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Economics. 2003 13, 55-69
out edg
derivatives
of
transaction
and
of Business. Stockholm University. S-106 9/ Stockholm. Sweden
nh fek.su.se
e examines Swedish firms use of currency derivatives
to
provide empirical
on the determinants of firms hedging decisions. The study uses survey
in combination with publicly available data. The use of survey data makes
to differentiate between currency derivative usage aimed at hedging
and that aimed at hedging transaction exposure. This is of
and transaction exposure tend to affect firms
to increase firm value by reducing indirect costs
or
alleviating
the
underinvestment problem.
No
evidence
is
to support the notion that translation exposure hedges are used to increase
to hedge their exposure to a variety
a
lot
of
managerial and
to
firms
is of
importance
to
Theoretical research provides several rationales to why
in
hedging activities.
One
rationale suggests
can increase firm value by reducing the
of
financial distress, lowering
the
expected
of taxes, or alleviating the underinvestment problem
(see
Smith
and
1985; Froot et al., 1993). Another rationale is
sified managers
to reduce their risk exposure through the
s hedging activity (see Smith
and
Stulz, 1985).
Earlier empirical studies have examined whether firms
to prescriptions based on theoretical
of the
studies analysed
the use of
derivatives in general (see Nance et al., 1993; Dold
1995;
Berkman
and
Bradbury.
1996; Gay and Na
1998; Guay, 1999). others exatnined the use of derivativ
to manage particular types
of
exposures (see Mian,
19
Tufano, 1996; Geczy et al., 1997; Goldberg et al., 19
Howton
and
Perfect, 1998; Allayannis
and
Ofek, 200
Graham and Rogers, 2000; Haushalter, 2000). As in th
study, Mian (1996), Geczy
et al.
(1997), Goldberg
e
(1998), Howton and Perfect (1998), Allayannis and Of
(2000),
and
Graham
and
Rogers (2000) directly examin
the tise of currency derivatives. One advantage of exam
ing the use
of
derivatives
for a
particular type
of
exposu
is that it improves the ability to control for variation
inherent exposure.
This article contributes to the previous research by n
only examining firm characteristics associated with the u
of currency derivatives in general, but also by analysing t
type
of
foreign exchange exposure that
is
hedged. Mo
specifically, the association between firm characteristi
and hedging of translation exposure, committed transacti
and Haushalter (2000) examined the use of derivatives in the gold mining industry and the gas and oil indus
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^.
Hag
exposure, and anticipated transaction exposure, is investi-
gated respectively. ^ This is of intere st since tran slati on
exposure and transaction exposure tend to affect firms
differently.
Transaction exposure to currency risk refers to potential
changes in the value of future cash flows (committed or
anticipated) as a result of unexpected changes in exchange
rates. Hedging transaction exposure can increase firm value
by reducing the variability of cash flows and thereby redu-
cing expected costs associated with financial cjisfress, taxes
or the underinvestmenf problem. In addition, since trans-
action exposure hedges can affect the variability of firm
value fhey can also affect fhe risk of poorly diversified
managers' shareholdings. Translation exposure, on fhe
other hand, arises as the financial accounting statetnents
of foreign affiliates are translated into the currency of the
parent firm.^ The general recommendation of the finance
hterature is not to worry about this type of exposure and
thus not fo hedge it.^ There are two main reasons for this.
First, translation gains (losses) tend fo be unrealized and
have little direct impact on firms' cash flows, which sug-
gests that translation exposure hedges create little share-
holder value through reducing expected costs of financial
distress, taxes or the underinvestment problem. Second,
translation gains (losses) can be poor estimators of real
changes in firm value, which suggests that managing trans-
lation exposure is also inefficient in reducing the share price
exposure. Therefore, firm characteristics that represent the
rationales for hedging, discussed above, can be expected to
be more closely related to currency derivative usage aimed
at transaction exposure hedging, rather than translation
exposure hedging.
The use of questionnaire data makes this study's closer
examination of different types of foreign exchange expo-
sure possible. In addition, most of the empirical studies
that investigate determinants of derivative hedging use
financial statement data and can therefore only observe
whether derivatives are used or not, and not if they are
used for hedging purposes. However, by using a questi
naire that specifically asks whether currency derivatives
used for hedging purposes, it was possible to assert that
investigated variable should not include currency derivat
usage aimed at speculation.^
The previous studies that examined the use of curre
derivatives investigated US firms. This article adds to
knowledge by investigating Swedish firms* use of curre
derivatives. Given the fact that Swedish firms have a re
tively high foreign exchange exposure it is likely that
use of currency derivatives is of great importance to them
For this reason, Sweden is a suitable environment fo
study on firms' use of currency derivatives.
It was found thaf larger firms are more likely fo
currency derivatives than smaller firms are, which sugg
that fixed costs act as a barrier to small firms. Also, tra
action exposure hedging with currency derivatives is rela
to variables that represent indirect costs of financial d
tress and the underinvestment problem associated w
costly external financing. Notably, translation expos
hedging with currency derivatives is unrelated to th
proxy variables. The results suggest that firms hedge tra
action exposure with currency derivatives to increase fi
value, while there was no evidence thai translation ex
sure hedges are used for this reason.
The current study is organized as follows: the next s
tion contains a description of the sample selection p
cedure and data used. Section III reviews theoreti
prescriptions and previous empirical evidence on
determinants of firm hedging. The results are presen
in Section IV, which is followed by a summary a
conclusion.
I I .
S A M P L E S E L E C T I O N A N D D A T A
Since detailed public data are not available on firms' use
derivatives for different hedging purposes, a survey w
Operating exposure is usually broken into two components: the exposure of identifiable anticipated transactions and compet
exposure (the exposure of unidentifiable future cash flows). The reason for not investigating competitive exposure directly is that
firms tend to hedge this type of exposure with currency derivatives (see e,g. Bodnar et al 1996). Instead, the longer-termed competi
exposure is typically managed by operational hedges. From an examination of annual reports, it is suggested that this is also the case
Swedish firms. Butler (1999) provides a discussion on the problems associated with using financial hedges to manage longer-term
competitive exposure,
Translation exposure depends on the translation m ethod used. The fn temational Accounting Stan dard 21 (IAS 2f) suggests the us
the current rate method for self-contained foreign affiliates and the use of the temporal method for integrated foreign affiliates and
foreign affiliates in cou ntrie s with high inflation. The exp osu re und er the curre nt rat e metho d is given by the equity of the foreign affil
whereas under the temporal method it is the net amount of assets and liabilities translated at the current exchange rate. Change
exchange rates on foreign operations thus always cause changes in group equity and under the temporal method, these changes also af
group net income. Swedish firms follow The Swedish Institute of Authorised Public Accountants' proposal to recommendation, wh
builds on the IAS 21, In practice, the current rate method dominates among Swedish firms.
