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Evidence on Corporate Hedging PolicyAuthor(s): Shehzad L. MianSource: The Journal of Financial and Quantitative Analysis, Vol. 31, No. 3, (Sep., 1996), pp. 419-439Published by: University of Washington School of Business AdministrationStable URL: http://www.jstor.org/stable/2331399Accessed: 27/06/2008 11:28

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JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS VOL. 31, NO. 3, SEPTEMBER 1996

Evidence on Corporate Hedging Policy

Shehzad L. Mian*

Abstract

This paper provides empirical evidence on the determinants of corporate hedging decisions. The paper examines the evidence in light of currently mandated financial reporting require? ments and, in particular, the constraints placed on anticipatory hedging. Data on hedging are obtained from 1992 annual reports for a sample of 3,022 firms. Out of the 771 firms classified as hedgers, 543 firms disclose information in their annual reports on their hedging activities; the remaining 228 firms report use of derivatives but no information on hedging activities. Based on the evidence, I draw the following conclusions with respect to the models of hedging: evidence is inconsistent with financial distress cost models; evidence is mixed with respect to contracting cost, capital market imperfections, and tax-based models; and evidence uniformly supports the hypothesis that hedging activities exhibit economies of scale.

I. Introduction

Corporations are exposed to uncertainties regarding a variety of prices. Hedg?

ing refers to activities undertaken by the firm in order to mitigate the impact of

these uncertainties on the value of the firm. In order to explain the demand for

hedging, researchers have modeled the role that corporate taxes, contracting costs, and capital market imperfections play in the corporate decision to hedge.1

The lack of publicly available information on corporate hedging activity

severely limited previous empirical research in this area. Information on hedging is not available on databases such as COMPUSTAT. Furthermore, in the absence

of specific Financial Accounting Standards Board (FASB) reporting requirements, firms have not voluntarily disclosed hedging activities in their financial statements

in a uniform manner. Given this limitation, previous empirical work on hedging has relied primarily on survey-based data.2

*Goizueta Business School, Emory University, Atlanta, GA 30322. The author thanks George Benston, Omesh Kini, Grace Pownall, James Rosenfeld, Kumar Sivakumar, Clifford Smith, Gregory Waymire, participants at 1994 Georgia Summer Research Colloquium, and Michael Barclay (the referee and associate editor) for valuable comments. The author also thanks Zhong Min Chen, Matthew Friedman, Mary Sevier, David Shaw, Sahar Tohamy, Rowena Williams, and Yihong Xia for excellent research assistance.

'For example, see Mayers and Smith (1982), Stulz (1984), Smith and Stulz (1985), Froot, Scharf- stein, and Stein (1993).

2Studies using survey data include Booth, Smith, and Stolz (1984), Block and Gallagher (1986), Houston and Mueller (1988), and Nance, Smith, and Smithson (1993).

419

420 Journal of Financial and Quantitative Analysis

Recent changes in financial accounting standards have mandated that all en-

tities disclose off-balance-sheet financial instruments in financial statement foot?

notes. The application of these financial standards has enhanced the information

available on corporate hedging activity, providing an opportunity to conduct more

sophisticated tests than has previously been possible. This paper provides empirical evidence on the determinants of hedging using

nonsurvey data for a large sample of firms. Data on hedging are obtained directly from disclosures made by 3,022 firms in their annual reports for 1992.3 As a

result, this study does not suffer from the nonresponse bias typical of survey

samples and yields results that are more readily generalizable to a broader set

of firms. This study provides evidence on the models of the hedging decision, which emphasize that hedging is desirable because it lowers contracting costs

(Mayers and Smith (1987)), financial distress costs (Mayers and Smith (1982), Smith and Stulz (1985)), taxes (Smith and Stulz (1985)), and external financing costs associated with capital market imperfections (Froot, Scharfstein, and Stein

(1993)). The evidence is mixed with respect to models of hedging emphasizing the

role of contracting costs and capital market imperfections. One piece of evidence

consistent with these models is that regulated utilities are less likely to hedge. However, contrary to the predictions of the contracting costs and capital market

imperfections models, I find no evidence that hedgers have more growth options relative to assets in place in their investment opportunity set. In this study, I also

examine whether the absence of a positive relation between likelihood of hedging and growth options can be explained in light of mandated financial reporting re?

quirements. I find that currency hedging is not associated with presence of growth

options, which is consistent with the interpretation that costs associated with fi?

nancial reporting requirements inhibit firms from cost effectively hedging their

growth option-related currency exposures. However, given that the reporting re?

quirements for interest-rate hedging are less cumbersome, hedge accounting rules

are unlikely to be a major factor driving the robust negative association between

interest-rate hedging and growth options. The data provide only weak evidence in favor of the hypothesis that hedging

decisions are motivated by income tax savings strategies. The data also do not

provide any support for the predictions derived from the models of hedging based

on financial distress costs. Finally, the evidence uniformly supports the hypothesis that hedging activities exhibit economies of scale.

The paper also examines whether the evidence is sensitive to classification

of all derivative users as hedgers. Out of 3,022 sample COMPUSTAT firms, 543

firms disclose that they hedge their exposures or disclose information related to

their hedging activities. An additional 228 firms disclose their use of derivatives

but do not disclose that they engage in hedging activities. I find that the conclusions

concerning the determinants of hedging are robust with respect to treatment ofthe

228 derivative users as hedgers or speculators.

3 Previous empirical examinations ofthe determinants of hedging have typically relied on survey data with sample sizes in the range of 48 to 163 firms. Moreover, these studies restrict their sample firms to include only Fortune 500 industrials or firms in the Standard & Poor's 400 list.

Mian 421

The rest of the paper is organized as follows. Section II describes the empir? ical specification of the determinants of hedging. Section III discusses mandated

financial reporting requirements with respect to use of derivatives. Section IV

reports the empirical evidence on the determinants of hedging. Section V reports the correlation between hedging and other policy choices. Section VI presents concluding remarks.

