investments with the aim of transferring the parent's firm-specific advantages to the subsidiaries, a strategy identified in the literature as effective in hedging against FOREX (Kennedy, 1984; Porter, 1990; Sundaram and Black, 1992; Sundaram and Mishra, 1991). In addition, firms in the sample included the study and assessment of their future subsidiaries' FOREX during the planning stage (also suggested by Miller and Reuer, 1998).

Post-crises initiatives

Participants said that after the crises, companies designed complex tools, policies, and mechanisms to protect their cash flows from unexpected variations in the exchange rate; as one of them put it, these initiatives are “sons of the crises”. These firms created dedicated teams based in the HQ in Spain that are constantly monitoring the economic, financial, and political situation in these countries. These teams report to the highest level of the company at short intervals (e.g. every 15 days in one of the cases) and have a direct link to the subsidiaries' commercial policy (an initiative proposed by Lees and Mauer, 2002). The majority of these companies also developed exchange rate policies (as suggested by Hakkarainen et al., 1998). Finally, one of the companies (Co6) made a large investment in a European country (outside the eurozone) as a hedging strategy against its exposure in Latin America (a hedging strategy put forward by Bodnar et al., 1998; Chow et al., 1997a, b; George and Schroth, 1991; Jacque, 1981; Jorion, 1990; Lessard and Lightstone, 1986; Martin et al., 1999; Martin and Mauer, 2003; Pantzalis et al., 2001; Pringle, 1995).

The companies in the sample, the largest European investors in Latin America, based their original hedging strategies on financial tools but then recognised that these tools have not been completely effective in dealing with the currency crises in these emerging markets. As a consequence, they started the development and use of these cross-functional “post-crises” initiatives to protect their overseas investments against FOREX. Participants claimed that these initiatives were based on the idea that unexpected fluctuations in the value of the currencies of these emerging Latin American markets have impacted the companies' performance and operations and that financial hedging “is not enough”, as one of them put it. This idea is in line with previous findings in relation to the FOREX indirect effects, its longer-term nature, and the question mark over the effectiveness of financial hedging (Chow et al., 1997a, b; Pringle, 1991; Pringle and Connolly, 1993).

The participants said that these cross-functional initiatives have helped them to have a better understanding and a closer look at the environment in Latin America. However, these seem to be reactive strategies; no currency crises have occurred since their implementation to measure the results, and they could eventually magnify the consequences of a crisis if the decisions are short-sighted.

The outcomes of the qualitative analysis support only a part of the second research proposition as participants recognised that assessing the FOREX and hedging their potential consequences is difficult, and that the effectiveness of financial hedging instruments is unclear.

Participants also said that, in general, before/during the crises they did not implement initiatives in areas other than finance (e.g. marketing, operations management, strategic planning, etc.) specifically aimed at protecting the value of their investments in Latin America. The majority control in their investments was mainly a “knowledge transfer” strategy rather than a hedging strategy, therefore it cannot be considered a pre-emptive hedging measure in the context of this study.

All in all, the second research proposition is rejected as these companies did not include initiatives from different functional areas to hedge the value of their investments during the crises. This could be one of the reasons why companies' value was affected as shown in the quantitative analysis section. An area for future research would be the study of the effectiveness of the initiatives resulting from their experience during the crises, described in the “post-crises initiatives” section.

Quantitative and qualitative analyses results

An analysis of the three tiers of FOREX (described previously) against the answers received in the interviews based on the key themes identified in the literature was carried out with the aim of assessing the effectiveness of their hedging strategies. This analysis looked at the relations, differences and similarities in the hedging strategies pursued by the companies in the different tiers.

First, companies in the high exposure tier (Co3, Co4 and Co7) are the ones with the relatively lower operating profit coming from Latin America in 2003 (Table II). This can be explained by a possible offsetting effect of the operations in multiple currencies of the companies in the other two tiers.

Second, Co3 and Co7 saw an important reduction in the operating profits produced in Latin America between 2000 and 2003 (Table II); participants said that this reduction was a consequence of unanticipated variations in the cash flow, decreases in the demand for their products, changes in the demand's composition, debtors in arrears, non-performing debts, and changes in the supply chain. These consequences show empirical evidence of the indirect and longer-term effects of the variations in the exchange rate and also why financial hedging instruments are not always effective (Chow et al., 1997a, b; Pringle, 1991; Pringle and Connolly, 1993). They also lend support to the idea that a cross-functional approach to hedging FOREX may offer a more effective way to deal with this risk. In fact, the three companies in the high exposure tier recognised that their foreign exchange risk assessment is carried out only by the finance area.

Finally, the six companies in the high and medium exposure tiers said that the subsidiaries' degree of autonomy to make decisions and implement initiatives against foreign exchange risk is medium and low (contrary to what was suggested by Sundaram and Black (1992) that a high degree of autonomy should be given to subsidiaries operating in turbulent environments). Co1, the only one with low exposure, has given high autonomy to the regional headquarters located in Mexico.

