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Applied Financial Economics. 2003, 13, 55-69

RoutJedge

Why firms hedge with currency derivatives, an examination of transaction and translation exposure

NICLAS HAGEEIN

School of Business. Stockholm University. S-106 9/ Stockholm. Sweden e-mail: nh%fek.su.se

This article examines Swedish firms' use of currency derivatives to provide empirical evidence on the determinants of firms' hedging decisions. The study uses survey data in combination with publicly available data. The use of survey data makes it possible to differentiate between currency derivative usage aimed at hedging translation exposure and that aimed at hedging transaction exposure. This is of interest since translation exposure and transaction exposure tend to affect firms differently. The results are consistent with the conjecture that firms hedge transaction exposure with currency derivatives to increase firm value by reducing indirect costs of financial distress or alleviating the underinvestment problem. N o evidence is found to support the notion that translation exposure hedges are used to increase firm value.

I.

INTRODUCTION

Firms use derivatives to hedge their exposure to a variety of risks. Hedging exposure attracts a lot of managerial and financial resources. Hence, knowledge about whether deri- vative hedging adds value to firms is of importance to shareholders. Theoretical research provides several rationales to why firms engage in hedging activities. One rationale suggests that hedging can increase firm value by reducing the expected costs of financial distress, lowering the expected cost of taxes, or alleviating the underinvestment problem associated with costly external financing (see Smith and Stulz, 1985; Froot et al., 1993). Another rationale is based on the private motives of poorly diversified managers who attempt to reduce their risk exposure through the firm's hedging activity (see Smith and Stulz, 1985). Earlier empirical studies have examined whether firms' behaviour conforms to prescriptions based on theoretical research. While some of the studies analysed the use of

derivatives in general (see Nance et al., 1993; Dolde, 1995; Berkman and Bradbury. 1996; Gay and Nam , 1998; Guay, 1999). others exatnined the use of derivatives to manage particular types of exposures (see Mian, 1996; Tufano, 1996; Geczy et al., 1997; Goldberg et al., 1998; Howton and Perfect, 1998; Allayannis and Ofek, 2000; Graham and Rogers, 2000; Haushalter, 2000). As in this study, Mian (1996), Geczy et al. (1997), Goldberg et al. (1998), Howton and Perfect (1998), Allayannis and Ofek (2000), and Graham and Rogers (2000) directly examined the tise of currency derivatives.' One advantage of examin- ing the use of derivatives for a particular type of exposure is that it improves the ability to control for variation in inherent exposure.

This article contributes to the previous research by not only examining firm characteristics associated with the use of currency derivatives in general, but also by analysing the type of foreign exchange exposure that is hedged. More specifically, the association between firm characteristics and hedging of translation exposure, committed transaction

' Tufano (1996) and Haushalter (2000) examined the use of derivatives in the gold mining industry and the gas and oil industry, respectively.

Applied Finam-ial Eiommiir.y ISSN 0960-3107 prini/TSSN t466 4305 online i(;) 2003 Taylor & Francis Ltd hll p://www. Itindf,co.uk/jouriiats DOI: 10.lOSO/09603l0011009450t

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exposure, and anticipated transaction exposure, is investi- gated respectively."^ This is of interest since translation 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

Hagelin

used for hedging purposes. However, by using a question- naire that specifically asks whether currency derivatives are used for hedging purposes, it was possible to assert that the investigated variable should not include currency derivative usage aimed at speculation.^ The previous studies that examined the use of currency derivatives investigated US firms. This article adds to our knowledge by investigating Swedish firms* use of currency derivatives. Given the fact that Swedish firms have a rela- tively high foreign exchange exposure it is likely that the use of currency derivatives is of great importance to them.*' For this reason, Sweden is a suitable environment for a study on firms' use of currency derivatives. It was found thaf larger firms are more likely fo use currency derivatives than smaller firms are, which suggests that fixed costs act as a barrier to small firms. Also, trans- action exposure hedging with currency derivatives is related to variables that represent indirect costs of financial dis- tress and the underinvestment problem associated with costly external financing. Notably, translation exposure hedging with currency derivatives is unrelated to these proxy variables. The results suggest that firms hedge trans- action exposure with currency derivatives to increase firm value, while there was no evidence thai translation expo- sure hedges are used for this reason. The current study is organized as follows: the next sec- tion contains a description of the sample selection pro- cedure and data used. Section III reviews theoretical prescriptions and previous empirical evidence on the determinants of firm hedging. The results are presented in Section IV, which is followed by a summary and conclusion.

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II.

SAMPLE

SELECTION

AND

DATA

Since detailed public data are not available on firms' use of derivatives for different hedging purposes, a survey was

"Operating exposure is usually broken into two components: the exposure of identifiable anticipated transactions and competitive exposure (the exposure of unidentifiable future cash flows). The reason for not investigating competitive exposure directly is that few firms tend to hedge this type of exposure with currency derivatives (see e,g. Bodnar et al. 1996). Instead, the longer-termed competitive exposure is typically managed by operational hedges. From an examination of annual reports, it is suggested that this is also the case for Swedish firms. Butler (1999) provides a discussion on the problems associated with using financial hedges to manage longer-termed competitive exposure, ^ Translation exposure depends on the translation method used. The fntemational Accounting Standard 21 (IAS 2f) suggests the use of the current rate method for self-contained foreign affiliates and the use of the temporal method for integrated foreign affiliates and for foreign affiliates in countries with high inflation. The exposure under the current rate method is given by the equity of the foreign affiliate, whereas under the temporal method it is the net amount of assets and liabilities translated at the current exchange rate. Changes in exchange rates on foreign operations thus always cause changes in group equity and under the temporal method, these changes also affect group net income. Swedish firms follow The Swedish Institute of Authorised Public Accountants' proposal to recommendation, which 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 causes 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 operate in a small open economy. In 1995. goods imported into Sweden represented 28% of GDP and goods exported were 34,5% of GDP. For the USA. imports were 10.7% of GDP and exports were 8,4% (see OECD economic surveys. Sweden 1998).