II. Determinants of Corporate Hedging

Smith and Watts (1992) report that policy choices with respect to dividend

policy, compensation, and leverage are correlated and that these policy choices, in general, are driven by common predetermined variables such as the investment

opportunity set, taxes, regulation, and so forth. They also point out that to allow for

interdependencies in policy choices, one would require specification of a simulta?

neous equations model. However, current finance theory is not developed enough to describe adequately the structural form of this system of equations. They further

note the approach proposed by Titman and Wessels (1988) is an example that tries

to impose a simultaneous equations framework but encounters the unavoidable

problems of such a methodology: "(I)f the structure they use is correct, the power of their estimates is increased, but if their structure is incorrect, they impose bias.

Given our current knowledge of these empirical relations, we believe progress is

better served by documenting robust empirical relations between policy param? eters and exogenous variables before attempting to subdivide the relations into

component effect." In the spirit of Smith and Watts (1992), Barclay and Smith

(1995a), and Barclay and Smith (1995b), I specify hedging policy choice solely a

function of exogenous variables.

In the basic Modigliani Miller (MM) world, hedging does not alter firm

value. The MM assumptions include the absence of taxes, financial distress costs,

contracting costs, information costs, and capital market imperfections. Within this

framework, the demand for corporate hedging can be derived by relaxing one or

more ofthe MM assumptions. Subsections II. A through II.D examine how hedging can create value for the stockholders through lower expected costs of financial

distress (Mayers and Smith (1982) and Smith and Stulz (1985)), lower contracting costs (Mayers and Smith (1987) and Nance, Smith, and Smithson (1993)), lower

costs of raising external capital (Froot, Scharfstein, and Stein (1993)), and lower

expected taxes (Mayers and Smith (1982) and Smith and Stulz (1985)). These

models and associated predictions are discussed next.

A. Costs of Financial Distress

In the MM world, financial distress is assumed to be costless. Hence, altering the probability of financial distress does not affect firm value. If financial distress

is costly, firms have incentives to reduce its probability. Smith and Stulz (1985)

argue that hedging is one method by which a firm can reduce the volatility of its

earnings. Based on this model, probability of hedging is higher for firms with

higher expected costs of financial distress. Nance, Smith, and Smithson (1993)

argue that if there is a fixed cost component to financial distress costs, then smaller


firms are more likely to hedge. As a proxy for firm size, I use book value of assets

minus book value of common equity plus market value of common equity (firm

value).4 Hence, hedgers are predicted to have smaller firm value than nonhedgers.

B. Contracting Costs

In the classic stockholder-bondholder conflict described by Jensen and Meck-

ling (1976), bondholders forecast the set of possible actions stockholders can un-

dertake once bonds have been issued. One interesting dimension ofthe bondholder-

stockholder conflict is the "underinvestment problem," described by Myers (1977), where firms forego positive NPV projects. As a starting point, Myers (1977) dis-

tinguishes between the NPV ofa project and the NPV ofthe cash flows accruing to

the stockholders and notes that if a sufficiently large fraction ofthe cash flows from

the project accrues to the current bondholders, it is plausible that the stockholders

could decide not to accept the project. Bondholders anticipate these potential con?

flicts of interest at the time of bond issuance and incorporate them in the price of

the bond. As shown by Mayers and Smith (1987), hedging reduces the probability that the firm will default on its promised payments, thereby increasing stockhold?

ers' expected cash flows from a positive NPV project. Since the underinvestment

problem is more pronounced for firms with more discretion in their choice of in?

vestment decisions, hedgers are predicted to be firms that derive a relatively higher

proportion of their market value from growth options relative to asset in place. As a proxy for the relative importance of discretionary investment decisions,

I use the ratio ofthe market to the book value of total assets (market-to-book ratio), where the market value of total assets is defined as the market value of common

equity (at year-end) plus the book value of preferred equity and liabilities.5 This

variable has previously been used by Smith and Watts (1992), Gaver and Gaver

(1993), and Barclay and Smith (1995a), (1995b) to capture the distinction between

assets in place and growth opportunities. The basic assumption behind the use of

this variable as an empirical proxy for the investment opportunity set is that firms

with more growth options will have market values far in excess of their book values.

Hence, the incentive contracting hypothesis predicts that hedgers will have higher market-to-book ratio as compared to nonhedgers.

Finally, prior work has shown that regulation is an important determinant of

corporate financing and dividend policy choices (Smith and Watts (1992), Barclay and Smith (1995a), (1995b)). Managers of firms in regulated industries are likely to have less discretion in their choice of investment policies. Regulation also makes

it easier for fixed claim holders to observe managerial action. As a consequence, firms in regulated industries face lower contracting costs and, therefore, they have

less of an incentive to hedge. Hence, the incentive contracting hypothesis predicts that hedging is less likely in the regulated utilities industry.6

4Firm value is calculated using COMPUSTAT data items (6 - 60 + 24 * 25). 5Market-to-book ratio is calculated using COMPUSTAT data items ((6 - 60 + 24 * 25)/6). 6Regulated utilities comprise 227 sample firms in two-digit SIC code 49, which comprises firms

in electric, gas, and sanitary services.

Mian 423

C. Capital Market Imperfections

In a recent paper, Froot, Scharfstein, and Stein (1993) examines the role of

capital market imperfections in determining the demand for corporate hedging. If access to external financing (debt and/or equity) is costly, firms with investment

projects requiring funding will hedge their cash flows to avoid a shortfall in their funds that could precipitate a costly visit to the capital markets. The costs of

visiting the capital markets include out-of-pocket costs, such as issuance costs associated with new bond or equity issues and more complex indirect costs, such as the agency costs of debt (Myers (1977)) and equity issuance costs arising from informational asymmetries between managers and outside investors (Myers and

Majluf (1984)). Since there is likely to be more asymmetric information about the quality of new projects for firms with high market-to-book ratios and for firms that are not in regulated industries, their model predicts that hedging is more

likely for firms with higher market-to-book ratios and for firms that are not in a

regulated utilities industry. Also, fixed costs associated with capital market visits are likely to make financing more expensive for smaller firms, therefore leading to the prediction that smaller firms are more likely to hedge.