See for instance Eiteman et al (1995). Sercu and Uppal (1995) and Butler (1999) who underscore that translation exposure only cau
real economic consequences given some special circumstances under which it may also be rational to hedge it.
Leland's (1998) results suggest that firms may use risk management tools for speculative purposes,
Swedish firms oper ate in a small open econ omy . In 1995. goods im ported into Sweden represen ted 28 % of G D P and goo ds expo
were 34,5% of GDP. For the USA. imports were 10.7% of GDP and exports were 8,4% (see OECD economic surveys. Sweden 19
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firms hedge with currency derivatives
Firms that met the follov^'ing three criteria were included
(1) The firm had been listed on the Stockholm stock
exchange since January 1996.
(2) The firtn was a non-financial firm. Financial firms
were excluded as the focus of the study is on end-
users rather than producers of financial services.
(3) The firm's headquarters was located in Sweden. For-
eign firms were excluded to eliminate potential
differences that could arise between firms due to dif-
ferences in accounting standards between countries.
This produced a sample of 160 firms. The questionnaire,
From a possible 160, 101 useable responses were
d. This response rate of 63 % com pares favourably
response achieved by Na nce
et at.
Firms were asked in the questionnaire whether or not
concerning TL exposure hedging, while three firms le
the questions regarding CT and AT exposure hedgin
unanswered. For this reason, the sample size is somewh
reduced when the closer examinations of hedging a
conducted.
Furthermore, firms were asked how much of their T
CT, and AT exposure they hedged. Panel B, in Table
presents the average percentage of the inherent exposu
that was hedged with currency derivatives among tho
that hedged th at pa rticula r expos ure. It is evident fro
Pane B that a firm tbat hedged a particular type of exp
Table 1. Sample data on firms currency derivatives iiedgi
activities
Panel A: distribution of currency derivatives users and nonusers
among sample firms
Number of
observations Percen
Firms that use currency derivatives
Firms that do not use currency derivatives
Firms that hedge TL exposure
Firms that do not hedge TL exposure
Firms that did not respond to the question
Firms that hedge CT exposure
Firms that do not hedge CT exposure
Urms that did not respond to the question
Firms that hedge AT exposure
Firms that do not hedge AT exposure
Firms that did not respond to the question
Panel B: percentage of exposure hedged with currency derivatives
among hedgers:
First Third
Mean quartile Median quarti
6
4
33
64
4
5
47
3
38
6
3
6Q
4
33
63
4
5
47
3
38
59
3
Percentage of TL exposure hedged 74
Percentage of CT exposure hedged 82
Percentage of AT exposure hedged 53
50
70
31
90
90
50
100
100
70
Notes:
Frequency of sample firms' use of currency derivatives a
perce ntage of expos ure that Is offset. Pane A reports on the dist
bution of currency derivatives users and nonusers, while panel
reports on the percentage of the exposure that was offset wi
currency derivatives. The data were obtained from a questio
naire sent to firms listed on the Stockholm stock exchang
Firms" use of currency derivatives to hedge: foreign exchan
(FX) exposure and exposure broken down by translation (TL
committed transactions (CT), and anticipated transactio
(AT) were investigated. A total of lOf firms answered t
questionnaire.
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'̂ .
Hag
sure with currency derivatives did so to hedge a substantial
part of it. This is in accordance with survey results of
Hakkarainen et al. (1998) and seems to be particular ly
true for TL and CT exposure hedges. Tt is consistent with
derivative hedging being associated with large fixed costs,
which in turn, causes hedging that manages only a minor
part of the exposure to be uneconomical.
In view of the evidence presented in Panel B, it appears
that the decision as to whether currency derivative hedges
should be employed or not is of more importance to the
sample firms than the decision regarding how much of the
exposure should be hedged. This is the reason why this
article primarily investigates if firms hedge rather than
the level of exposure that firms hedge. However, the associ-
ation between firm characteristics and the level of exposure
hedged with currency derivatives was also investigated.
While this provided no additional insights into the deter-
minants of TL and CT exposure hedging, additional
insights were gained regarding the determinants of AT
exposure hedging.'^ For this reason, regression results are
also reported on the association between firm characteris-
tics and the level of AT exposure hedged with currency
derivatives.
Publicly available data on firm characteristics include
accounting data, stock price data and data on ownership
structure. Accounting data were obtained from annual
reports, Nordbanken's stock exchange guide 1998 and
Bolags Fakta 1997. Stock price data were gathered from
Bonnier Findata. Finally, data on ownership struct
were collected from Sundin and Sundqvist (1997)
annual reports. All the data concemed 1996.
I I I . H E D G I N G D E T E R M I N A N T S
This section describes hedging determinants, the variab
used as proxies for these determinants, and earlier emp
cal findings of studies that examined the use of curre
derivatives. To conserve space, the presentation of ear
empirical findings is primarily confined to proxy variab
used in this study. Furthermore, if a study uses both c
tinuous (the level) and binary measures to describe
dependent variable (use of derivatives), priority is gi
to results pertaining to the binary variable. Table 2 s
marizes the empirical findings of earlier studies for the v
ables that are used in this article as proxies for incentive
hedge. Finally the last subsection presents a summary
the empirical predictions generated in this section,
their implications for transaction and translation expos
hedging, respectively.
Shareholder value maximization
Modigliani and Miller (1958) showed that firm value
financial policy decisions are unrelated in the absence
market imperfections. Recent theoretical studies., howe
Table 2.