Why firms hedge with currency derivatives

employed to determine if specific firms use currency deri- vatives (i.e. forwards, futures, swaps or options) for risk management purposes. The survey results are linked to public data on firm cbaracteristics to enable tests on the theoretical predictions presented in Section III. Firms that met the follov^'ing three criteria were included in this article:

(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, with a pre-paid return envelope, was mailed to these firms. The first rnailing in October 1997 was followed by a second mailing to improve the response rate. The questionnaire consisted of eight questions concerning the respondent's currency derivatives hedging policy und inherent exposure. (A translated version of the questionnaire is available on request.) From a possible 160, 101 useable responses were obtained. This response rate of 63% compares favourably with for instance the 32% response achieved by Nance et at. (1993). To check for potential non-response bias, the 101 sample firms were compared with the 59 firms that did not return the questionnaire. Only one of the 11 variables used to describe hedging determinants (see Section III) was sig- nificantly different between the samples, at the 10% level, indicating that no response bias exists. This is of import- ance if out-of-sample predictions are desired. (The results of the Wilcoxon rank sum tests are available on request.) Firms were asked in the questionnaire whether or not they hedged foreign exchange (FX) exposure with deriva- tives and if so, if their hedging concerned translation (TL), committed transaction (CT), and/or anticipated transac- tion (AT) exposure. Patiel A in Table I shows that 61 firms (or 60Vo) used derivatives to hedge FX exposure. It is also shown that 33 firms hedged TL exposure, whereas 51 and 38 firms hedged CT and AT exposure, respectively.'' Unfortunately, four firms did not answer the question

concerning TL exposure hedging, while three firms left the questions regarding CT and AT exposure hedging unanswered. For this reason, the sample size is somewhat reduced when the closer examinations of hedging are conducted. Furthermore, firms were asked how much of their TL, CT, and AT exposure they hedged. Panel B, in Table I, presents the average percentage of the inherent exposure that was hedged with currency derivatives among those that hedged that particular exposure. It is evident from Pane! B that a firm tbat hedged a particular type of expo-

Table 1. Sample activities

data

on firms'

currency

derivatives

iiedging

Panel A: distribution of currency derivatives users and nonusers among sample firms

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

Number of

observations

Percent

61

6Q

40

40

33

33

64

63

4

4

51

50

47

47

3

3

38

38

60

59

3

3

Panel B: percentage of exposure hedged with currency derivatives among hedgers:

First

Third

Mean quartile Median quartile

Percentage ofTL exposure hedged

74

50

90

100

Percentage of CT exposure hedged

82

70

90

100

Percentage of AT exposure hedged

53

31

50

70

Notes: Frequency of sample firms' use of currency derivatives and percentage of exposure that Is offset. Pane! A reports on the distri- bution of currency derivatives users and nonusers, while panel B reports on the percentage of the exposure that was offset with currency derivatives. The data were obtained from a question- naire sent to firms listed on the Stockholm stock exchange. Firms" use of currency derivatives to hedge: foreign exchange (FX) exposure and exposure broken down by translation (TL), committed transactions (CT), and anticipated transactions (AT) were investigated. A tota l of lOf firms answered the questionnaire.

•'As a general matter, the author notes that firms can use means other than derivatives to manage their inherent exposure. For this reason, the questionnaire also contained a question asking firms whether or not they used debt denominated in foreign currency to manage their FX exposure. Fifty-three per cent of the firms responded that they did. The use of debt denominated in foreign currency was more common among lirms that used currency derivatives for hedging purposes (67%) than among non-users (32%). More specifically, 84% of the firms that hedged TL exposure with currency derivatives also used debt denominated in foreign currency. The equivalent numbers for the two samples of CT and AT exposure-hedgers was 67% and 71 % respectively. To explore the possible impact on the results presented in Tables 6 and 7 from firms using debt denominated in foreign currency to hedge their FX exposure, the regressions were re-run with a dummy variable included, which indicated whether or not debt was used for hedging purposes. However, the results were qualitatively similar and are therefore not presented in any detail (see also note 21).

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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 particularly 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

'^. Hagelin

Bonnier Findata. Finally, data on ownership structure were collected from Sundin and Sundqvist (1997) and annual reports. All the data concemed 1996.

III.

HEDGING

DETERMINANTS

This section describes hedging determinants, the variables used as proxies for these determinants, and earlier empiri- cal findings of studies that examined the use of currency derivatives. To conserve space, the presentation of earlier empirical findings is primarily confined to proxy variables used in this study. Furthermore, if a study uses both con- tinuous (the level) and binary measures to describe the dependent variable (use of derivatives), priority is given to results pertaining to the binary variable. Table 2 sum- marizes the empirical findings of earlier studies for the vari- ables that are used in this article as proxies for incentives to hedge. Finally the last subsection presents a summary of the empirical predictions generated in this section, and their implications for transaction and translation exposure hedging, respectively.

Shareholder value maximization

Modigliani and Miller (1958) showed that firm value and financial policy decisions are unrelated in the absence of market imperfections. Recent theoretical studies., however,

Table 2. Summary of empirical papers that study determinants of firms' use of currency derivatives

 

Type of

variable

Leverage

Liquidity

Prediction

Mian (1996)

Bmary

*

*

Geczy et al. (1997)

Binary

No

Yes

Goldberg ef a/. (1998)

Binary

No

Yes

Howton and Perfect (1998)

Level

No

Yes

Allayannis and Ofek (2000)

Binary

No

Graham and Rogers (2000)

Binary

No

Dividend

yield

*

No

*

*

No

No

 

Market-to-

Firm size

book

No

Yes( + ) Yes( -1-)

No

No

*

Yes( -1-)

*

Yes( + )

No

Yes( +)

No

Managerial

Managerial

Institutional stock option ownership ownership ownership

No

No

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 the /evtV of usage. The last eight columns summarize the variables, predicted signs (row 1), and whether a specific study lends support for the prediction. 'Yes" indicates support for the prediction while "No" indicates that no support for the prediction was found. "*' indicates that the variable was not investigated. To conserve space, the presentation of variables is confined to those that are used in this study. Furthermore, if a study uses both continuous (the level) and binary measures to describe the dependent variable, priority is given to the 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 (i.e. the decision to hedge) and a truncated regression (i.e. the regression equation for non-zero outcomes). The results from the Tobit model and the first step of the Cragg (197!) model, the probit analysis, are broadly similar to the results presented in Table 6. The results from the second step of the Cragg (197f) model showed that the association between the variables used to describe hedging determinants and the fevef of TL and CT exposure hedged is low. This result was expected due to the relatively low distribution in the dependent variables. The level of AT exposure hedged, on the other hand, is significantly associated with some of the variables used to describe hedging determinants.

