Since the yen was floated in 1973, Japanese firms have continuously been concerned and struggled with the yen’s volatile movement. Faced with a strong yen, Japanese exporters have two choices in the short run. First, the yen-denominated export prices can be maintained – yen appreciation is passed through to the retail prices in the destination market – resulting in lower profits due to lower sales volumes. The second option is to maintain the dollar-denominated export prices – yen appreciation is not passed through – resulting in lower profits due to a lower profit margin, while export quantities can be maintained. Japanese exporters have developed various measures to mitigate foreign exchange risk over time.
Japanese firms usually use both financial and operational hedges to manage their currency exposure. With the development of financial techniques, such as forward transactions, currency swaps, and currency options, firms can hedge their currency exposure against foreign exchange risks. Japanese exporting firms have accelerated expansion of production bases overseas in response to the unprecedented level of the strong yen in the mid-1990s. The firms have also increased the proportion of imported components from overseas and used other operational hedges to mitigate the exchange rate risk.
The choice of invoicing currency is also related with their currency exposure. If yen invoicing can be adopted, the firms can escape the profit squeeze due to yen appreciation, but may still suffer sales decline. If dollar invoicing is adopted, profits will automatically decline proportionately to the exchange rate, unless financial hedge is adopted. According to the Ministry of Finance data, Japanese exporters have a strong tendency to choose the importer’s currency for their exports to advanced countries such as the US and EU. This is one of the reasons why currency risk management is a serious problem among Japanese firms.
Japanese firms’ exchange-rate risk management
Following Döhring (2008) and Bartram et al. (2010), we assume that Japanese firms have four options in managing exchange rate risk: (1) choice of invoice currency, (2) pricing (pass-through) policy, (3) operational hedging, and (4) financial hedging. Figure 1 shows our conceptual diagram of exchange rate risk management. Compared with the related studies above, the novelty of our analysis is to conduct rigorous empirical analysis of the exchange rate risk management of Japanese firms using the four different tools.
Figure 1. Concept of exchange rate risk management
Note: The part of "Operational hedges" and "Financial Hedges" is from Döhring (2008).
In order to obtain information on how export firms are coping with exchange rate fluctuations, a large scale questionnaire survey was designed and conducted with the cooperation of the Research Institute of Economy, Trade, and Industry (RIETI). The questionnaire survey (hereafter, the 2009 RIETI survey) were sent in September 2009 to 920 Japanese Tokyo Stock Exchange listed manufacturing firms, and we got 227 sample firms’ rich information related not only to the firms' foreign exchange rate risk management but also to the firms' choice of invoicing currency and price revision strategy (pass-through).
Japanese firms’ exchange rate exposure
How can we measure the effectiveness of Japanese firms' exchange rate risk management? One way is to measure each firm's exchange rate exposure, and to investigate the relationship between the exchange rate exposure and the exchange rate risk management. We follow previous studies such as Dominguez (1998) and Doukas (2003) that have derived exchange rate exposure by estimating the sensitivity of firms’ cash flows to the fluctuations in the exchange rate. The value of a firm is the present value of its future cash flow stream and the exchange rate variation will affect the cash flows in the future. To date, many empirical studies have used stock price returns as a proxy for the firm value, and have obtained exchange rate exposure from a regression of stock price returns on an exchange rate change. To control for other macroeconomic factors on realised returns, most empirical studies include a return to a market portfolio in the regression model (e.g. Dominguez and Tesar 2006).
Figure 1 presents the estimated exchange rate exposures using the yen-to-dollar exchange rate and nominal effective exchange rate (NEER). Among 15 industries in Japan, the exchange rate exposure of "Transport Equipment" is the highest. The second is "Precision Instruments", and "Electric Machinery" and "General Machinery" are the next except for "Other Products". These results are consistent with the fact that such Japanese representative manufacturing industries are highly exposed exchange rate risk.
Figure 2. Exchange rate exposure by industry (controlled by TOPIX, on a monthly basis from January 2005 to December 2009, Industry average of sampled firms)
Note: Exchange rate exposure captures the sensitivity of firms’ cash flows to the fluctuations in the exchange rate.
Source: Authors’ calculations.
Determinants of firms' foreign exchange exposure
We then conducted a regression analysis to investigate the relationship between the Japanese firms' exchange rate risk management based on the 2009 RIETI survey and the exchange rate risk exposures estimated above. Our hypotheses with respect to firms’ exchange rate risk management are as follows:
- Large share of foreign sales to total sales increases exchange rate exposure.
- High share of dollar invoicing increases exchange rate exposure.
- Financial and operational hedges reduce exchange rate exposure.
- Financial and operational hedges can be effective in reducing exchange rate exposure, especially for a firm that chooses mainly dollar invoicing.
- High share of yen invoicing decreases exchange rate exposure.
- Frequent price revision (pass-through) decreases exchange rate exposure.
Hypotheses 1, 2 and 3 have been examined in many previous studies. Our contribution is in Hypotheses 4 and 5, which examine the effectiveness of financial and operational hedge with the choice of invoicing currency.
Our novel findings, which provide the characteristics of Japanese exporting firms’ exchange rate risk management, are as follows:
- Large Japanese manufacturing industries have a significant exposure to the exchange rate risk.
- The higher the dollar invoicing share, the greater the exchange rate exposure is. However, the risk is reduced by both financial and operational hedging.
- Yen invoicing leads to a lower exchange rate exposure measured in the stock market.
- Price revision (pass-through) theoretically reduces a firm’s total exchange rate exposure, but it is not found to be statistically significant in the regression.
Our analysis shows how Japanese firms combine three different tools of exchange rate risk management – operational hedge, financial hedge and control of exchange rate pass-through via their choice of invoicing currency – to reduce their exchange rate exposure. Most of results are consistent with conventional wisdom. However, it is a novel finding that those firms employing currency hedge and choosing yen invoicing are judged by the market to have reduced currency exposures. We also found that Japanese firms do use operational and financial hedging strategies. Theoretically, in the medium run, the firms with large currency risk revise the export prices to partially counter losses from yen appreciation. However, this was not confirmed by the data.
This is the first detailed investigation of the exchange rate risk management policy of Japanese firms, which was made possible by the newly conducted survey. These findings suggest important implications and tools for Japanese firms' exchange rate risk managers to build more efficient risk management schemes.
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