Summ ary of empirical papers that study determinan ts of firms use of currency derivatives
Type of
v a ri ab le L ev er ag e L iq ui di ty
Dividend
yield
Firm size
Managerial Manage
Ma rket-to- Institutional stock option
book ownership ownership ownersh
Prediction
Mian (1996)
Geczy et al. (1997)
Goldberg ef a/. (1998)
Howton and Perfect (1998)
Allayannis and Ofek (2000)
Graham and Rogers (2000)
Bmary
Binary
Binary
Level
Binary
Binary
*
N o
N o
N o
N o
N o
*
Yes
Yes
Yes
•
*
N o
*
*
N o
No
Yes( + )
Yes( -1-
No
Yes(
-1-
Yes( + )
Yes( +)
N o
N o
*
*
N o
N o
N o
N o
4
No
*
No
No
*
•
No
Notes:
The type of variable column indicates whether the results of the study pertain to a
binary
variable or a variable that measures
/evtV of usage. The last eight colum ns s umm arize the variables , predicted signs (row 1), and whether a specific study lends suppo rt for
prediction. 'Yes" indicates support for the prediction while "No" indicates that no support for the prediction was found. "*' indicates
the variable was not investigated. To conserve space, the presentation of variables is confined to those that are used in this st
Furthermore, if a study uses both continuous (the level) and binary measures to describe the dependent variable, priority is given to
results pertaining to the binary variable.
To investigate this. Tobit regressions and a model proposed by Cragg (1971) were used, which is a combination of a probit analysis
the decision to hedge) and a truncated regression (i.e. the regression equation for non-zero outcomes). The results from the Tobit mo
and the first step of the Cragg (197 ) model, the probit analysis, are broadly similar to the results presented in Table 6. The results fr
the second step of the Cragg (197f) model showed that the association between the variables used to describe hedging determinants
the fevef of TL and CT exposure h edged is low. This result was expected due to the relatively low distribu tion in the depen dent variab
The level of AT exposure hedged, on the other hand, is significantly associated with some of the variables used to describe hed
determinants .
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60
.̂ Hag
tionship between use of currency derivatives and the ratio
of the market-to-book value was able to document the
expected positive relationship.'^
Lessard (1991) and Froot
et al
(1993) argued that if
external financing is mo re costly tha n intern al financing.,
hedging can be a value-creating activity if it more closely
matches inflows of funds with outflows of funds, thereby
lowering the likelihood that a finii needs costly external
financing for future investments. The costs of external
finance include not only the agency costs of debt (see
Myers, 1977) but also equity issuance costs arising from
information asymmetries between managers and outside
investors (see Myers and Majluf 1984). Consequently,
firms that are associated with relatively more information
asymmetries are also more likely to hedge. As a proxy for
inform ation asym metries, I used, in accord ance with Geczy
et al (1997) and Graham and Rogers (2000). the percen-
tage of each sample firm's shares that are owned by
institutions. * Geczy et al (1997) and Graham and
Rogers (2000) argued that higher institutional ownership
implies less information asymmetry, and thus a lower prob-
ability of hedging. In contrast, they found that use of deri-
vatives was positively related to institutional ownership.
Tax function convexity Smith and Stulz (1985) showed
that hedging could reduce expected tax liabihties for a
firm facing a convex tax function. Therefore, a greater
convexity of the tax schedule should lead to a greater
probability of hedging. A convex tax function can be
derived from a progressive corporate tax schedule or tax
loss carry-forwards. Firms in Sweden do not face a pro-
gressive corporate tax schedule; however, tax loss carry-
forwards do exist. Mian (1996), Geczy et al (1997), How-
ton and Perfect (1998) and Allayannis and Ofek (2000)
found no evidence supporting the idea that the existence
of tax loss carry-forwards is an im portant determinan t
for firms decisions regarding derivatives usage.
Graham and Rogers (2000) argued that earlier studies
are based on variables that 'are too simple to capture incen-
tives that result from the shape of the tax function, and
may even work backwards for expected loss firms'. For this
reason, they used the approach advanced by Graham and
Smith (1999) which is based on estimates of firms' pre-
dicted tax liabilities. However, Graham and Rogers
(2000) failed to document the expected relation
between use of derivatives and the convexity of the
function. Gr ah am and R ogers (2000) concluded
firtns do not hedge in response to convexity because
incentive is small relative to other hedging incentives.
Given the difficulty in obtaining a reliable estimato
the convexhy of the tax function and its weak predic
power in earlier studies, the author decided not to incl
this variable in the analysis.
Managerial wealth and risk aversion
Smith and Stulz (1985) examined managerial risk avers
as a driver of firms' hedging decisions. A risk-averse m
ager who owns a large number of the firm's shares an
poorly diversified prefers to reduce the firm's share p
risk. Managers who believe that it will be iess costly (to
or him) for the firm to hedge the share price risk than
hedge it on her or his own account, will direct the firm
hedge. Smith and Stulz's (1985) model predicts that m
agers with greater proportions of their wealth invested
the firm's shares would prefer more hedging, while th
with greater option holdings would prefer less hedging.
rationale for this is that stocks provide linear payoffs a
function of stock prices, whereas options provide con
payoffs.
To investigate the relationship between managerial s
ownership and use of currency derivatives for hedging,
use of a proxy that measures the percentage of total m
agerial wealth invested in the firm would be ideal. In ac
dance with the data available for earlier studies, t
managerial wealth is not o btainable. Therefore, the per
tage of the firms' shares owned by the chief executive off
(CEO) was used.'^^ As depicted in Table 2, the hypoth
of a positive relationship between use of derivatives
ma nage rial stock ownersh ip is not sup ported by the ea
studies.
To examine whether a negative relationship betw
managerial option ownership and use of currency der
tives for hedging exists, a dummy variable that is set to
if managerial option ownership programmes exist an
zero otherwise was used. No support for a negative r
tionship is offered by the results of the studies presente
Table 2.
Scaled versions of firms' research and development expenditures have been used by some researchers as proxies for future gr
opportunities. Unfortunately, information on firms' research and development expenditures is not widely available for the Swe
sample.
' *
Institutional owners include insurance companies, trusts, mutual funds, and pension funds.
'-̂ One alternative to the proxy used is the monetary value of the CEO's stock ownership. The regressions presented in Tables 6 a
were repeated using the CEO's stock ownership measured in SEK instead of the percentage of the firms' shares that the CEO owned
with similar results. It is important to recognize that finiis' risk management decisions may result from a larger group of officers
directors than the CEO. In fact, this is suggested by the results of Tufano's (1996) study of the North American gold mining indu
Ideally, ownership data covering the complete group of managers that influence the firm's hedging decision should be used. This req
knowledge of the size of the decision-making group and the holdings of the individuals that constitute this group. Unfortunately, th
information that could not be obtained.