Why firms hedge with currency derivatives

have shown that hedging can increase firm value if capital market imperfections exist.

Costs of financial distress. Smith and Stuiz (1985) showed that hedging could increase the value of the firm by redu- cing the probability, and thus the expected costs, of financial distress. Therefore, the probability of hedging can be expected to increase with increases in the probabil- ity of financial distress or increases in costs of financial distress. Nance et al. (1993) hypothesized that the prob- ability of encountering financial distress increases with increases in leverage. Leverage is defined as the book value of debt divided by the book value of equity.^ As shown in Table 2. a positive relationship between the use of currency derivatives and leverage is not supported by the results of earlier studies.'"

Nance et at. (1993) argued that firms can reduce the probability of encountering financial distress not only by hedging, but also by rnaintaining more liquid assets or lower dividend yields. They predicted that increases in liquidity or decreases in the dividend yield reduce the prob- ability of hedging. The three studies that investigated the relationship between derivative usage and liquidity found support for a negative relationship, while none of the studies that examined the association between use of deri- vatives and dividend yield suggested a positive relationship. Like Nance et at. (1993), the ratio of current assets to current habilities, and dividend per share divided by stock price per share, are used as a proxy for liquidity and dividend yield, respectively.

Warner (1977) found that direct costs of financial dis- tress were less than proportional to firm size. For this rea- son small firms are more likely than large firms to employ derivative hedges. However, empirical evidence suggests a positive relationship between firm size and the use of deri- vatives, which instead indicates that hedging programmes are associated with large fixed costs acting as a barrier to small firms (see below). Like most of the earlier studies, the log of the market value of total assets was used as a proxy for firm size. The market value of total assets is defined as the book value of total assets minus the book value of equity plus the market value of equity.

Jensen and Meckling (1976) pointed to the relative im- portance of indirect costs of financial distress for the firm's choice of financial structure. In view of this, Sharpe (1994)

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investigated the relationship between financial structure, costs of financial distress and the cyclicality of employment. He found that during cyclical downturns, firms with higher leverage tend to adjust their labour force downward rela- tively more than firms with lower leverage do. Sharpe (1994) hypothesized that this is because firms balance the benefits of debt finance with the benefits of a more highly trained labour force. Accordingly, firms with relatively higher costs for training their employees are more likely to employ deri- vative hedges to reduce the probability of outcomes when reductions in the labour force are needed.

A dummy variable was constructed to delineate those firms for which one expects costs of financial distress aris- ing from human capital investments to be particularly im- portant. Unfortunately, human capital investments are not directly observable. Therefore, the firms' average wage cost per employee were used," and firms with values above the median classified as having high average human capital investments per employee. The rationale for using this proxy is that human capital investments per employee tend to increase with pay and job complexity (see e.g. Bishop. 1994; Frazis et at., 1998). However, firms need not only have high average human capital investments per employee, but should also be personnel intensive. To measure personnel intensity, the ratio of total wage costs to total costs was computed and firms with ratios above the median was classified as personnel intensive. Finally, the dummy variable takes the value of one only if a firm is classified as having high human capital investments per employee atid being personnel intensive.'"

Investment opportunity set. Myers (1977) showed that issuance of claims with higher priority than equity creates incentives for the firm's equity holders to underinvest. Bessembinder (1991) demonstrated that hedging reduces the incentive to underinvest since hedging shifts individ- ual future states from default to non-default outcomes. Because firms with more valuable growth opportunities and higher leverage are more likely to be affected by the underinvestment problem, these firms are also more likely to hedge. As a measure of future growth opportunities. the ratio of the market to the book value of total assets (market-to-book) was used, where the market value of total assets is defined as described above. It is noteworthy that none of the earlier studies that investigated the rela-

The use of book value of equity instead of market value is in accordance with Graham and Rogers (2000) and is motivated by the current study's interest in financial rather than economic distress. '" Interestingly, Goldberg et al. (1998) and Graham and Rogers (2000) found that leverage afTects the level of FX exposure being hedged but not the decision to do so. This finding, however, is not supported by the results of Allayannis and Ofek (2000). In contrast to information on human capital investments, wage costs are available from annual reports in Sweden. - This proxy for human capital investments draws on an index constructed by Hansson (1997). This index (in a way similar to Hansson, 1997) was also used with results broadly similar to those presented in Tables 6 and 7. fiowever, tests with multiple dummies suggested that the relationship is non-linear and that a possible effect mainly results from differences between the firms constituting the group with the highest index values (i.e. the firms with the dummy set to one) and other lirms.

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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 more costly than internal 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 information asymmetries, I used, in accordance 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 important determinant 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

Hagelin

(2000) failed to document the expected relationship between use of derivatives and the convexity of the tax function. Graham and Rogers (2000) concluded that firtns do not hedge in response to convexity because the incentive is small relative to other hedging incentives. Given the difficulty in obtaining a reliable estimator of the convexhy of the tax function and its weak predictive power in earlier studies, the author decided not to include this variable in the analysis.

