ATJ Asian Tax Journal

Asian Tax Journal

Print ISSN 1738-3323 Online ISSN 2733-9270

The Effectiveness of Exchange Rate Risk Management Practice by the Korean Shipbuilders

  • Jeongsun Kim Korea University Business School

Asian Tax Journal Vol. 15 No. 6 (2014), pp. 237-264

Abstract

Shipbuilders typically face the risk of uncertain future cash flow due to the change in exchangerates because their operations largely depend on U.S. Dollar denominated foreign orders forgenerating revenue. In order to manage currency risk exposure and reduce the firms’vulnerabilities from major exchange rate movements, they often enter into forward contracts thatfix the rate at which they can convert the foreign currency into the domestic currency at prespecifiedtime in the future. Prior studies suggest that active currency risk management using the financial derivatives havepositive impact on the capital market by increasing firm value (Aretz and Bartram 2010；Kwonet al. 2011), signaling the manager’s ability (DeMarzo and Duffie 1995), and enhancing theusefulness of accounting information (Lee and Shin 2013). Hedging activities, however, also havedownsides. For example, unrestricted use of the derivatives instruments can lead to a large lossthat can haunt the firm’s entire operations. In addition, there is a fair chance that using hedgeaccounting may mislead the investors regarding the firm’s performance and financial position bydistorting the economic substance of the entity’s risk management activities. This study analyzes the real－world effectiveness of financial derivatives as part of the hedgingpractice by the Korean shipbuilders. For many firms in the industry, significant depreciation ofKorean Won in 2008 at the onset of the global financial crisis resulted in a large loss from thechange in fair value of the outstanding forward contracts. Inaccurate reflection of the firm’seconomic reality in the financial statements called for a change. In order to prevent capitalimpairment by some firms, the Financial Supervisory Service revised the rules of hedgeaccounting to permit the use of fair value hedge accounting. The results of this case study suggest that the shipbuilders using the forwards showed lowerprofit ratios and more stable debt ratios than would have shown otherwise. By entering into theforward contracts, companies not only incurred revaluation losses but also forfeited large salesrevenue when foreign exchange rate rose suddenly. This result implies that the foreign currencyhedging strategies using the derivatives was ineffective. The results of this study suggest that the hedging activities undertaken by these firms should beevaluated more strictly by carefully analyzing the economic implication behind them. Cautionshould be given for the ineffective exchange rate risk management as any inadequate treatment ofthe risk can be penalized by the investors.

Keywords

  • Financial Crisis
  • Shipbuilders
  • Derivatives
  • Hedge Accounting

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