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firms hedge w ith currency derivatives
As a proxy for transaction exposure (CT and AT expo-
the percentage of revenues that is denominated in
et al (1997) and Goldberg et al (1998) used scaled
6
As a proxy for TL exposure, the percentage of the firm
equity that is derived from foreign affiliates and is denom
nated in foreign currency (foreign equity) was used. Gecz
ct al (1997) used the ratio of foreign assets to total asse
They found that the ratio of foreign assets to total asse
had no predictive power in explaining currency derivati
usage.
Empirical predictions for transaction and translation
exposure hedging
Based on the above discussion., Table 3 presents a summa
of the predicted directions for potential relationshi
between firm characteristics and the likelihood of usin
currency derivatives for hedging purposes. Except for pr
diction 4b, these directions should also be valid for the lev
of exposure hedged with currency derivatives. Table 3 als
summarizes variable definitions.
As mentioned earlier, transaction exposure and T
exposure tend to affect firms differently. Therefore, on
expects the validity of the predictions to differ betwee
transaction (CT and AT) exposure hedges and TL expo
sure hedges with currency derivatives.
Since transaction exposure hedges can reduce the vari
bility of cash flows and firm value, one expects predictio
Summ ary of predicted relationships between firm characterislics and the likelihood of hedging and variable definitions
Prediction
Variable definition
(1)
(2)
(3)
(4a)
(4b)
(5 )
ownersh ip (7)
gerial stock ownership (8)
agerial option ownership (9)
revenues (10)
equity (I I)
Book value of debt divided by book value of equity
Current assets to current liabilities
Dividend per share divided by .stock price per share
Log of market value of total assets (book value of total assets minus book value of
equity plus market value of equity)
Dummy set to one if average wage cost per employee is above the sample median an
total wage costs to total costs is above the sample median
Market value of total assets divided by book value of total assets
Percentage of each sample firm's shares owned by institutions
Percentage of the firm's shares owned by the CFO
Dummy set to one if managerial option ownership programme exists
Percentage of revenues denominated in foreign currency
Percentage of equity derived from foreign affiliates denominated in foreign currency
Based on the discussion in Section III, Prediction shows the predicted direction for potential relationships between firm cha
ty of firms ope rating incom es to exchan ge rates change s. As reported by Dolde (1995). this proc edure ca n cause biased estima t
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62
A'. Hage
l-4a and 5-9 to be valid for transaction (CT and AT)
exposure hedges. For TL exposure hedges, on the other
hand, the validity of these predictions is less clear. This is
because TL gains and losses: (i) tend to be unrealized and
have little direct impact on firms' cash flows; and (ii) can be
poor estimators of real changes in firm value.'** This is also
why the general recommendation of the finance literature is
not to hedge TL exposure. However. Eiteman et al (1995),
among others, pointed out that TL exposure hedging can
be justified under some circum stances, even if not directly
related to cash flows. This is the case, for instance, when
the firm has debt covenants that state that the firm's lever-
age (debt equity ratio) will be maintained within specific
limits. In this case, a hedge of TL exposure can ensure that
the firm retains its access to funds. If debt covenants based
on balance sheet measures affected by translation gains
(losses) are widespread, there could be a relationship
between TL exposure hedging and for instance the
market-to-book ratio (proxy for valuable growth opportu-
nities). However, given that TL exposure only causes real
economic consequences under some specific circumstances,
one expects the validity of prediction l ^ a and 5-9 to be
lower for TL exposure hedges on average than for CT and
AT exposure hedges. The prediction based on economies of
scale (4b) should be as valid for TL hedges as for CT and
AT hedges. As mentioned in the previous subsection, pre-
diction 10 and 11 are intended for transactio n (C T and A T)
and TL exposure hedges, respectively.
Since a majority of the firms that indicated that they
hedged FX exposure with currency derivatives did hedge
transaction exposure, one also expected the predictions
that are valid for CT and AT exposure to be valid for
the variable indicating FX exposure hedging (with currency
derivative.s) in genera l. Finally , predicti on 11 was expected
to be valid for the variable indicating FX exposure hedging
in general, since a large number of the firms that constitute
this group hedged TL exposure.
I V . R E S U L T S
This section examines firm characteristics associated with
the use of currency derivatives to provide evidence on the
determinants of derivative usage. Summary statistics and
univariate tests are presented below. The following section
reports on multivaiiate tests for the probability of using
currency derivatives to hedge FX, TL, CT, and AT expo-
sure, respectively. Finally, the association between firm
characteristics and the level of AT exposure hedged is
examined.
Summary statistics and univariate tests
Table 4, presents summary statistics for the proxy variab
described in Section III, and significance tests of differen
between the distributions of these variables for users
non-users of currency derivatives. Summary statistics
significance tests are shown for the exposure categories
TL, CT and AT respectively.
It is shown from the Wilcoxon rank sum tests, repor
in Ta ble 4, that no statistical differences at the 10 leve
leverage, liquidity or dividend yield exist between users
non-users of currency derivatives, independent of expos
category being hedged. Table 4 shows that users of
rency derivatives have significantly larger firm size t
do non-users, which is consistent with the conjecture
fixed costs act as a barrier to small firms. A comparison
the frequency with which users and non-users of curre
derivatives are classified as having high human cap
investments shows that no significant differences exist
can also be seen from Table 4 that two of the four expos
categories that are investigated (FX and CT) indicate
nificantly greater median market-to-book ratios for u
than for non-users. This suggests that firms using curre
derivatives to hedge CT exposure have more valua
growth o ppo rtun ities than n on-user s do, which is con
tent with the underinvestment argument by Bessembin
(1991). Contrary to the prediction, but in similarity w
the evidence presented by Geczy et al (1997) atid Grah
and Rogers (2000), users exhibit less informational as
metry, as measured by institutional ownership, than
non-users.
Table 4 shows that, independent of exposure categ
being hedged, users of currency derivatives have sign
cantly lower managerial stock ownership than non-us
In addition, firms classified as having managerial op
ownership are statistically more likely to use currency d
vatives to hedge FX, CT and AT exposure than o
firms. The results do not support the perception that m
agers are hedging with currency derivatives to incr
their own well-being.