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Managerial wealth and risk aversion

Smith and Stulz (1985) examined managerial risk aversion as a driver of firms' hedging decisions. A risk-averse man- ager who owns a large number of the firm's shares and is poorly diversified prefers to reduce the firm's share price risk. Managers who believe that it will be iess costly (to her or him) for the firm to hedge the share price risk than to hedge it on her or his own account, will direct the firm to hedge. Smith and Stulz's (1985) model predicts that man- agers with greater proportions of their wealth invested in the firm's shares would prefer more hedging, while those with greater option holdings would prefer less hedging. The rationale for this is that stocks provide linear payoffs as a function of stock prices, whereas options provide convex payoffs.

To investigate the relationship between managerial stock ownership and use of currency derivatives for hedging, the use of a proxy that measures the percentage of total man- agerial wealth invested in the firm would be ideal. In accor- dance with the data available for earlier studies, total managerial wealth is not obtainable. Therefore, the percen- tage of the firms' shares owned by the chief executive officer (CEO) was used.'^^ As depicted in Table 2, the hypothesis of a positive relationship between use of derivatives and managerial stock ownership is not supported by the earlier studies.

To examine whether a negative relationship between managerial option ownership and use of currency deriva- tives for hedging exists, a dummy variable that is set to one if managerial option ownership programmes exist and to zero otherwise was used. No support for a negative rela- tionship is offered by the results of the studies presented in Table 2.

"Scaled versions of firms' research and development expenditures have been used by some researchers as proxies for future growth opportunities. Unfortunately, information on firms' research and development expenditures is not widely available for the Swedish 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 and 7 were repeated using the CEO's stock ownership measured in SEK instead of the percentage of the firms' shares that the CEO owned, but with similar results. It is important to recognize that finiis' risk management decisions may result from a larger group of officers and directors than the CEO. In fact, this is suggested by the results of Tufano's (1996) study of the North American gold mining industry. Ideally, ownership data covering the complete group of managers that influence the firm's hedging decision should be used. This requires knowledge of the size of the decision-making group and the holdings of the individuals that constitute this group. Unfortunately, this is information that could not be obtained.

Why firms hedge with currency derivatives

Economies of scale and variation in inherent exposure

As mentioned earlier, empirical research supports the per- ception that starting and managing a derivatives pro- gramme is associated with significant economies of scale. These economies arise from fixed costs associated with, among other things, training employees and developing hedging strategies. Given the costs associated with a deri- vatives programme the decision to initiate one is not only determined by whether inherent exposure exists or not, but also by its level. One expects the probabiUty of hedging to increase with increases in inherent exposure. As a proxy for transaction exposure (CT and AT expo- sure), the percentage of revenues that is denominated in foreign currency (foreign revenues) was used."" Alternatives based on scaled versions of foreign sales do exist. While an estimator based on foreign sales appears not to offer any particular benefits, except for being directly obtainable from annual reports, it may over- or underesti- mate the actual transaction exposure since the exposure is not caused by the cash flow's origin. Instead, the exposure pertains to the actual exchange of foreign currency.''' Geczy et al. (1997) and Goldberg et al. (1998) used scaled versions of foreign sales and found that their estimators of foreign exchange exposure were successful in explaining currency derivative usage.

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As a proxy for TL exposure, the percentage of the firm's equity that is derived from foreign affiliates and is denomi- nated in foreign currency (foreign equity) was used. Geczy ct al. (1997) used the ratio of foreign assets to total assets. They found that the ratio of foreign assets to total assets had no predictive power in explaining currency derivative usage.

Empirical predictions for transaction and translation exposure hedging

Based on the above discussion., Table 3 presents a summary of the predicted directions for potential relationships between firm characteristics and the likelihood of using currency derivatives for hedging purposes. Except for pre- diction 4b, these directions should also be valid for the level of exposure hedged with currency derivatives. Table 3 also summarizes variable definitions. As mentioned earlier, transaction exposure and TL exposure tend to affect firms differently. Therefore, one expects the validity of the predictions to differ between transaction (CT and AT) exposure hedges and TL expo- sure hedges with currency derivatives. Since transaction exposure hedges can reduce the varia- bility of cash flows and firm value, one expects prediction

Table 3. Summary of predicted relationships between firm characterislics and the likelihood of hedging and variable definitions

 

Prediction

Leverage

(1)

Liquidity

(2)

Dividend yield

(3)

Firm size

(4a)

(4b)

High human capital

(5)

Market-to-book

(6)

Institutional ownership

(7)

Managerial stock ownership

(8)

Managerial option ownership

(9)

Foreign revenues

(10)

Foreign equity

(II)

Variable definition

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 and 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

Notes: Based on the discussion in Section III, Prediction shows the predicted direction for potential relationships between firm char- acteristics and the likelihood of hedging. Variable definition summarizes how the 11 variables approximating different firm characteristics are estimated.

Information on the proportion of revenues, expenditures and equity that is denominated in foreign currency is obtained with the questionnaire. To take account of the potential impact that arises from imports, an estimator was also included in the regressions presented in Tables 6 and 7 based on the absolute difference between revenues and expenditures denominated in foreign currency. The results were qualitatively similar to those presented in Tables 6 and 7. For instance, if a Swedish exporter company invoices its customer in SEK rather than in the currency of the customer the source of transaction exposure is effectively eliminated. However, if the objective is to estimate the total economic exposure it is important to measure the total change in the firm's cash flows that arises from an unexpected change in exchange rates. Dolde (1995) estimated the sensitivity of firms" operating incomes to exchange rates changes. As reported by Dolde (1995). this procedure can cause biased estimates as some firms consolidate the effects of hedges with the corresponding operating cash Hows.

62

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 circumstances, 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 transaction (CT and AT) 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 general. Finally, prediction 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.

IV.

RESULTS

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.

