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Based on theoretical and empirical research results from uniquely designed analysis frameworks, KCMI Research Papers draw out implications as well as policy directions for Korea’s financial industry and markets.

보고서 1
Effects of FX Hedging on Korea’s Outward Portfolio Investment [19-01]
Senior Research Fellow LEE, Seungho and others / Jan. 25, 2019
Korea has seen a rapid increase in foreign financial assets owned by local residents on the back of persistent current account surpluses. In particular, Korea’s outward portfolio investment has shown a pronounced upward trend since the global financial crisis. In the context of portfolio investment, effective management of exchange rate risk is very important to maximize the benefits of global diversification because exchange rate fluctuations could give rise to gains or losses. In this regard, the challenge facing major institutional investors in Korea is to have a foreign exchange (FX) risk management policy tailored to institution-specific characteristics.  

FX risk management by domestic institutional investors in relation to outward portfolio investment is still in its infancy. Many institutions do not have a well-established FX hedging policy or they usually take a conservative approach to managing FX risk arising from exchange rate changes. More specifically, most institutions or funds tend to emulate their larger peers (e.g., public funds) in designing an FX hedging policy rather than taking into account their unique features. As a result, domestic institutional investors maintain FX hedging policies under which their outward portfolio investments are hedged at the asset-class level with global stocks unhedged and global bonds fully hedged. However, the effects of FX hedging at the asset-class level are hardly consistent across countries and across periods. Furthermore, given the intended purpose of an FX hedging policy is to manage FX exposures within an international portfolio, hedging FX risks at the individual asset class level is a local optimum so that this approach does not guarantee a global optimum for a global multi-asset and multi-currency portfolio, which makes asset-level FX hedging become a limited tool.
    
In this study, we aim to highlight key considerations, decision-making criteria and analytical frameworks that major domestic institutional investors engaging in outward portfolio investment should take into account when formulating their FX risk management policies. We conduct a multi-faceted analysis on changes in the risk return profiles of global portfolios (based on final investment returns converted into Korean won) when FX hedging policy is established either at the asset-class or portfolio level. In addition, we examine the effects of FX hedging on the foreign exchange market in that the foreign exchange market is affected by the FX hedging policies of institutional investors engaging in outward portfolio investment, and accordingly the foreign exchange authorities directly or indirectly regulate FX hedging policy formulation and implementation by institutional investors, which in turn affects FX hedging practices in the market.   
More specifically, we investigate the effects of asset-level FX hedging on stocks and bonds issued in four developed economies (the US, Japan, Eurozone, and the UK) and two emerging market economies (China and Brazil) since 2004 in order to explore the efficiency and persistence of the asset-level FX hedging policy adopted by the majority of Korean institutional investors. Our empirical analysis yielded different results for developed and emerging market economies when it comes to foreign stocks. As for developed countries including the US, a strong negative correlation was found between stock and currency returns, which means leaving foreign stocks unhedged would be an effective risk minimizing strategy. On the other hand, the full hedge strategy performed better in Brazil, one of the emerging markets. But no significant difference between fully hedged and unhedged foreign stocks was found in the case of China. Also, we analyze the impacts of asset-level FX hedging on the foreign stocks and bonds in different periods, taking the 2008 global financial crisis into consideration, to measure the persistence of static FX hedging policy. We find that there can be no assurance that FX hedging effects will be persistent. However, the findings provide strong support for fully hedging foreign stocks, which is the FX hedging policy widely used by domestic institutional investors engaging in outward portfolio investment. 

We also analyze the effects of portfolio-level FX hedging on the foreign stocks and bonds to confirm the importance of portfolio hedging, which is the focus of our study.  The analysis of the portfolio-level hedging showed different results in several respects from the analysis of the asset-level hedging described above. With the asset-level FX hedging over the entire sample period, it seems desirable for foreign stocks to be unhedged and for foreign bonds to be fully hedged. With the portfolio-level FX hedging, however, full hedging looks effective for all asset classes to minimize the overall portfolio volatility. In addition, the analysis of global multi-asset class and multi-currency portfolios reveals that as the number of currencies and asset classes included in the portfolio increases, the use of a full hedge should be reduced, if possible, in order to maximize global diversification effects and mitigate the volatility of the overall portfolio. Not only that, we find FX hedging at the total portfolio level would be more stable in terms of persistence of the hedging effects. 
Turning to the foreign exchange market, we discover that the FX hedging of outward portfolio investments has a negative impact on the swap rate in the FX swap market rather than the spot rate, but this finding is not statistically significant. Nevertheless, it is difficult to exclude the possibility that when Korean residents invest in foreign bonds, if over- hedging of exchange rate risk as seen today continues and the investment volume rises steadily, then such hedging activities would create demand for FX swaps, which would eventually result in greater imbalance in the FX swap market. 
The following implications can be drawn from the results: First, further review is required for asset-level FX hedging policies, which domestic institutions have in place as a result of imitating their larger peers, in terms of consistency or persistence of the effects. A shift in FX hedging should be made by institutional investors with global multi-asset and multi-currency portfolios to make FX hedging decisions at the portfolio level rather than the asset-class level. 