As expected, users of currency derivatives have sign
cantly higher percentages of revenues denominated in
eign currency (foreign revenues) than do non-us
Finally, the percentage of equity that is derived from
eign affiliates and is den om inat ed in foreign currenc y
eign equity) is significantly different across users and n
users for the four exposure categories examined.
Table 5 presents the correlation matrix of
independent variables. The smallest correlation is -
between leverage and mark et-to-boo k ratio, and the lar
^ Notably, to the extent that TL gains and losses do involve cash flows or real changes in firm value, these predictions should be val
TL exposure hedges for the same reasons as for transaction exposure hedges. This could be the case, for instance, when a firm is abo
liquidate its foreign affiliate so the value will be realized.
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Summ ary of firm characteristics for currency derivatives users and
non u.sers
FX expo.sure
L exposure
T exposure
T exposure
FX exposure
L exposure
T exposure
AT exposure
FX exposure
L exposure
T exposure
T exposure
FX exposure
L exposure
T exposure
AT exposure
Users
Mean
1.68
1.95
1.64
1.76
1.86
1.66
1.88
1.89
2.55
2.93
2.56
2.56
3.72
3.98
3.73
3.72
hum an capital ( incidence)
FX exposure
L exposure
T exposure
AT exposure
FX exposure
L exposure
T exposure
AT exposure
29.51
30.30
33.33
3f.58
1 64
1 45
L67
1,56
ownership ( )
FX exposure
L exposure
T exposure
AT exposure
38.06
42.42
37.83
40.67
erial stock ownership ( )
FX exposure
L exposure
T exposure
AT exposure
4.64
2.86
5.37
4.18
erial option ownership ( incidence)
FX exposure
L exposure
T exposure
T exposure
revenues ( )
FX exposure
T exposure
AT exposure
equity ( )
FX exposure
L exposure
T exposure
T exposure
21.31
21.21
21.57
26.32
53.11
50.50
52.11
60.64
28,84
32.33
28.00
32,33
Median
1.40
1,61
1,43
1,40
1,65
1,62
1.65
1.77
2.40
2.50
2.40
2.30
3.71
3.93
3.72
3.67
0,00
0.00
0.00
0.00
1.32
1.27
1,32
1.36
40.80
47.80
40.70
46.80
0.04
0.03
0.04
0.04
0.00
0.00
0.00
0.00
35.00
50.00
50.00
70.00
20.00
2f.00
20.00
21.00
N
60
33
50
38
61
33
51
38
61
33
51
38
61
33
51
38
61
33
51
38
61
33
51
38
61
33
51
38
60
33
50
38
61
33
51
38
61
33
51
38
57
30
47
36
Non-users
Mean
2.13
1.86
2.16
1.97
3.51
2.98
3.23
2.95
2.44
2.31
2.44
2.42
3.04
3.17
3.13
3.25
22.50
26.56
19.15
23.33
1,59
L7 3
1,59
1,68
27.21
29.13
29.29
28.82
7.40
7,60
6,49
7,03
2,50
10.94
6,38
6.67
25.68
35.23
29.06
28.40
10.48
16.34
14.47
13,91
Median
1.52
1,38
1,54
1.54
1.81
1,86
L7 7
1.75
1.75
2,05
2,10
2.40
2.86
3,01
3,01
3,16
0,00
0.00
0.00
0.00
Lf4
1.19
1,16
1,19
21.35
26.85
26.90
27.15
1,65
0,87
0,87
0.45
0.00
0.00
0.00
0.00
8.50
20.00
10.00
10.00
0,00
3,50
LOO
1,50
N
40
63
47
59
40
64
47
60
40
64
47
60
40
64
47
60
40
64
47
60
40
64
47
60
40
64
47
60
40
63
47
59
40
64
47
60
40
64
47
60
40
64
47
58
/j-values
differenc
0,70
0,11
0.49
0,96
0.88
0,22
0.87
0,72
0.50
0.29
0,77
0,75
1
0,55
0.77
0.23
0.49
3
0.37
7
0.13
1
5
1
1
6
1
0.17
3
1
4
Summary statistics of proxy variables and significance tests of difTerences between firms on the Stockholm stock exchange that u
All variables areas defined in Section 111. The /)-va lues are from a Wilcoxon rank sum test for the differences in the median ol e
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64
N Hag
Table
5, Pearson correlation coefficients
LEV LIQ
Y
FS H H C
MB
l
M SO
MOO FR
Leverage (LEV)
Liquidity (LIQ)
Dividend yield DY)
Firm size
FS)
High human capital
HHC)
Market- to-book MB)
Institutional ownership
lO)
Managerial stock ownership (MSO)
Managerial option ownership (MOO)
Foreign revenues FR)
Foreign equity FE)
1
0.09
- 0 . 2 6
0.07
- 0 . 3 0
- 0 . 3 0
- 0 . 1 9
- 0 . 0 2
- 0 . 0 9
- 0 . 2 6
- 0 . 1 1
I
- 0 . 1 0
- 0 . 0 7
0.05
0.10
0.05
0.15
- 0 . 0 9
- 0 . 0 2
- 0 . 1 6
1
0.02
0.25
- 0 . 1 5
0.03
- 0 . 0 6
- 0 . 0 1
0.12
0.01
1
- 0 . 0 2
- 0 . 0 9
0,59
- 0 . 2 0
0,26
0.31
0.44
1
0.23
0.18
- 0 . 0 5
0.02
0.12
0.04
1
0.06
0.17
0.08
0.14
- 0 . 0 1
1
- 0 . 2 5
0.29
0.56
0.46
1
- 0 . 1 2
- 0 . 1 9
0.04
1
0.13
0.22
0.58
Note Pearson correlation coefficients
for
independent variables used
in the
regressions presented
in
Tables
6 and 7. The
sample con
of firms listed
on the
Stockhohn stock exchange.
All
variables
are as
defined
in
Section
IIL
is 0.59 between firm size and institutional ownership.
Given the correlations among the different firm character-
istics, these univariate tests are inefficient in revealing dif-
ferences in firm attributes between users and non-users,
holding other traits constant. Hence, multivariate tests
are motivated.
Logit regression estimates on usage of currency derivatives
Logit regressions were estimated to distinguish among the
potential explanations for use of currency derivatives.
Table 6 presents the results of logit regressions of binary
variables representing usage of currency derivatives on
explanatory variables. There are coefiScient estimates
/7-values for the six models used. In the first three mod
the dependent variable is set to one for firms that use c
rency derivatives to hedge FX exposure and zero for n
users.