D. Taxes

Mayers and Smith (1982) and Smith and Stulz (1985) argue that hedging can reduce the expected tax liability for a firm facing a progressive corporate tax structure over the range of possible income outcomes. This result follows from the

convexity ofthe corporate tax schedule and the observation that hedging reduces the

volatility ofthe firm's expected taxable income stream. Under the current corporate tax rates, this progressivity applies to the range of pre-tax incomes between $0 to

$100,000. To characterize this progressivity, I use the empirical proxy in Nance, Smith, and Smithson (1993). First, the standard deviation of each firm's earnings before depreciation is calculated using annual data over the period 1981 to 1991. This standard deviation is then used to compute a 95-percent confidence interval around the reported 1991 earnings, as a proxy for the range of possible pre-tax income outcomes. If any part of this range lies in the interval $0 to $100,000, a value of one is assigned to the variable (progressivity) indicating the presence of

progressivity, and zero otherwise.7

In addition to progressivity in the tax schedule, which admittedly applies to a very narrow range of pre-tax income, other aspects of the corporate tax struc? ture can also influence the hedging decision. Specifically, tax shields (tax loss

carry forwards and foreign tax credits) introduce convexities in the corporate tax

schedule.8 If firms do not hedge their cash flows, the utilization of these tax shields

7One problem with this variable is that the observed outcomes of income are post-hedging. Hence, the evidence with respect to progressivity should be viewed with caution. In tests not reported here, I estimated all the logistic regressions reported in this paper without PROG as an explanatory variable and found that the evidence with respect to other variables was not affected in any significant manner.

8The Tax Reform Act of 1986 repealed regular investment tax credit for most property placed under service after 1985. Therefore, investment tax credits are unlikely to be an important tax shield for 1992 data. The data are consistent with this observation. Nance, Smith, and Smithson (1993) uses 1986 data and reports that the mean investment tax credit was $7.22 million for hedgers and $1.54 million for


may be postponed to a later date, thereby reducing their present value. Hedging in? creases the present value of these tax shields by smoothing out corporate earnings. Dummy variables measuring incidence of tax loss carry forwards and foreign tax credits are used to characterize the other aspects of the tax environment, with one

indicating presence, and zero indicating absence.9 The tax hypothesis predicts that

probability of hedging is positively associated with both these dummy variables.

E. Scale Economies

Organizing the Treasury for risk management involves significant fixed costs. A recent survey by Dolde (1993) found that more than 45 percent of the Fortune 500 firms surveyed used at least one full-time-equivalent professional for risk

management, with almost 15 percent using three or more full-time-equivalents. In addition to professional staff, he reports that more than 20 percent of the sample firms used local area networks or main frame computers in their risk management

operations. Dolde's survey data also indicate that management's lack of famil-

iarity with sophisticated financial instruments is a major impediment towards the

hedging decision. In addition to economies of scale in obtaining information on

hedging techniques and instruments, there also are economies of scale in trans?

action costs associated with trading financial derivatives. Firms generally find it more difficult to find cost-effective methods of hedging exposures that are less than market amounts of $5 or $10 million. Nance, Smith, and Smithson (1993)

hypothesizes that the presence of these apparently significant fixed costs suggests that small firms are less likely to hedge than large firms.

Overall, the empirical relation between the hedging decision and firm value is

indeterminate. A positive empirical relation would suggest that economies of scale

associated with information and transaction considerations have more influence

on hedging activities than the cost of raising capital or the costs associated with

financial distress; a negative empirical relation would suggest the opposite.

F. Summary of Empirical Predictions

The models discussed in this section generate the following predictions with

respect to the determinants of hedging:

hedgers have higher market-to-book ratios than nonhedgers;

hedgers are less likely to be in regulated utilities than nonhedgers;

hedgers are more likely to have tax-related progressivity than nonhedgers;

hedgers are more likely to have foreign tax credits than nonhedgers;

hedgers are more likely to have tax loss carry forwards than nonhedgers; and

the empirical association between hedging and firm size is indeterminate.

nonhedgers. For my sample, based on 1992 data, the mean values of investment tax credit are $0.22 million for hedgers and $0.01 million for nonhedgers.

9Incidence of tax loss carry forward is obtained from COMPUSTAT data item 17. Data on presence/absence of foreign tax credit is obtained from search of financial statement footnotes available on NAARS.

Mian 425

III. Financial Reporting of Hedging Activities

Under current generally accepted accounting principals (GAAP), hedging ac?

tivities are either classified as "hedging" or "speculative" activities. Those trans?

actions that are classified as hedging activities are afforded preferential accounting treatment in that the firm does not have to recognize any gains or losses on the

hedging instrument until the underlying transaction is recorded. At that time, any

gain or loss realized on the hedging instrument is offset (netted) against the cost or

revenue of the hedged transaction when it is recorded in the financial statements.

If a transaction is not given "hedging" treatment, it is deemed speculative and

any gain or loss realized on the hedging instrument must be recognized currently, as a component of other income or loss, even though the underlying transaction

may not be recognized until future periods. Thus, gains and losses on speculative

hedging activities are recognized in one period, while the underlying transaction

to which they apply may be recorded in another period, creating a greater volatil?

ity of earnings, and a mismatching of revenue and expenses. If managers have

incentives to avoid volatile earnings, they have incentives to choose those hedging activities that are afforded the preferential hedge accounting treatment and avoid

those that are classified as "speculative." There are three significant differences in hedge accounting rules for interest-

rate derivatives (SFAS 80, Accounting for Futures Contracts) vs. currency deriva?

tives (SFAS 52, Foreign Currency Translation).10 First, the application of hedge

accounting rules differs as far as anticipated exposures are concerned. Foreign

currency transactions are not considered to be a hedge unless the underlying trans?

action is a firm commitment (SFAS 52, paragraph 21(b)); interest-rate hedges of

certain anticipated transactions are afforded hedge accounting treatment without

the existence of a firm commitment (SFAS 80, paragraph 9). Second, the risk

reduction test for obtaining hedge accounting treatment is different. SFAS 52

applies the test at the transaction level, while SFAS 80 applies the test at the enter-

prise level. Third, the rules vary as far as cross-hedging is concerned. SFAS 52 is

strict with respect to cross-hedges and generally requires the currency of denomi-

nation of the hedge instrument and the exposure to be the same; SFAS 80 allows

cross-hedging if exposure and hedge instrument have a clear economic relation?

ship. Overall, the reporting requirements for hedging interest-rate exposures are

less restrictive as compared to the reporting requirements for currency exposures.