A'. Hagelin

Summary statistics and univariate tests

Table 4, presents summary statistics for the proxy variables described in Section III, and significance tests of differences between the distributions of these variables for users and non-users of currency derivatives. Summary statistics and significance tests are shown for the exposure categories FX, TL, CT and AT respectively. It is shown from the Wilcoxon rank sum tests, reported in Table 4, that no statistical differences at the 10% level in leverage, liquidity or dividend yield exist between users and non-users of currency derivatives, independent of exposure category being hedged. Table 4 shows that users of cur- rency derivatives have significantly larger firm size than do non-users, which is consistent with the conjecture that fixed costs act as a barrier to small firms. A comparison of the frequency with which users and non-users of currency derivatives are classified as having high human capital investments shows that no significant differences exist. It can also be seen from Table 4 that two of the four exposure categories that are investigated (FX and CT) indicate sig- nificantly greater median market-to-book ratios for users than for non-users. This suggests that firms using currency derivatives to hedge CT exposure have more valuable growth opportunities than non-users do, which is consis- tent with the underinvestment argument by Bessembinder (1991). Contrary to the prediction, but in similarity with the evidence presented by Geczy et al. (1997) atid Graham and Rogers (2000), users exhibit less informational asym- metry, as measured by institutional ownership, than do non-users.

Table 4 shows that, independent of exposure category being hedged, users of currency derivatives have signifi- cantly lower managerial stock ownership than non-users. In addition, firms classified as having managerial option ownership are statistically more likely to use currency deri- vatives to hedge FX, CT and AT exposure than other firms. The results do not support the perception that man- agers are hedging with currency derivatives to increase their own well-being. As expected, users of currency derivatives have signifi- cantly higher percentages of revenues denominated in for- eign currency (foreign revenues) than do non-users. Finally, the percentage of equity that is derived from for- eign affiliates and is denominated in foreign currency (for- eign equity) is significantly different across users and non- users for the four exposure categories examined. Table 5 presents the correlation matrix of the independent variables. The smallest correlation is -0.30 between leverage and market-to-book ratio, and the largest

^'* Notably, to the extent that TL gains and losses do involve cash flows or real changes in firm value, these predictions should be valid for TL exposure hedges for the same reasons as for transaction exposure hedges. This could be the case, for instance, when a firm is about to liquidate its foreign affiliate so the value will be realized.

Why firms hedge with currency derivatives

63

Tabie 4, Summary

of firm characteristics for currency derivatives users and non-u.sers

 
 

Users

Non-users

 

/j-values of

 

Mean

Median

N

Mean

Median

N

differences

Leverage

FX expo.sure

1.68

1.40

60

2.13

1.52

40

0,70

TL exposure

1.95

1,61

33

1.86

1,38

63

0,11

CT exposure

1.64

1,43

50

2.16

1,54

47

0.49

AT exposure

1.76

1,40

38

1.97

1.54

59

0,96

Liquidity

FX exposure

1.86

1,65

61

3.51

1.81

40

0.88

TL exposure

1.66

1,62

33

2.98

1,86

64

0,22

CT exposure

1.88

1.65

51

3.23

L77

47

0.87

AT exposure

1.89

1.77

38

2.95

1.75

60

0,72

Dividend yield

FX exposure

2.55

2.40

61

2.44

1.75

40

0.50

TL exposure

2.93

2.50

33

2.31

2,05

64

0.29

CT exposure

2.56

2.40

51

2.44

2,10

47

0,77

AT exposure

2.56

2.30

38

2.42

2.40

60

0,75

Firm size

FX exposure

3.72

3.71

61

3.04

2.86

40

0.00

TL exposure

3.98

3.93

33

3.17

3,01

64

0.00

CT exposure

3.73

3.72

51

3.13

3,01

47

0.00

AT exposure

3.72

3.67

38

3.25

3,16

60

0.01

High human capital (% incidence)

 

FX exposure

29.51

0,00

61

22.50

0,00

40

0,55

TL exposure

30.30

0.00

33

26.56

0.00

64

0.77

CT exposure

33.33

0.00

51

19.15

0.00

47

0.23

AT exposure

3f.58

0.00

38

23.33

0.00

60

0.49

Market-to-book FX exposure

1.64

1.32

61

1,59

Lf4

40

0.03

TL exposure

1.45

1.27

33

L73

1.19

64

0.37

CT exposure

L67

1,32

51

1,59

1,16

47

0.07

AT exposure Institutional ownership (%)

1,56

1.36

38

1,68

1,19

60

0.13

FX exposure

38.06

40.80

61

27.21

21.35

40

0.01

TL exposure

42.42

47.80

33

29.13

26.85

64

0.00

CT exposure

37.83

40.70

51

29.29

26.90

47

0.05

AT exposure

40.67

46.80

38

28.82

27.15

60

0.01

Managerial stock ownership (%)

 

FX exposure

4.64

0.04

60

7.40

1,65

40

0.00

TL exposure

2.86

0.03

33

7,60

0,87

63

0.00

CT exposure

5.37

0.04

50

6,49

0,87

47

0.01

AT exposure

4.18

0.04

38

7,03

0.45

59

0.06

Managerial option ownership (% incidence)

 

FX exposure

21.31

0.00

61

2,50

0.00

40

0.01

TL exposure

21.21

0.00

33

10.94

0.00

64

0.17

CT exposure

21.57

0.00

51

6,38

0.00

47

0.03

AT exposure

26.32

0.00

38

6.67

0.00

60

0.01

Foreign revenues (%) FX exposure

53.11

35.00

61

25.68

8.50

40

0.00

TL exposure

50.50

50.00

33

35.23

20.00

64

0.04

CT exposure

52.11

50.00

51

29.06

10.00

47

0.00

AT exposure

60.64

70.00

38

28.40

10.00

60

0.00

Foreign equity (%) FX exposure

28,84

20.00

57

10.48

0,00

40

0.00

TL exposure

32.33

2f.00

30

16.34

3,50

64

0.00

CT exposure

28.00

20.00

47

14.47

LOO

47

0.00

AT exposure

32,33

21.00

36

13,91

1,50

58

0.00

Notes: Summary statistics of proxy variables and significance tests of difTerences between firms on the Stockholm stock exchange that use currency derivatives to hedge and those firms which do not. Mean, medians, and number of observations (A^ are reported. Foreign exchange (FX) exposure is broken down by exposure due to translation (TL), committed transactions (CT). and anticipated transactions (AT). All variables areas defined in Section 111. The/)-values are from a Wilcoxon rank sum test for the differences in the median ol each proxy variable between firms that use currency derivatives to hedge and firms that do not. /j-values less than 0,10 are shown in boldface type.