The models differ with respect to how variations
FX exposure are accounted for. Model 1 contaitis the v
able foreign revenues, while Model 2 includes the pro
foreign equity. The third model is unrestricted in
sense that it comprises both the variables. Models 4
and 6 present results broken down by type of FX expos
that is hedged with currency derivatives. More specifica
Table
6.
Logit regression estimates of the likelihood of usin currency derivatives
Intercept
Leverage
Liquidity
Dividend yield
Firm size
High human capital
Market- to-book
Institutional ownership
Managerial stock ownership
Managerial option ownership
Foreign revenues
Foreign equity
N u m b e r
of
observations
Log likelihood
M odel 1:
FX exposure
Coeff.
- 4 . 7 5
- 0 . 2 3
- 0 . 1 7
- 0 . 0 2
1.80
1.28
- 0 . 3 0
- 0 . 0 4
0.3
2.48
0,03
~
99
- 4 3 . 6 3
p-value
0.01
0.32
0.26
0.82
0.00
0.09
0.32
0.03
0.88
0.04
0.00
Model 2:
FX exposure
Coeff.
- 2 . 5 3
- 0 . 4 3
- 0 . 1 3
- 0 . 2 3
1.45
0.97
- 0 . 2 9
- 0 . 0 2
- 1 . 6 6
1.82
0.02
95
- 4 5 . 3 8
/7-value
0.12
0.07
0.27
0.18
0.00
0.17
0.39
0.21
0.44
0.12
-
0.08
Model 3:
FX exposure
Coeff.
- 3 . 8 7
- 0 . 3 0
- 0 . 1 6
- 0 . 1 2
1.64
1.17
- 0 . 3 3
- 0 . 0 4
- 0 . 1 5
2.42
0.02
0.01
95
- 4 2 . 5 6
Model 4:
TL exposure
/j-value Coeff.
0.03
0.22
0.28
0.44
0.00
0,12
0.29
0.05
0.95
0.05
0.02
0.60
- 4 . 8 2
- 0 . 0 5
- 0 . 1 6
- 0 . 1 3
1.44
- 0 . 1 2
- 0 . 4 3
0.01
- 0 . 4 0
0.08
-
0.01
92
- 4 4 . 3 3
Model 5:
CT exposure
/j-value Coeff.
0.01
0.81
0.32
0.53
0.00
0.85
0.26
0.72
0.87
0.92
-
0.61
- 4 . 9 1
- 0 . 3 6
- 0 . 1 6
- 0 . 0 5
1.86
1.84
- 0 . 3 4
- 0 . 0 5
1.14
1.57
0.03
-
96
- 4 5 . 7 8
M od el 6:
AT exposure
p va ue Coeff
0.00
0.17
0.32
0.55
0.00
0.01
0.24
0.02
0.59
0.08
0.01
-
- 3 . 6 1
0.10
- 0 . 1 4
0.04
0.69
0.88
- 0 . 3 2
-0.02
1.21
1.94
0.04
-
96
- 4 8 . 1 3
/j-val
0.03
0.63
0.39
0.61
0.11
0.19
0.28
0.17
0.58
0.03
0.00
-
Notes
Logit regression estimates of the relation between the likelihood that a iirm uses currency derivatives to hedge and proxies
incentives
to use
derivatives
and
proxies
for
foreign exchange exposure.
The
sample consists
of
iirms listed
on the
Stockholm stoc
exchange.
In
Model
I. 2, and 3 the
dependent variable
is set to one if
the firm uses currency derivatives
to
hedge foreign exchange
exposure. Model 4 uses translation (TL) exposure hedging with currency derivatives as the dependent variable, M odel 5 uses commi
transaction (CT) exposure hedging with currency derivatives as the dependent variable, and Model 6 uses anticipated transaction A
exposure hedging with currency derivatives
as
the dependent variable.
All
variables a re
as
defined
in
Section
III.
Th e /7-value
is
based
two-side test and values less than 0.10 are shown in boldface type.
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and Model 6 uses AT exposure hedging with currency
can be seen from Tabl e 6 that the n um ber
For leverage, only one coefficient is found to be signifi-
e coefficient for liquidity is neg ativ e, as pred icted , for all
All models, except the one with AT exposure as the
ende nt variable (/7-value = 0.1 ), show that greater
Model supports the view that firms classified as having
—
0.09) to use currency derivatives to hedge
expo sure, while Mo del 3 (/)-value = O.I2), and in par-
M ode l 2 (/7-value = O.I7), provide weak er, if an y,
For the market-to-book ratio, none of the coefficients
sistent with the evidence of earlier studies on usage of cu
rency derivatives. In contrast to the results for the marke
to-book ratio, the proxy for information asymmetry (i
institutional ownership) suggests that currency derivativ
are used to alleviate the underinvestment proble
Specifically, greater institutional ownership is found to
significantly associated with lower probability of curren
derivative usage to hedge FX expo sure (Mo dels 1 and
and CT exposure, respectively.
Table 6 presents no evidence that the likelihood of he
ging with currency derivatives is increasing along with t
degree of managerial stock ownership, which is in parall
with the other studies.
In contrast to the prediction, the coefficient for manag
rial option ownership is found to be positive. In additio
the coefficient is significant for four of the six mode
Although this result is in accordance with most of the ea
lier studies, it is still noteworthy and one can only specula
why this is so. One possible explanation is related to t
fact that a majority of the stock options owned by t
managers were in the money (at 30 December 199
which provided them with a stock-like character. In fa
according to Smith and Stulz's (1985) framework, this m
have provided risk-averse managers with an incentive
hedge rather than to avoid doing so. This explanatio
however, lacks credibility given the results for the variab
managerial stock ownership. Another explanation is th
firms using technically more advanced incentive scheme
such as stock options, also use technically advanced he
ging instruments, such as currency derivatives. If so, th
can be related to differences in knowledge about derivativ
across firms. "
In accordance with the prediction, finns with larger pe
centages of revenues denominated in foreign currency (fo
eign revenues) are more likely to use currency derivatives
hedge FX exposure, CT exposure and AT exposur
Surprisingly, the percen tage of equity that is derived fro
foreign affiliates and is de no m ina ted in foreign cu rrenc
(foreign equity) is not able to explain the use of currenc
derivatives to hedge TL exposure.^' In view of these resul
it is noteworthy that Geczy et al (1997) found no signi
The red uction from 101 to 99 sam ple firms is due to the fact that the au tho r was una ble to comp ute the variab le leverage for o
t is derived from foreign affiliates and is deno min ated in foreign currenc y.