Hedge accounting rules have implications for predictions for currency hedg?

ing based on the contracting cost model. Specifically, hedge accounting rules cause

the cost of hedging to depend on the same exogenous firm characteristic (market-

to-book ratio) that is also a determinant of the benefits associated with hedging.

Hence, an increase in market-to-book ratio increases both the benefits as well as

the costs of currency hedging, leading to an ambiguous net effect. In contrast, the

reporting requirements for hedging via interest-rate derivatives impose relatively fewer costs as compared to the reporting requirements for hedging via currency derivatives. Hence, an examination of the determinants of interest-rate hedging

provides evidence based on an environment where there is a higher likelihood for

the empirical relation between hedging and market-to-book ratio to be positive.

10For a more detailed discussion of this issue, see AICPA (1994).


IV. Evidence on Determinants of Hedging

Classification of firms into hedgers vs. nonhedgers is based on annual financial

statements available on the NAARS file on the LEXIS/NEXIS database for the year 1992. I delete financial entities (SIC codes 60 to 69) since they are both users and

providers of risk management products. Of the remaining 3,319 firms, 3,022 firms are both on COMPUSTAT and on NAARS. Out of 3,022 firms, 543 firms

explicitly state that they hedge their exposures or disclose information related to

their hedging activities.11 An additional 228 firms disclose use of derivatives but

do not disclose that the firm engages in hedging activities (henceforth, referred to

as derivative users).12 One problem with classifying derivative users as hedgers is that these firms

could potentially be using derivative financial instruments for speculation and not

for hedging. To shed light on this issue, the empirical tests reported in this section

examine the sensitivity of the evidence to alternate classification schemes with

respect to the derivative users. In subsection IV.A, I classify the 228 derivative

users as well the 543 firms that explicitly disclose information on their hedging

activity as hedgers. Later, in subsection IV.B, I reexamine the evidence after I

exclude the 228 derivative users from the sample.

A. Derivative Users Classified as Hedgers

I initially classify as hedgers 228 derivative users and 543 firms that disclose

information related to their hedging activities. This definition results in a sample of 771 hedgers and 2,251 nonhedgers. For each hedger in the sample, data are

obtained on whether the firm hedged currency-price risk, interest-rate risk, and/or

commodity-price risk. Table 1 reports the distribution of hedgers and nonhedgers for the sample firms. While commodity-price hedging appears to be concentrated

in only a few industries, there appears to be both variation in policy choice within

industries as well as variation across industries in interest-rate and currency-price

hedging.13

1. Univariates

Table 2 reports the differences in financial characteristics between hedgers and nonhedgers for the 3,022 sample firms. For each financial characteristic, panel A reports three comparisons of means: i) hedgers vs. nonhedgers, ii) interest-rate

hedgers vs. nonhedgers of interest-rate risk, and iii) currency-price hedgers vs.

nonhedgers of currency-price risk. Panel B of Table 2, reports correlations between

11 As an example of such a disclosure, Appendix A provides excerpts from Abbott Laboratories' 1992 annual report.

12As an example of such a disclosure, Appendix B provides excerpts from B.R Goodrich's 1992 annual report.

13In the balance ofthe paper, I focus on the cross-sectional variation in currency and interest-rate hedging. Determinants of commodity hedging are not discussed because the number of commodity hedgers in the sample are relatively few as compared to currency or interest-rate hedgers. Furthermore, the number of commodity hedgers is further reduced in logistic specifications due to missing values for explanatory variables.

Data on hedging are obtained from 1992 annual reports. Hedgers are firms that state that they hedge interest-rate, currency-price, and/or commodity-price risk, or firms that mention use of risk management products such as options, swaps, forwards, futures, caps, collars, or floors. aThe number of hedgers (nonhedgers) in these columns will not add up to column totals for interest rate, currency price, and commodity price hedging numbers if the industry includes firms that hedge multiple risks

financial characteristics and hedging, interest-rate hedging, and currency-price

hedging.

a. Investment Opportunity Set

Hedgers have lower market-to-book ratio (1.65 vs. 1.78). Consistent with

this result, the correlation between market-to-book ratio and hedging is negative

(_0.04). Similar results are reported when mean values of market-to-book ratio

are compared for interest-rate hedgers vs. nonhedgers of interest-rate risk: interest-

rate hedgers have lower market-to-book ratio (1.54 vs. 1.78), and the correlation

between market-to-book and interest-rate hedging is negative (-0.06). However,

hedgers and nonhedgers of currency-price risk have no significant difference in

market-to-book and the correlation between market-to-book and currency-price

hedging is insignificant as well.


A comparison of the frequency with which regulated utilities hedge when

compared with other sample firms shows that hedging is significantly less likely

among regulated utilities (5.77 percent vs. 8.04 percent). Similar results are re?

ported when the data are split by type of risk hedged. Overall, contrary to the predictions ofthe contracting cost and capital market

imperfections models, I find no evidence that hedgers of any type of risk have

higher market-to-book. The only aspect of the investment opportunity set that is

consistent with these models is that regulated utilities are less likely to hedge.

b. Tax Variables

Hedgers have a lower incidence of progressivity (36.19 percent vs. 47.58

percent), lower incidence of tax loss carry forwards (21.66 percent vs. 30.30 per? cent), and a higher incidence of foreign tax credits (13.75 percent vs. 3.73 per? cent). The evidence on foreign tax credits is consistent with the tax-based rationale

for hedging, while the evidence on both tax loss carry forwards and progressiv-

TABLE 2 A Comparison of Financial Characteristics of 771 Hedgers vs. 2251 Nonhedgers for a Sample of COMPUSTAT Firms

forthe Year 1992 Firms classified as hedgers include 543 firms that disclose that they hedge and 228 firms that use derivatives but do not disclose that they hedge. For each firm characteristic, three comparisons are reported: 771 hedgers vs. 2,251 nonhedgers, 439 interest-rate hedgers vs. 2,583 nonhedgers of interest-rate risk, and 440 currency-price hedgers vs. 2,582 nonhedgers of currency-price risk.

