Corporate Governance and Currency Hedging

In the late spring of 2008, it became clear the United States economy was headed for a period of economic contraction.  It had been several years since the last recession, and it seemed right and prudent that the U.S. economy was correct.  We had enjoyed several years of aggressive growth and business expansion in the U.S., and the natural order of things in general economic theory instructs us that there must always be a short corrective period after several years of aggressive growth.  Thus, in the late spring of 2008, economists and financial professionals were expecting a general slow-down in the economy.  However, very, very few were prepared for what was about to hit the global economy.

Just a few months later, the very existence of our modern global financial system came under attack.  In late August and early September of 2008, major financial firms in the United States and Europe collapsed.  Bear Stearns, Lehman Brother, Fannie & Freddie, and others came crashing down, and for a few weeks, it was unclear if the economy would survive.  Interbank lending markets completely froze as banks refused to lend to one another due to the historically unprecedented market volatility, and this credit market freeze trickled down to the real economy and complete hysteria began to grip the general public.

Strength of Corporate Governance

During the 1990’s and 2000’s, financial markets were largely deregulated in an attempt to allow the free market to establish market cycles.  However, in the wake of the 2008 Recession, many lawmakers and economists are now calling for much stricter corporate governance because the Recession of ’08 proved that when left unchecked, too many corporations will engage in questionable behavior, and the interconnectedness of today’s global economy causes the failure of a few financial firms to be felt around the world.

One problem is forex scalping.  High frequency trading involves holding trades for a few seconds or even less than a second.  Highly quantitative mathematical models are built by quantitative analysts and they take advantage of extremely small price movements in the market.  Weak corporate governance allows firms to engage in activity that does not foster a healthy economic and fair trading environment but actually hinders it.  The proper functioning of financial markets is essential to the health of an economy, and some corporations engage in high frequency trading in a way that removes liquidity from the market, which makes trading much more difficult, and critics argue that this offers these corporations an unfair advantage.

The improper use of high frequency trading has come under even more fire as a result of the Flash Crash this spring.  Although corporate governance is not the only solution, it is one way to bring more regulation and accountability to U.S. financial firms.

The strength of corporate governance over a firm tends to significantly influence its interaction with currency.  Ugur Lel, an economist for the Federal Reserve who works in the Division of International Finance, recently wrote a paper entitled, “Currency Hedging and Corporate Governance:  A Cross-Country Analysis.”  Lel’s findings are quite fascinating.  First of all, in the course of his research he discovered that firms with strong corporate governance tend to employ a currency trading strategy and use currency derivatives for value-maximizing reasons, while firms with weak corporate governance tend to use currency derivatives mostly based on the self-interests of the management team and selective hedging.

Firms with weak corporate governance are more likely to speculate in the currency market with a high disregard concerning the inherent risks.  They tend to use very complex currency derivative products because investors have a very difficult time understand true firm exposure surrounding the use of these products, so these firms can speculate aggressively, and investors cannot tell.

The 2008 Sub-Prime Mortgage Crisis was largely due to very complex derivatives that investors largely did not understand.  Thus, many politicians and economists are calling for stricter corporate governance concerning the use of these complex financial instruments in relation to currency hedging and forex scalping, and Lel’s findings seem to support the notion that stronger corporate governance tends to encourage responsible use of these very powerful and complex instruments.

Companies exposed to foreign trade and capital flows must hedge against currency volatility, so the use of currency derivatives is essential in order to protect a firm’s profits, and this hedging activity will continue to be essential in the coming months and years as the global economy faces a likely extended period of market volatility.  However, strong corporate governance must be in place in order to provide protection to the entire economy by encouraging firms to responsibly use these complex financial instruments.

Guest post by Jennifer Gorton of Forex Traders.

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