That derivatives are perceived as complicated by a notable number of financial directors is suggested by the results of Alkeback an
As reported in note 7, firms can also manage their FX exposure by using debt denominated in foreign currency. The failure
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66
A'. Hag
canf difference between the ratio of foreign assets to total
assets for users and non-users of currency derivatives.
Furthermore, the evidence from Models I, 2 and 3 suggest
that the variable foreign revenues better explain cross-
sectional variations in total currency derivative usage
than foreign equity does.
Although it is interesting to note that the significant
regression coefficients for high human capital and institu-
tional ow nership in Mod el 5 (using CT exposure hedging as
the dependent variable) are in contrast to the results For
Models 4 and 6, the implication of this is uncertain. This is
because parts of the firms that are classified as non-hedgers
of the investigated type of FX exposure (with currency
derivatives) do hedge another type of FX exposure (with
currency derivatives), which may be hedged of similar
ration ales as the investigated exposure. ' ' Therefore, the
regressions M odels 4, 5 and 6 were re-run, allowing only
firms that did not hedge any other type of FX exposure to
remain in the sample as non-hedgers. Consequently, the
sample size for Models 4, 5 and 6 was reduced to 70, 89
and 78 observations, respectively. The results for Models 4
and 5 did not change in any material way. The results for
Model 6, using AT exposure hedging as the dependent
var iab le, did chang e: nam ely, the coefficient for firm size
(p-value —0.01) and insfifutional own ership
{p -
valu e —0.09) were foutid to be significant a nd ha d the pre -
dicted signs. Although the author is aware of the difference
in sample size and construction, it is noted that fhe results
of Models 5 and 6 still differ with respect to the variable
indicating high human capital investments.
Finally, the results for Model 6 can be criticized because
only seven of the 38 firms that hedge AT exposure did not
hedge CT exposure, suggesting that it is not possible to say
whether the regression model describes firm characteristics
associated with AT or CT exposure hedging. The associ-
ation between firm characteristics and the level of AT expo-
sure hedged, is therefore examined in the next section.
An exam ination of the level of anticipated transa ction
exposure hedged
As reported in Section II, firms that hedge a particular fype
of exposure tend to hedge a large part of it. From looking
at the distribution in Panel B of Table 1, it is apparent t
firms hedging AT exposure have adopted a somewhat m
diverse practice than those hedging TL and CT expos
with currency derivatives. For this reason, an analysis
the level of AT exposure that is hedged with currency d
vatives can provide additiona l insights into firms hedg
practices. By analysing the level of AT exposure tha
hedged, the problem related to the fact that a majority
the firms hedging AT exposure also hedge CT exposure
be circumvented. ^
A model proposed by Cragg (1971) was utilized, wh
allows the decision of whether or not to hedge and the
conceming the level of hedging to be separately de
mined. This model is a combination of a probit analy
(i.e,
the decision to hedge) and a truncated regression (
the regression equation for nonzero outcomes). Goldb
et ai. (1998), Allayannis and Ofek (2000) and Graham
Rogers (2000) used the Cragg (1971) model and discus
its ability to accommodate for the possibility that a fir
hedging policy decision depends on two decisions, wh
could have different determinants. This ability is relev
for the varia ble firm size. This is because economies of sc
are expected to result in a positive relationship betwe
firm size and the likelihood of hedging (as suggested
Tables 2 and 6). while theories linking risk managem
fo direct costs of financial distress suggest that hedg
benefits decrease with firm size (see above). Thus,
extent to which a firm hedges, once it decides to hedge
predicted to be negatively correlated with firm size.
other predictions are left unaltered. Table 7 presents
results from the truncated regression. The results from
binomial probit regression are similar to those from
logit regression model p resented in Table 6 and theref
not presented.
The regression coefficients of leverage, liquidity and d
dend yield all have their expected signs, but none of th
are significant at the 10% level (/7-values range from 0.
0.33). If is noteworthy that the number of observations
only 38 (at the same time as the model uses 10 independ
variables), which suggests that the results should be in
preted with caution.
In accordance with the prediction, firm size has
expected negative sign. However, the coefficient is fou
respects). To explore the possible impact from firms using (iebt denominated in foreign currency to manage their TL exposure, hed
are reclassified by adding those firms that used debt denominated in foreign currency to the group consisting of TL exposure hedgers
re-ran Model 4. This established the expected relationship between TL exposure hedging and the variable foreign equity p-vahie 0
However, the results did not change in any other way.
^̂ For exam ple, if firms th at hed ge CT and AT ex posure d o so to alleviate the un derinvestm ent p roblem , they are expected to
characterized by similar firm-specific traits (e,g, low institutional ownership). However, if a substantial number of the firms only he
CT exposure (perhaps because their expected cash flows are troublesome to predict) and consequently are classified as non-hedgers of
exposure, the results from Model 6 are blurred since firms classified as hedgers and non-hedgers are partly characterized by similar tr
^ ^This is not necessarily true if firms that hedge more AT exposure also hedge more CT exposure. To investigate this, the 38 firms
hedged AT exposure with currency derivatives were divided in two. One group consisted of those 19 firms that hedged high levels and
of those f9 firms that hedged low levels. The 19 firms that hedged higher levels of their AT exposure hedged on average 70% while
other 19 firms only hedged 32,5% of their AT exposure. On average, firms in both groups hedged 70% of their CT exposure.
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6
7. Truncated regression estimate on the use of eurrenev deri
to
hedge anticipated transaetinn
AT)
exposure
likcli iot>d
Modei 7: Truncated
CoefT.
53.98
5.14
-6.43
0.84
- 6 . 4
20.25
2.48
-0.65
0.05
3.99
0.39
38
- 60.76
/7-value
0.12
0.22
0.28
0.33
0.30
3
1
0,99
0.57
0.01
Regression estimates
on the
level
of
AT exposure hedged
and proxies for incentives to use deri-
and a proxy for foreign exchange exposure. The sample
on the Stockho m stock exchange. Model 7
a truncated regression m ode with positive values of the
of AT exposure hedged with currency derivatives as the
variable. All variables are as delined in Section III. The
are based on a two-sided test and values less than 0.10
in boldface type.
be insignificant at the 10% level, indicating that direct
of financial d istress hav e little predictive pow er for
Firms classified as having high hutnan capita invest-
are
found
to
hedge more
of
their
AT
exposure
in conjunc-
the
results
for
firm size, suggests th at indirect
of financial distress is of more impor t ance for firms'
of
financial d istress .