Panel A. Comparison of Means

Firm Characteristic3

Investment Opportunity Set Market-to-Book Value of Assets Hedging Interest-Rate Hedging Currency-Price Hedging Regulated Utilities (% incidence) Hedging Interest-Rate Hedging Currency-Price Hedging Tax Progressivity and Tax Shields Progressivity (% incidence) Hedging Interest-Rate Hedging Currency-Price Hedging Tax Loss Carry Forwards (% incidence) Hedging Interest-Rate Hedging Currency-Price Hedging Foreign Tax Credits (% incidence) Hedging Interest-Rate Hedging Currency-Price Hedging Firm Size Firm Value Hedging Interest-Rate Hedging Currency-Price Hedging continued on next page

*, **, and *** indicate significance (two-sided) at the 0.10, 0.05, and 0.01 levels, respectively. a Market-to-book ratio is defined as book value of total assets minus book value of common equity plus market value of equity divided by book value of total assets. (COMPUSTAT data items (6 - 60+(24 * 25))/6). Regulated utilities variable = 1 if firm is a regulated utility, zero otherwise. Tax progressivity = 1 if firm faces progressivity in its tax schedule over the 95 percent confidence interval around 1991 net earnings, zero otherwise. Tax loss carry forwards = 1 if firm has tax loss carry forwards, zero otherwise. FTC = 1 if firm has foreign tax credits, zero otherwise. Firm value is book value of total assets minus book value of common equity plus market value of equity. (COMPUSTAT data items (6 - 60 + 24 * 25)). Hedging is an indicator variable, which takes a value of one if the firm hedges, otherwise zero. Interest-rate hedging is an indicator variable, which takes a value of one if the firm hedges interest-rate risk, otherwise zero. Currency-price hedging is an indicator variable, which takes a value of one if the firm hedges currency-price risk, otherwise zero.

ity is inconsistent with tax-based explanations. Examination of interest-rate and

currency-price hedging leads to similar conclusions.

c. Firm Size

Examination of firm value reveals that hedgers are significantly larger as com?

pared to nonhedgers ($5,869 million vs. $803 million); interest-rate hedgers are

larger than nonhedgers of interest-rate risk ($8,436 million vs. $1,028 million); and

currency-price hedgers are larger than nonhedgers of currency-price risk ($8,355 million vs. $1,015 million). This evidence indicates that economies of scale in

hedging dominate other considerations with respect to firm size.

2. Logistic Regressions

Table 3 reports results from logistic regressions relating the probability of

hedging to the determinants of hedging. The predetermined variables include

the market-to-book ratio, a dummy variable for regulated utilities, and indicator variables measuring incidence of tax loss carry forwards, foreign tax credits, and

tax progressivity. In addition, the natural logarithm of the market value of total assets is included as a measure of firm size. Models 1, 2, and 3 report parameter estimates from logistic regressions with the dependent variable being hedging

(hedgers = 1, otherwise = 0), interest-rate hedging (interest-rate hedgers = 1, otherwise = 0), and currency-price hedging (currency-price hedgers = 1, otherwise


= 0), respectively. These alternate specifications help establish the robustness of

the parameter estimates across type of risk hedged.

TABLE 3

Estimates of Logistic Models Relating Probability of Hedging to Firm-Specific Financial Characteristics for a Sample of 3,022 Compustat Firms

The data are for 3,022 firms comprised of 771 hedgers and 2,251 nonhedgers. Firms classified as hedgers include 543 firms that disclose that they hedge and 228 firms that use derivatives but do not disclose that they hedge. Model 1 relates probability of hedging to the independent variables. model 2 relates probability of interest-rate hedging to the independent variables, and model 3 relates probability of currency-price hedging to the independent variables. * indicates p < 0.10, ** indicates p < 0.05, and *** indicates p < 0.01. aMarket-to-book ratio is defined as book value of total assets minus book value of common equity plus market value of equity divided by book value of total assets. (COMPUSTAT data items (6 - 60 + (24 * 25))/6). Regulated utilities variable = 1 if firm is a regulated utility, zero otherwise. Tax progressivity = 1 if firm faces progressivity in its tax schedule over the 95 percent confidence interval around 1991 net earnings, else zero. Tax loss carry forwards = 1 if firm has tax loss carry forwards, zero otherwise. FTC = 1 if firm has foreign tax credits, zero otherwise. Firm value is book value of total assets minus book value of common equity plus market value of equity. (COMPUSTAT data items (6 - 60 + 24 * 25)).

bHedging is an indicator variable, which takes a value of one if the firm hedges, otherwise zero. Interest- rate hedging is an indicator variable, which takes a value of one if the firm hedges interest-rate risk, otherwise zero. Currency-price hedging is an indicator variable, which takes a value of one if the firm hedges currency-price risk, otherwise zero.

a. Investment Opportunity Set

The parameter estimates from model 1 suggest that probability of hedging is

negatively related to market-to-book ratio.14 This evidence is inconsistent with the

predictions derived from the contracting cost model. One plausible explanation for not finding a positive association between hedging and market-to-book ratio

is the constraints imposed by the mandated reporting requirements on hedging of

anticipated exposures (however, the reporting requirements do not predict a neg? ative association). As discussed earlier, I expect that interest-rate hedging (model

2) is less likely to be influenced by these considerations. The parameter estimate

14Nance, Smith, and Smithson (1993) examines a survey sample of 169 Fortune 500/Standard & Poors 400 firms for the year 1986 comprising 104 hedgers and 65 nonhedgers. They find probability of hedging to be unrelated to the ratio of book-to-market value of the firm's assets.