Second, a single bottom line instead of a double bottom line, which seeks higher returns and less risks at the same time, should be adopted as criteria for determining an optimal FX hedge strategy. Recognizing that FX hedging is an intrinsic part of risk management, institutions need to develop a FX hedging policy that reflect risks lurking in their portfolios. Further, the FX hedging policy should factor in institution-specific characteristics, such as the size of investment, debt or maturity structure, and risk tolerance, as well as portfolio-specific features.   

Third, it is worth noting that FX hedging could have greater influence on the FX market because of continuously growing outward portfolio investments. The foreign exchange authorities need to keep in mind that the practice of over-hedging for foreign bonds in the absence of clear FX hedging policies among Korean institutional investors would reduce the positive effects of a virtuous cycle in which idle foreign currency-denominated funds arising as a result of current account surpluses are channeled into portfolio investment, and that such over-hedging practice would add more imbalance and volatility to the FX market. In the meantime, institutional investors investing in overseas markets should formulate their FX hedging policies considering that the effects of FX hedging in global portfolio investments on the FX market, may differ between the spot market and the swap market depending on whether or not to hedge.   
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보고서 1
Driver Analysis on the Determinants of Change in Corporate Cash Holdings [18-05]
Senior Research Fellow Park, Yong Rin / Dec. 26, 2018
This report aims to analyze the drivers of the secular increase in cash holdings of Korean companies using fund flow identity from cash flow statement in an effort to determine whether the rise in corporate cash holdings stems from decline in corporate investment or rational corporate financial decision making.
This report contributes to the existing literature in the following ways. First, this report adopts a systematic and integrated approach toward identifying the drivers of the increase in corporate cash holdings, utilizing information contained in the corporate fund flow identity. Second, this report employs Dominance Analysis to identify the independent variable with the highest relative importance defined as average incremental explanatory power for the dependent variable. Third, this report integrates the fund flow identity and a variant of the regression equation for the determinants of corporate cash holdings, to generate a regression equation for the determinants of the change in corporate cash holdings.
The fund flow identity means that cash flow from operations as a source of fund, should be equal to the sum of the change in cash holdings, investments, dividends, share repurchases, net debt redemption, and net equity redemption, all of which are uses of funds. The regression equation for the determinants of the change in corporate cash holdings is composed of the change in cash holdings as the dependent variable, and the five uses of funds other than cash holdings, the first difference of stock independent variables used in the literature on the determinants of corporate cash holdings (i.e., asset, R&D, leverage, net working capital, ROA, and sector average cash flow volatility), firm age, and asset tangibility, as independent variables.
The results of empirical analyses including the Dominance Analysis on the determinants of the change in corporate cash holdings are provided below. First, the fund flow variables altogether explain 33% of the change in corporate cash holdings whereas the first difference of the determinants of corporate cash holdings explains the majority. Second, investment exhibits the largest relative importance for the change in corporate cash holding since 2014. In a similar vein, the absolute value of the regression coefficients on the investment has been increasing since 2011. Third, when the sample is separated into positive and negative cash flows from operations, investment has had the dominant explanatory power for the change in corporate cash holdings over the whole sample period.
The analysis results have the following implications. First, the recent increase in corporate cash holdings in Korea has been driven by decreasing corporate sector investment. Second, government policy should focus on how to boost corporate investment, the driver of the increase in corporate cash holdings, rather than trying to suppress cash holdings. Third, financial intermediaries should strengthen M&A and corporate restructuring advisory services in an environment where corporate demand for capital raising dwindles.  
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