64

Table 5, Pearson correlation coefficients

N.

Hagelin

 

LEV

LIQ

DY

FS

HHC

MB

lO

MSO

MO O

FR

F E

Leverage (LEV)

1

Liquidity (LIQ)

0.09

I

Dividend yield (DY)

-0.26

-0.10

1

Firm size (FS)

0.07

-0.07

0.02

1

High human capital (HHC)

-0.30

0.05

0.25

-0.02

1

Market-to-book (MB)

-0.30

0.10

-0.15

-0.09

0.23

1

Institutional ownership (lO)

-0.19

0.05

0.03

0,59

0.18

0.06

1

Managerial stock ownership (MSO)

-0.02

0.15

-0.06

-0.20

-0.05

0.17

-0.25

1

Managerial option ownership (MOO)

-0.09

-0.09

-0.01

0,26

0.02

0.08

0.29

-0.12

1

Foreign revenues (FR)

-0.26

-0.02

0.12

0.31

0.12

0.14

0.56

-0.19

0.13

Foreign equity (FE)

-0.11

-0.16

0.01

0.44

0.04

-0.01

0.46

0.04

0.22

0.58

Note: Pearson correlation coefficients for independent variables used in the regressions presented in Tables 6 and 7. The sample consists 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 the explanatory variables. There are coefiScient estimates and /7-values for the six models used. In the first three models, the dependent variable is set to one for firms that use cur- rency derivatives to hedge FX exposure and zero for non- users. The models differ with respect to how variations in FX exposure are accounted for. Model 1 contaitis the vari- able foreign revenues, while Model 2 includes the proxy foreign equity. The third model is unrestricted in the sense that it comprises both the variables. Models 4, 5 and 6 present results broken down by type of FX exposure that is hedged with currency derivatives. More specifically.

Table 6. Logit regression estimates of the likelihood of using currency derivatives

 

Model 1:

Model 2:

Model 3:

Model 4:

Model 5:

Model 6:

FX exposure

FX exposure

FX exposure

TL exposure

CT exposure

AT exposure

Coeff.

p-value

Coeff.

/7-value

Coeff.

/j-value

Coeff.

/j-value

Coeff.

p-va]ue

Coeff.

/j-value

Intercept

-4.75

0.01

-2.53

0.12

-3.87

0.03

-4.82

0.01

-4.91

0.00

-3.61

0.03

Leverage

-0.23

0.32

-0.43

0.07

-0.30

0.22

-0.05

0.81

-0.36

0.17

0.10

0.63

Liquidity

-0.17

0.26

-0.13

0.27

-0.16

0.28

-0.16

0.32

-0.16

0.32

-0.14

0.39

Dividend yield

-0.02

0.82

-0.23

0.18

-0.12

0.44

-0.13

0.53

-0.05

0.55

0.04

0.61

Firm size

1.80

0.00

1.45

0.00

1.64

0.00

1.44

0.00

1.86

0.00

0.69

0.11

High human capital

1.28

0.09

0.97

0.17

1.17

0,12

-0.12

0.85

1.84

0.01

0.88

0.19

Market-to-book

-0.30

0.32

-0.29

0.39

-0.33

0.29

-0.43

0.26

-0.34

0.24

-0.32

0.28

Institutional ownership

-0.04

0.03

-0.02

0.21

-0.04

0.05

0.01

0.72

-0.05

0.02

-0.02

0.17

Managerial stock ownership

0.3!

0.88

-1.66

0.44

-0.15

0.95

-0.40

0.87

1.14

0.59

1.21

0.58

Managerial option ownership

2.48

0.04

1.82

0.12

2.42

0.05

0.08

0.92

1.57

0.08

1.94

0.03

Foreign revenues

0,03

0.00

-

-

0.02

0.02

-

-

0.03

0.01

0.04

0.00

Foreign equity

~

0.02

0.08

0.01

0.60

0.01

0.61

-

-

-

-

Number of observations

99

95

95

92

96

96

Log likelihood

-43.63

-45.38

-42.56

-44.33

-45.78

-48.13

Notes: Logit regression estimates of the relation between the likelihood that a iirm uses currency derivatives to hedge and proxies for incentives to use derivatives and proxies for foreign exchange exposure. The sample consists of iirms listed on the Stockholm stock exchange. In Model I. 2, and 3 the dependent variable is set to one if the firm uses currency derivatives to hedge foreign exchange (FX) exposure. Model 4 uses translation (TL) exposure hedging with currency derivatives as the dependent variable, Model 5 uses committed transaction (CT) exposure hedging with currency derivatives as the dependent variable, and Model 6 uses anticipated transaction (AT) exposure hedging with currency derivatives as the dependent variable. All variables are as defined in Section III. The /7-value is based on a two-side test and values less than 0.10 are shown in boldface type.

Why firms hedge with currency derivatives

Model 4 uses TL exposure hedging with currency deriva- tives as the dependent variable; Model 5 uses CT exposure hedging with currency derivatives as the dependent vari- able; and Model 6 uses AT exposure hedging with currency derivatives as the dependent variable in the logit regression estimation. In addition. Model 4 contains the variable for- eign equity, whereas Models 5 and 6 use the variable for- eign revenues. It can be seen from Table 6 that the number of observations ranges from 92-99.''^ For leverage, only one coefficient is found to be signifi- cant at the 10% level. In addition, contrary to the predic- tion, this coefficient is found to be negative. As shown in Table 2, the finding that no significant positive association between leverage and use of derivatives exists is in accor- dance with earlier studies on use of currency derivatives. The coefficient for liquidity is negative, as predicted, for all six models, but never significant at the 10% level. Likewise, the regression coefficients for dividend yield are found to be non-significant. While the results for the dividend yield correspond with those of earlier studies investigating cur- rency derivatives usage, the results for liquidity are at odds with the evidence of earlier studies (see Table 2). All models, except the one with AT exposure as the dependent variable (/7-value = 0.1!), show that greater firm size is significantly associated with greater probability of currency derivative usage well beyond the 10% level. This result supports the hypothesis that a firm's choice of whether to use currency derivatives or not is influenced by the existence of economies of scale. Model 1 supports the view that firms classified as having high human capital itivestments are significantly more likely (/^-value — 0.09) to use currency derivatives to hedge FX exposure, while Model 3 (/)-value = O.I2), and in par- ticular Model 2 (/7-value = O.I7), provide weaker, if any, support for this perception. The results for Models 4, 5 and 6 show that the variable indicating high human capital investments is significantly associated with CT exposure hedging but insignificantly related to TL and AT exposure hedging at the 10% level. For the market-to-book ratio, none of the coefficients was found to be significant at the 10% level, which is con-