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associated with market-to-book ratio is negative in model 2 as well. Finally, in

model 3, no significant relation exists between currency-hedging and market-to-

book ratio. Overall, evidence based on the empirical relation between hedging and market-to-book ratio fails to provide any support for the contracting cost and

capital market imperfections models.

In models 1, 2, and 3, the parameter estimate associated with incidence of

regulated utilities is negative. This evidence is consistent with contracting cost

and capital market imperfections models, which predict that regulated firms are

less likely to hedge.

b. Tax Variables

The tax-based motivation for hedging predicts that hedging is positively re?

lated with progressivity, tax loss carry forwards, and foreign tax credits. The

only tax variable that is significant in Table 3 is foreign tax credits (models 1 and

3). The positive sign on the parameter estimate of foreign tax credits in these

two models is consistent with the hypothesis that firms with tax shields hedge in

order to maximize the present value of these tax shields. However, an alternate

explanation for this result is that instead of proxying for the convexity of the tax

schedule, the foreign tax variable is a proxy for the presence of foreign operations and, consequently, foreign-currency risk.

The absence of a significant association between hedging and tax loss carry

forwards, an alternate proxy for presence of a tax shield, suggests that the associ?

ation between hedging and incidence of tax shields is not robust.15 Overall, the

data, at best, provide very weak support for the predictions ofthe tax hypotheses.16

c. Firm Size

The positive association between firm size and hedging (models 1-3) sug?

gests that the relation between size and hedging is more strongly influenced by economies of scale in risk management activities rather than financial distress costs

or costs associated with raising external capital.17

B. Tests Excluding Derivative Users

As a final test, I examine whether the basic evidence reported in this paper is robust across an alternate definition of hedging. Table 4 reports the evidence

based on a sample where the 228 derivative users are excluded and only firms that

explicitly state that they hedge their exposures or disclose information related to

their hedging activities are classified as hedgers.18 The basic results in Table 7

15 One reason for the weak results with respect to the tax loss carry forward variable is that it is probably a good proxy for a low marginal tax rate, but a poor proxy for the convexity ofthe tax schedule.

I6Nance, Smith, and Smithson (1993) also finds the probability of hedging to be unrelated to progressivity in tax structure and tax loss carry forwards.

17Nance, Smith, and Smithson (1993) and Block and Gallagher (1986) also find that users of derivative financial instruments are larger in size than nonusers.

18I treat the 228 derivative users as "greys" and delete them from the sample since they potentially include both hedgers as well as nonhedgers. If instead of excluding these firms, I classify them as nonhedgers, then the results are qualitatively the same with the following exception: progressivity and tax loss carry forward are both positively related (significant at 0.10 level) to probability of hedging in model 1. A detailed table based on this alternate classification scheme is available from the author


are not qualitatively different from the Table 3 results. In models 1 and 2,1 find

probability of hedging to be negatively associated with market-to-book ratio and

incidence of regulated utilities, and positively associated with foreign tax credits

and firm value. In model 3, parameter estimates associated with market-to-book

ratio and regulated utilities are insignificant and negative, respectively. Overall, the evidence in Tables 3 and 4 suggests that potential misclassifications resulting from inclusion of derivative users as hedgers do not appear to fundamentally alter

the conclusions in any significant fashion.19

The data are for 543 firms that disclose they hedge and 2,251 nonhedgers (228 firms that use derivatives but do not disclose that they hedge are excluded from the empirical tests). Model 1 relates probability of hedging to the independent variables, model 2 relates probability of interest-rate hedging to the independent variables, and model 3 relates probability of currency-price hedging to the independent variables. * indicates p < 0.10, ** indicates p < 0.05, and *** indicates p < 0.01. aMarket-to-book ratio is defined as book value of total assets minus book value of common equity plus market value of equity divided by book value of total assets. (COMPUSTAT data items (6 - 60 + (24 * 25))/6). Regulated utilities variable = 1 if firm is a regulated utility, zero otherwise. Tax progressivity = 1 if firm faces progressivity in its tax schedule over the 95-percent confidence interval around 1991 net earnings, otherwise zero. Tax loss carry forwards = 1 if firm has tax loss carry forwards, zero otherwise. FTC = 1 if firm has foreign tax credits, zero otherwise. Firm value is book value of total assets minus book value of common equity plus market value of equity. (COMPUSTAT data items (6 - 60 + 24 * 25)).

bHedging is an indicator variable, which takes a value of one if the firm hedges, otherwise zero. Interest- rate hedging is an indicator variable, which takes a value of one if the firm hedges interest-rate risk, otherwise zero. Currency-price hedging is an indicator variable, which takes a value of one if the firm hedges currency-price risk, otherwise zero.

19This evidence is consistent with Hentschel and Kothari (1995) which examines financial statements of 425 large U.S. corporations to test whether the risk characteristics of derivatives users are different from those of firms that do not use derivatives and reports that there are few, if any, measurable differences in risk characteristics of the two groups. Hence, the study also concludes that firms use derivatives to hedge and not to speculate.

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C. Summary of Evidence

Based on the evidence documented above, I conclude that the association be?

tween hedging and its determinants is robust with respect to inclusion or exclusion

of derivative users as hedgers. The summary of the evidence with respect to the

association between hedging and investment opportunity set, taxes, firm size, and

financial reporting requirements is as follows:

i) Investment Opportunity Set. Probability of hedging is negatively related to

market-to-book ratio. Further examination ofthe evidence by type of risk hedged

suggests that the negative association between hedging and market-to-book ratio

is primarily driven by interest-rate hedgers. While this evidence does indicate that

the relation between hedging and proxy for growth opportunities does vary across

type of risk hedged, the documented relations with respect to market-to-book ratio

fail to provide evidence consistent with the contracting cost model. In contrast, consistent with the contracting cost model, I find robust evidence that regulated utilities are less likely to hedge. This evidence also suggests that capital market

imperfections appear to be of mixed importance as a determinant of the hedging decision.

