hedging currency derivatives

8/9/2019 Hedging Currency derivatives

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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 .


5/16


6/16

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


8/16

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.


9/16

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


10/16

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.


11/16

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


12/16

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.


13/16

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


14/16

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.

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Journal of

International Money and Finance forthcoming.

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Journal of Internationai Financial Man agemen t and

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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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