65

sistent with the evidence of earlier studies on usage of cur- rency derivatives. In contrast to the results for the market- to-book ratio, the proxy for information asymmetry (i.e. institutional ownership) suggests that currency derivatives are used to alleviate the underinvestment problem. Specifically, greater institutional ownership is found to be significantly associated with lower probability of currency derivative usage to hedge FX exposure (Models 1 and 3) and CT exposure, respectively. Table 6 presents no evidence that the likelihood of hed- ging with currency derivatives is increasing along with the degree of managerial stock ownership, which is in parallel with the other studies. In contrast to the prediction, the coefficient for manage- rial option ownership is found to be positive. In addition, the coefficient is significant for four of the six models. Although this result is in accordance with most of the ear- lier studies, it is still noteworthy and one can only speculate why this is so. One possible explanation is related to the fact that a majority of the stock options owned by the managers were in the money (at 30 December 1996) which provided them with a stock-like character. In fact, according to Smith and Stulz's (1985) framework, this may have provided risk-averse managers with an incentive to hedge rather than to avoid doing so. This explanation, however, lacks credibility given the results for the variable managerial stock ownership. Another explanation is that firms using technically more advanced incentive schemes, such as stock options, also use technically advanced hed- ging instruments, such as currency derivatives. If so, this can be related to differences in knowledge about derivatives across firms. " In accordance with the prediction, finns with larger per- centages of revenues denominated in foreign currency (for- eign revenues) are more likely to use currency derivatives to hedge FX exposure, CT exposure and AT exposure. Surprisingly, the percentage of equity that is derived from foreign affiliates and is denominated in foreign currency (foreign equity) is not able to explain the use of currency derivatives to hedge TL exposure.^' In view of these results, it is noteworthy that Geczy et al. (1997) found no signiii-

fact tha t the autho r was unable t o comput e the variable leverage for one

sample firm and managerial stock ownership for another. For the closer examination of TL, CT and AT exposure hedging, the number of observations is further reduced, as some firms did not answer the questions regarding TL. CT and AT exposure hedging (see Table 1). The number of observations is further reduced for Models 2, 3 and 4 since four sample firms did not report on the percentage of the firm's equity that is derived from foreign affiliates and is denominated in foreign currency. That derivatives are perceived as complicated by a notable number of financial directors is suggested by the results of Alkeback and Hagelin (1999). They reported that the issue that concerned financial directors in Sweden most in using derivatives was lack of knowledge about derivatives. As reported in note 7, firms can also manage their FX exposure by using debt denominated in foreign currency. The failure to document a significant coefficient for the variable foreign equity in Model 4 can be explained if many firms use debt denominated in foreign currency to hedge their TL exposure rather than currency derivatives. In fact, that firms use debt to manage their TL exposure is suggested from examining annual reports and the fact that a dummy variable indicating usage of debt denominated in foreign currency. which was included in an augmented version of Model 4, had a significant (p-value = 0.03) and positive coefficient (the dummy variable was non-signilicant for the other models and, as reported in note 7, the inclusion of the dummy left the conclusions unaltered in all other

The reduction from

101 to

99 sample firms is du e t o

th e

66

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 ownership in Model 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 rationales as the investigated exposure."'' Therefore, the regressions Models 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 variable, did change: namely, the coefficient for firm size (p-value —0.01) and insfifutional ownership {p- value —0.09) were foutid to be significant and had 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 examination of the level of anticipated transaction 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

Hagelin

at the distribution in Panel B of Table 1, it is apparent thaf firms hedging AT exposure have adopted a somewhat more diverse practice than those hedging TL and CT exposure with currency derivatives. For this reason, an analysis of the level of AT exposure that is hedged with currency deri- vatives can provide additional insights into firms" hedging practices. By analysing the level of AT exposure that is hedged, the problem related to the fact that a majority of the firms hedging AT exposure also hedge CT exposure can be circumvented."^ A model proposed by Cragg (1971) was utilized, which allows the decision of whether or not to hedge and the one conceming the level of hedging to be separately deter- mined. This model is a combination of a probit analysis (i.e, the decision to hedge) and a truncated regression (i.e. the regression equation for nonzero outcomes). Goldberg et ai. (1998), Allayannis and Ofek (2000) and Graham and Rogers (2000) used the Cragg (1971) model and discussed its ability to accommodate for the possibility that a firm's hedging policy decision depends on two decisions, which could have different determinants. This ability is relevant for the variable firm size. This is because economies of scale are expected to result in a positive relationship between firm size and the likelihood of hedging (as suggested in Tables 2 and 6). while theories linking risk management fo direct costs of financial distress suggest that hedging benefits decrease with firm size (see above). Thus, the extent to which a firm hedges, once it decides to hedge, is predicted to be negatively correlated with firm size. All other predictions are left unaltered. Table 7 presents the results from the truncated regression. The results from the binomial probit regression are similar to those from the logit regression model presented in Table 6 and therefore not presented. The regression coefficients of leverage, liquidity and divi- dend yield all have their expected signs, but none of them are significant at the 10% level (/7-values range from 0.22- 0.33). If is noteworthy that the number of observations is only 38 (at the same time as the model uses 10 independent variables), which suggests that the results should be inter- preted with caution. In accordance with the prediction, firm size has the expected negative sign. However, the coefficient is found

A'.

respects). To explore the possible impact from firms using (iebt denominated in foreign currency to manage their TL exposure, hedgers are reclassified by adding those firms that used debt denominated in foreign currency to the group consisting of TL exposure hedgers and re-ran Model 4. This established the expected relationship between TL exposure hedging and the variable foreign equity (p-vahie — 0.01). However, the results did not change in any other way.