ii) Taxes. Progressivity is never significantly positive. Consistent with tax-

based motivation for hedging, the association between hedging and foreign tax

credits is positive. However, the parameter estimate associated with tax loss carry forwards is never significant in any of the logistic models estimated. Overall, the

evidence in favor of the tax hypotheses is very weak.

iii) Firm Size. There is a consistent positive relation between firm size and

hedging, suggesting that information and transaction considerations have more

influence on hedging activities than the cost of raising capital or the costs of

financial distress.

iv) Financial Reporting Requirements. The evidence shows that the key difference between currency-price and interest-rate hedging is in the association

between hedging and market-to-book ratio. Absence of a relation between market-

to-book and currency-price hedging does not support the predictions of the con?

tracting cost model. One potential explanation of this result is that costs associated

with financial reporting requirements inhibit firms from cost effectively hedging their growth option-related exposures. This explanation is consistent with Ben-

ston and Mian (1995) which documents that only 7 percent of the currency-price

hedgers disclose hedging of anticipated exposures. The paper concludes that

firms use currency derivatives predominantly to hedge firm commitments. Indeed,

given the conclusion, absence of a relation between currency hedging and market-

to-book ratio is not surprising. However, given that the reporting requirements for

interest-rate hedging are less cumbersome, hedge accounting rules are unlikely to be a major factor driving the robust negative association between hedging and

market-to-book ratio.

V. Hedging and Choice of Other Financing Policies

Smith and Watts (1992) reports that policy choices with respect to dividend

policy, compensation, and leverage are correlated and that these policy choices,


in general, are driven by common predetermined variables such as the investment

opportunity set, taxes, and regulation. Gaver and Gaver (1993) reexamines the Smith and Watts hypotheses using firm-level data. Barclay and Smith (1995a) focuses on the role ofthe investment opportunity set as a determinant ofthe maturity structure of corporate debt. These studies conclude that contracting cost theories

explain a significant part ofthe association between the policy choices. They also find that policy choices (debt maturity, leverage, and dividend yield) are correlated.

Prior research has also pointed out that these correlations represent the net effect of offsetting factors.20 For example, Smith and Watts (1992), in a discussion ofthe association between hedging and leverage, points to "an inability to separate out two effects that work through leverage: i) given investment opportunities, more leverage should produce stronger incentives to hedge; and ii) firms with more leverage have fewer growth options and lower incentives to hedge." Along the same lines, firms with more growth opportunities are likely to have lower

leverage, shorter-term debt, lower dividend payout, lower dividend yield, and

higher liquidity. Since firms with more growth opportunities are also less likely to

hedge, hedgers will have lower leverage, shorter-term debt, lower dividend payout, lower dividend yield, and higher liquidity. At the same time, Nance, Smith, and Smithson (1993) argues that, given investment opportunities, hedging and policy choices are substitutes. Hence, given the investment opportunity set, hedging is more likely for firms with higher leverage, longer term debt, higher dividend

payout, higher dividend yield, and lower liquidity. In this paper, consistent with Smith and Watts (1992) and Barclay and Smith (1995a), I examine the correlations

rather than attempt to specify a simultaneous equations model to separate out the

partial effects.21

I compute leverage as the year-end ratio of the book value of debt to the sum of market value of common equity and the book value of preferred equity. Debt

maturity is defined as year-end long-term debt as a percentage of the total debt

outstanding. Corporate liquidity is defined as the year-end ratio of current assets to current liabilities. I examine two aspects of dividend policy: i) dividend yield defined as the 1992 common dividend per share divided by the year-end stock

price, and ii) dividend payout defined as the 1992 common dividend divided by the 1992 earnings.22

Panel A of Table 5 reports the mean values of policy choices made by hedgers and nonhedgers. I find no significant difference in leverage between hedgers and

nonhedgers. I also find that hedgers issue more longer term debt (36.07 percent vs. 29.97 percent), they have lower liquidity (2.06 vs. 3.07), higher dividend yield (1.95 percent vs. 1.33 percent), and higher dividend payout (0.73 vs. 0.41). In panel B, I report correlations between hedging and the policy choices. The direction of

association evident in these correlations is consistent with the evidence based on

difference in means tests. Obviously, a formal interpretation of this evidence would

20This issue is discussed by Smith and Watts (1992) and Nance, Smith, and Smithson (1993). 21Refer to Section II for discussion of this issue. 22Leverage is calculated from COMPUSTAT data items (6 - 60 - 130)/(24 * 25 + 130). Debt

maturity is calculated from COMPUSTAT data items 9/(6 - 60 - 130). Liquidity is calculated from COMPUSTAT data items 4/5. Dividend yield is calculated from COMPUSTAT data items 26/?4. Dividend payout is calculated from COMPUSTAT data items 26/58.

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TABLE 5

A Comparison of Policy Choices Made by Hedgers vs. Nonhedgers for a Sample of 3,022 COMPUSTAT Firms for the Year 1992

Firms classified as hedgers include firms that disclose that they hedge and firms that use derivatives but do not disclose that they hedge. In Panel A, three comparisons are reported: 771 hedgers vs. 2,251 nonhedgers, 439 interest-rate hedgers vs. 2,583 nonhedgers of interest-rate risk, and 440 currency-price hedgers vs. 2,582 nonhedgers of currency-price risk. Panel B reports correlations between hedging variables and policy choices.

*, **, and *** indicate significance (two-sided) at 0.10, 0.05, and 0.01 level, respectively.

aLeverage is total debt divided by total common equity plus preferred stock (COMPUSTAT data items (6-60- 130)/(60+130)). Debt maturity is the percentage of long-term debt to total debt (COMPUSTAT data items 9/(6 - 60 - 130)). Liquidity is ratio of current assets to current liabilities (COMPUSTAT data items 21/22). Dividend yield is dividend per share divided by closing price per share (COMPUSTAT data items 26/24). Dividend payout is dividend per share divided by the primary earnings per share (COMPUSTAT data items 26/58).


require a methodology such as a simultaneous equations framework, which can

separate out the partial effects discussed earlier. Further work along these lines is

suggested as a direction for future research.