The
of a connec tion between AT exposure hedging
is at
odds with the evidence
for Mode l 6 in Tab le 6. but in parallel with the
for CT
exposu re h edging.
Unlike
the
results reported
in
Tab le
6, the
t runcated
a l inkage between hedging and valu-
the level of
is increasing
the marke t - t o -book ra t io . The coefficient for institu-
is negative and significant, which p rovid es
for the notion that AT exposure is
to alleviate the underin-
Manageria l s tock ownership and manageria l opt ion
are non-significant at the 10% level. That the
of AT exposu re hedged w ith currency derivatives is
to the
variable manage rial option ow nership
is
the suggested posit ive a ssociat ion in Table
6 between mana gerial option own ership and the likeliho
of currency derivatives usage. Perhaps this suggests that t
decision to use currency derivatives for hedging transacti
exposure is affected by differences in knowledge ab out de
vatives across firms, while
the
decision concerning
the
lev
of exposure hedged is unaffected (i.e. knowledge abo
derivatives act as a barr ier to some firms).
Finally, it can be seen from Ta ble 7 tha t the level of A
exposure hedged is positively cor relate d w ith the level
the t ransact ion exposure , as measured by the p ropo r t i on
revenues that is denom ina ted in foreign currency.
V . S U M M A R Y AND C O N C L U S I O N
Swedish firms' use of currency derivatives were exam in
to provide empirical evidence on the determinants of firm
hedging decisions.
The
article used survey d ata
in
comb
nation with publicly available data. The use of survey da
makes it possible to differentiate betw een currenc y deriv
tives usage aimed at hedging translat ion exposure, com
mitted transaction exposure, and an t ic ipated t ransact i
exposure . This is interest ing since transaction exposu
and translat ion exposure tend to affect firms different
which suggests thai the rat ionales for hedging them m
differ.
The results of mul t ivaria te tes ts show, am ong o th
things, that firms using currency derivatives to hedge co
mit ted t ransact ion exposure : (i) are m ore freque ntly clas
fied
as
having high hum an cap ital investments (proxy
f
indirect costs of financial distress) th an o ther firms: and
have lower inst i tut ional ownership (proxy for asymmetr
information) than other firms. In addi t ion , the results sho
that the level of an t ic ipated t ransact ion exposure tha t
hedged, once a firm decides to hedge it: (i) increases wi
classification as having high hum an cap ital investments; (
decreases in inst i tut ional ow nership; and (iii) increases
the market - to-book ra t io (proxy for valuable grow
opportuni t ies) . Notably , none of these proxy variables
significantly associated with use of currency derivatives
hedge translat ion exposure.
These results are consistent with the conjecture that firm
hedge transaction exposure with currency derivatives
increase firm value by reducing indirect costs of financ
distress or alleviating the underinvestment p roblem. T h
finding is important for shareholders to the extent that
suggests that the ma nagerial resources being t ied up b
t ransaction exposure hedges are used in a way consiste
with shareholder value maximization. The fact that no e
dence support ing the idea that t ranslat io n exposu re hedg
are used to increase firm value was found, suggests th
shareholders may wan t to be more re luctant to acce
this type of hedge if no specific justification is provid
by
the
m anag em ent. Such justification
may
arise from
th
existence of debt co venan ts based on balance sheet mea
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A'. Hage
ures affected by translation gains (losses). Future research
that include information on whether or not a firm is
restricted by the existence of such debt covenants should
be able to provide insight into the motive for translatioti
exposure hedging.
A C K N O W L E D G E M E N T S
This is a revised version of an earlier pap er circulated under
the title 'Why firms hedge with currency derivatives:
Evidence from Sweden'. The author would like to thank
an anonymous referee, seminar participants at the 48lh
annual meeting of the Midwest Finance Association in
Nashville, Stockholm University, and HANKEN in Vasa
for valuable comments. Valuable comments from Bjorn
Hansson., Bosse Hansson, Martin Holmen. Betigt
Pramborg, Add de Ridder, David VanderLinden, Lars
Vinell and Ingrid Werner are also acknowledged.
R E F E R E N C E S
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ging, and the use of currency derivatives.
Journal of
International Money and Finance forthcoming.
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financial finns in Sweden with an international comparison.
Journal of Internationai Financial Man agemen t and
Accounting. 10, 105-20.
Berkman, H. and Bradbury, M. E. (1996) Empirical evidence on
the corporate use of derivatives. Financial
Management.
25.
5-13.
Bessembinder, H. (1991) Forward contracts and firm value:
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Journal of
Financial a nd Quantitative Analysis
26, 519-32.
Bishop, J. (1994) The incidence of and payoff to employer train-
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Bodnar, G. M., Hayt, G. S. and Marston, R. C. (1996) 1995
Wharton survey of derivatives usage by US non-financial
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Butler, K. C. (1999) Multinational Finance South-Western
College Publishing, Cincinnati.
Cragg, J. G. (1971) Some statistical models for limited dependent
variables with application to the demand for durable goods,
Econometrica. 39, 829-44.
Dolde, W. (1995) Hedging, leverage, and primitive risk. Journal of
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Engineering.
4
187-216.
Eiteman, D. K., Stonehill, A. L and Moffett, M. H. (1995)
Multinational Business Finance Addison-Wesley Publishing
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Frazis, H., Gittleman, M., Horrigan, M. and Joyce, M. (1998)
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'•'The hypothesis that firms hedge translation exposure to meet bond covenants predicts that the likelihood of hedging translat
exposure increases with the existence of debt covenants affected by translation gains (losses) and the severity of the punishment fr
violating the covenant. One important cost from violating a covenant derives from reductions in future borrowing capacity suggest
that the cost increases with the future need of additional funds. A careful analysis of the association between translation expos
hedging and the existence of debt covenants would therefore include, in addition to detailed firm specific information on the design of
debt covenants and the likelihood of violating the covenant, estimates of future investment opportunities.
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