^^ For example, if firms that hedge CT and AT exposure do so to alleviate the underinvestment problem, they are expected to be characterized by similar firm-specific traits (e,g, low institutional ownership). However, if a substantial number of the firms only hedge CT exposure (perhaps because their expected cash flows are troublesome to predict) and consequently are classified as non-hedgers of AT exposure, the results from Model 6 are blurred since firms classified as hedgers and non-hedgers are partly characterized by similar traits. ^"^This is not necessarily true if firms that hedge more AT exposure also hedge more CT exposure. To investigate this, the 38 firms that hedged AT exposure with currency derivatives were divided in two. One group consisted of those 19 firms that hedged high levels and one of those f9 firms that hedged low levels. The 19 firms that hedged higher levels of their AT exposure hedged on average 70% while the other 19 firms only hedged 32,5% of their AT exposure. On average, firms in both groups hedged 70% of their CT exposure.

Why firms hedge with currency derivatives

Tabie 7. Truncated regression estimate on the use of eurrenev deri- vatives to hedge anticipated transaetinn (AT) exposure

Intercept Leverage Liquidity Dividend yield Firm size High human capita! Markel-lo-book !nstitutional ownership Managerial stock ownership Managerial oplion ownership Foreign revenues Number of observations Log likcli!iot>d

Modei 7: Truncated

CoefT.

/7-value

53.98

0.12

5.14

0.22

-6.43

0.28

0.84

0.33

-6.4!

0.30

20.25

0.00

!2.48

0.03

-0.65

0.01

0.05

0,99

3.99

0.57

0.39

0.01

38

-!60.76

Notes: Regression estimates on the level of AT exposure hedged with currency derivatives and proxies for incentives to use deri- vatives and a proxy for foreign exchange exposure. The sample consists of firms listed on the Stockho!m stock exchange. Model 7 uses a truncated regression mode! with positive values of the amount of AT exposure hedged with currency derivatives as the dependent variable. All variables are as delined in Section III. The ;)-values are based on a two-sided test and values less than 0.10 are shown in boldface type.

to be insignificant at the 10% level, indicating that direct

costs of financial

this sample. Firms classified as having high hutnan capita! invest- ments are found to hedge more of their AT exposure with currency derivatives. Perhaps this finding,, in conjunc- tion with the results for firm size, suggests that indirect costs of financial distress is of more importance for firms' hedging decisions than direct costs of financial distress. The evidence of a connection between AT exposure hedging and human capital investments is at odds with the evidence presented for Model 6 in Table 6. but in parallel with the results for CT exposure hedging.

Unlike the results reported in Table 6, the truncated regression supports a linkage between hedging and valu- able growth opportunities. More specifically, the level of AT exposure hedged with currency derivatives is increasing with the market-to-book ratio. The coefficient for institu- tional ownership is negative and significant, which provides additional support for the notion that AT exposure is hedged with currency derivatives to alleviate the underin- vestment problem. Managerial stock ownership and managerial option ownership are non-significant at the 10% level. That the level of AT exposure hedged with currency derivatives is unrelated to the variable managerial option ownership is interesting given the suggested positive association in Table

distress have little predictive power for

67

6 between managerial option ownership and the likelihood of currency derivatives usage. Perhaps this suggests that the decision to use currency derivatives for hedging transaction exposure is affected by differences in knowledge about deri- vatives across firms, while the decision concerning the level of exposure hedged is unaffected (i.e. knowledge about

derivatives act as a barrier to some firms).

Finally, it can be seen from Table 7 that the level of AT

exposure hedged is positively correlated with the level of

the transaction exposure, as measured by the proportion of

revenues that is denominated in foreign currency.

V. SUMMARY

AN D CONCLUSION

Swedish firms' use of currency derivatives were examined to provide empirical evidence on the determinants of firms' hedging decisions. The article used survey data in combi- nation with publicly available data. The use of survey data makes it possible to differentiate between currency deriva- tives usage aimed at hedging translation exposure, com- mitted transaction exposure, and anticipated transaction exposure. This is interesting since transaction exposure and translation exposure tend to affect firms differently, which suggests thai the rationales for hedging them may differ.

The results of multivariate tests show, among other things, that firms using currency derivatives to hedge com- mitted transaction exposure: (i) are more frequently classi- fied as having high human capital investments (proxy for indirect costs of financial distress) than other firms: and (ii) have lower institutional ownership (proxy for asymmetric information) than other firms. In addition, the results show that the level of anticipated transaction exposure that is hedged, once a firm decides to hedge it: (i) increases with classification as having high human capital investments; (ii) decreases in institutional ownership; and (iii) increases in the market-to-book ratio (proxy for valuable growth opportunities). Notably, none of these proxy variables is significantly associated with use of currency derivatives to hedge translation exposure.

These results are consistent with the conjecture that firms hedge transaction exposure with currency derivatives to increase firm value by reducing indirect costs of financial distress or alleviating the underinvestment problem. This finding is important for shareholders to the extent that it suggests that the managerial resources being tied up by transaction exposure hedges are used in a way consistent with shareholder value maximization. The fact that no evi- dence supporting the idea that translation exposure hedges are used to increase firm value was found, suggests that shareholders may want to be more reluctant to accept this type of hedge if no specific justification is provided by the management. Such justification may arise from the existence of debt covenants based on balance sheet meas-

68

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."

ACKNOWLEDGEMENTS This is a revised version of an earlier paper 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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