Examination of type of risk hedged yields results that are similar to the two-

way classification (hedgers vs. nonhedgers) except for two variables?leverage and debt maturity. The evidence indicates that interest-rate hedgers have higher

leverage (1.31 vs. 1.06) and longer term debt (41.28 percent vs. 29.91 percent) as

compared to nonhedgers of interest-rate risk. In contrast, currency-price hedgers have lower leverage (1.00 vs. 1.12) and shorter term debt (29.70 percent vs. 31.87

percent) as compared to nonhedgers of currency-price risk. Table 5, panel B

reports correlations between interest-rate hedging, currency-price hedging, and

other policy choices. Leverage is positively correlated with interest-rate hedging (0.06) and negatively correlated with currency-price hedging (?0.03). This evi?

dence shows that lumping interest-rate hedging and currency-price hedging into

one broad category essentially "averages out" the negative correlation between

leverage and currency-price hedging, and the positive correlation between lever?

age and interest-rate hedging. Finally, there is positive correlation (0.17) between

interest-rate hedging and debt maturity and weak negative correlation (?0.03) between currency-price hedging and maturity.23 The cross-sectional variation in

these correlations suggests that future work in this area has a rich set of empirical

regularities to explain.

VI. Conclusions

In this paper, I provide empirical evidence on the corporate hedging decision.

The unique aspects of the study are: i) use of financial statement footnotes to

derive information on the corporate hedging decision, instead of the survey data

that is typical of most previous work on hedging; ii) use of post-SFAS 105 data to

classify firms into hedgers vs. nonhedgers; and iii) use of a sample size of 3,022

firms, which is much larger than the sample sizes employed by earlier researchers

on hedging. Out ofthe sample of 3,022 firms, 543 firms are classified as firms that disclose

hedging-activity-related information and 228 firms are classified as derivative users

(use derivatives but no accompanying hedging-related disclosures). As far as the

empirical tests ofthe determinants of hedging are concerned, the relevant question is whether the 228 derivative users are better classified as hedgers or nonhedgers. Evidence indicates that the conclusions with respect to the determinants of hedging are robust with respect to treatment of these firms as hedgers or speculators.

The evidence is mixed with respect to models of hedging emphasizing the

role of contracting costs and capital market imperfections. Consistent with these

23 A potential explanation for the negative correlation between currency-price hedging and debt maturity follows from Barclay and Smith (1995a), which argues that firms with a greater degree of foreign operations are more likely to have shorter-term debt. This follows from two observations: i) these firms are more likely to finance their operations by issuing some debt in foreign debt markets, and ii) the typical maturity of debt instruments is shorter in foreign markets than in U.S. markets. Hence, the presence of foreign operations is associated with both hedging of currency-price risk and shortening of debt maturities.

Mian 437

models, regulated utilities are less likely to hedge as compared to firms in unreg- ulated industries. At the same time, inconsistent with these models, hedgers do

not have higher market-to-book ratios. Given that mandated financial reporting requirements can potentially influence the empirical relation between hedging and its determinants, I also examine whether the subsample in which the burden placed

by the reporting requirements is least onerous (i.e., interest-rate hedgers) yields results that are any different. Again, even for interest rate hedging, the evidence

on market-to-book ratios is inconsistent with contracting costs and capital market

imperfections models.

The evidence is also mixed with respect to the hypothesis that hedging deci?

sions are motivated by tax saving strategies. Consistent with the tax hypotheses, I

find incidence of foreign tax credit (as a proxy for tax shield) to be generally asso?

ciated with a higher likelihood of hedging. Inconsistent with the tax hypothesis, there is no robust relation between hedging and incidence of progressivity in tax

schedule and between hedging and incidence of tax loss carry forwards.

I find robust evidence that larger firms are more likely to hedge. This evidence

supports the hypothesis that there are economies of scale in hedging and that infor?

mation and transaction considerations have more influence on hedging activities

than the cost of raising capital. The evidence on firm size is also inconsistent with

models based on the costs associated with financial distress as a motivation for

hedging. Evidence on correlations across policy choices shows that hedging is uncorre?

lated with leverage, positively correlated with dividend yield and dividend payout, and negatively correlated with liquidity as measured by the current ratio. Profiles

of currency-price risk hedgers differ systematically from interest-rate risk hedgers; interest-rate risk hedgers have higher leverage and longer debt maturities, while

currency hedgers have lower leverage and shorter debt maturities. Formal inter?

pretation of these correlations requires specification of a simultaneous equations framework. Further investigation of this issue is suggested as a line for future

research.


APPENDIX A

Abbott Laboratories

Financial Instruments. The Company enters into foreign exchange contracts and foreign currency option contracts to manage its exposure to foreign currency rate changes. At December 31, 1992 and 1991, the Company held approximately $673 million and $1.5 billion, respectively, of such instruments maturing through early 1994, primarily in European and Japanese currencies. Realized and unrealized gains and losses on contracts that qualify as hedges of anticipated purchases by foreign subsidiaries are recognized in the same period that the foreign currency exposure is recognized. At December 31, 1992 and 1991, approximately $1.0 million and $7.4 million, respectively, of net losses had been deferred. Gains and losses on contracts that do not qualify for hedge accounting are recognized in income as foreign currency rates change. The Company also enters into a variety of interest rate hedge contracts in the management of interest rate exposures. At December 31, 1992 and 1991, the Company had $300 million and $200 million, respectively, of such instruments outstanding maturity through 1995. Gains or losses are recognized in income in the same period that the interest rate exposure is recognized. The net liability at December 31, 1992 for foreign exchange, foreign currency option and interest rate contracts was $9.3 million, compared with the fair value of the net liability of $9.8 million.

APPENDIX B

B.F. Goodrich Company

Interest Rate Swap Agreements. The Company enters into interest rate swap agreements that involve the exchange of fixed and floating rate interest payments on a notional principal amount over the life of the agreement. The differential to be paid or received is accrued as interest rates change and recognized as an adjustment to interest expense.

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