In summary, from the evidence collected during the interviews and the tables from the firms' balance sheets, it would be possible to say that:

companies with operations in multiple currencies have higher possibilities of offsetting their FOREX;
that unexpected fluctuations in the value of the currencies in emerging markets affect different areas within the company and that an effective way to deal with this challenge is by assessing the FOREX among the different functional areas; and
that giving more autonomy to subsidiaries operating in changing environments to make decisions and implement initiatives against FOREX seems to be effective in dealing with this risk.

Similar findings in industrialised countries have been presented in previous papers and discussed throughout the text; this work attempts to make a contribution in this area by providing evidence of companies operating in emerging markets.

Summary and conclusions

This section presents the outcomes of quantitative and qualitative analyses resulting from the analysis of annual reports and interviews on the decisions and strategies aimed at protecting the value of subsidiaries against variations in the exchange rate made by seven large Spanish investors in Latin America. The objective of these analyses was to examine the links between these decisions/strategies and the FOREX of the companies. As these firms have international operations and actively try to hedge their exposure, the idea was to study the effectiveness of their decisions/strategies in a context of emerging countries where it is claimed that institutions, transactions costs, and resources of the firm impact companies' performance in different ways than can be expected in industrialised countries (Aulakh et al., 2000; Hoskisson et al., 2000; Khanna and Palepu, 2000; Suarez and Oliva, 2002). In addition, this study gains relevance in the current environment of increasing economic integration between the European Union and Latin America, where the former is the largest foreign investor.

In the quantitative analysis, a foreign exposure coefficient for each company in the sample was estimated by running a set of time series regressions. This analysis falls within the first objective of this work, which is to look at the impact that variations in the exchange rate in Latin American countries had on the value of selected large investors in the region. As foreseen in the research proposition, these variations made medium and high negative impacts on the value of the majority of the companies in the sample.

Then, the qualitative analysis used data collected during interviews containing structured and open-ended questions. This analysis was carried out within the second objective of studying the decisions/strategies used by the largest Spanish investors in Latin America to protect the value of their investments against fluctuations in the value of currencies. These companies used mainly financial hedging instruments before/during the crises. Then, and likely as a consequence of a learning process, they developed and adopted models to manage exchange risk and mitigate impacts based on the active participation of the different functional areas in the companies. As these models were adopted after the crises, the second research proposal was rejected.

Finally, these quantitative and qualitative analyses were integrated with the aim of analysing the effectiveness of the decisions considering the FOREX coefficient obtained in the first step. The analysis showed that:

companies with operations in multiple currencies have higher possibilities of offsetting their FOREX;
that unexpected fluctuations in the value of the currencies in emerging markets affect different areas within the company and that an effective way to deal with this challenge is by assessing the FOREX between the functional areas; and
that giving more autonomy to subsidiaries operating in changing environments to make decisions and implement initiatives against FOREX seems to be effective in dealing with this risk.

All in all, from these results it is possible to conclude that to protect the company's value against variations in emerging countries' exchange rates a pre-emptive and cross-functional approach is needed, i.e. hedging in emerging markets seems to imply more than protecting the cash flows using financial instruments. These conclusions were obtained from the analysis of case studies from a relatively small sample, therefore limiting their possible generalisation; future works should aim at testing them in larger samples as well as in other emerging regions.

On the other hand, the analysis of the data collected in the interviews suggested an area that has been scarcely mentioned in the literature as effective in dealing with FOREX and would be worth investigating in future works. Participants emphasised the importance of having a deep knowledge (e.g. history, society, politics and culture) of the emerging markets where they have been operating, as the business environment in this emerging region is different from that in their home country. They recognised that the incorporation of local talent (in the form of local partners, local managers and/or local advisors) as well as the cross-subsidiary transfer/share of experiences/knowledge have offered flexibility to each functional area to react and have helped local operations to foresee and mitigate the effects of currency crises. Then, the question would be whether local knowledge and/or cross-subsidiary knowledge transfer should be included in the pre-emptive and cross-functional approach mentioned above, along with the design of measurements for its effectiveness. This “local knowledge” has been implied in previous works about companies in emerging markets (Del Sol and Kogan, 2007; Khanna and Palepu, 2000); however its links with foreign exchange hedging have not been widely studied.

Summarizing, the research results suggest that foreign companies exposed to exchange risks in emerging markets gain resilience when they take a cross-functional approach for the assessment and implementation of hedging strategies along with the decentralisation to subsidiaries of the decisions and implementation of hedging initiatives. This helps companies in:

elaborating scenarios;
assessing possible impacts of exchange rate variations;
designing pre-emptive measures; and
setting alternative strategies to mitigate potential impacts.

This cross-functional approach to manage risks in emerging markets seems to offer companies higher flexibility and new knowledge that can be shared among subsidiaries working in similar economic and political environments.

Equation 1

Table ICumulative net investment by selected Spanish firm in Latin America (2003, millions of euros)

Table IIOperating profits weighted by origin from the companies in the sample (2000 and 2003)

Table IIIEstimated for market risk and FOREX

References

Aggarwal, R., Soenen, L. (1989), "Managing persistent real changes in currency values: the role of multinational operating strategies", Columbia Journal of World Business, No.Fall, .