Derivative Gain/loss, Currency Hedging

and Management Compensation

Janikan Supanvanij, Ph.D., St. Cloud State University, St. Cloud, MN
ABSTRACT
This paper analyze whether gain/loss from using currency derivatives can affect a firms hedging decision
and top executives compensation. I examine 138 industry firms that report the use of derivatives during 1998-2000
for hedging purpose. I find that gain/loss has a significant impact on risk management and managerial pay package.
Firms may reduce risk management activities because gain/loss resulted from hedging can significantly affect
management compensation.
INTRODUCTION
This paper is the first study in the area that analyzes whether the gain/loss from using currency derivatives
affect the firms hedging decision and managerial compensation. The primary objective of hedging is to reduce
uncertainty, not to make profit. Hence, when the firm uses derivatives to manage risk, its decision should be free
from gain/loss resulting from the usage. Derivative use that is related to the gain/loss indicates that the firm may
use those tools for other purpose than hedging. Hedging can increase firm value by reducing underinvestment
problem, expected financial distress costs, and expected taxes (Froot, Scharfstein, and Stein, 1993; Mian, 1996;
Stulz, 1996; Haushalter, 2000; Allayannis and Weston, 2001). Management, therefore, should engage in risk
management activities to increase shareholders wealth. In this paper, I also investigate the effect of gain/loss on
executive compensation. When firms use derivatives to manage risk (for hedging purpose), gain/loss from using
derivatives is not a good measure of management performance. Management should not be rewarded (punished)
based on good (bad) luck. If management compensation is tied to derivative gain/loss, management may consider
reducing derivatives use, which in turn may not benefit the shareholders.
This paper examines 138 industry firms that report the use of derivatives for hedging purpose during 19982000 (the transition period regarding the impact of SFAS133). The sample starts in 1998 to coincide with the
Accounting for Derivatives Instruments and Hedging Activities (SFAS 133). Before 1998, firms were required to
enclose only the notional values of the derivative contracts in their 10-K forms. SFAS 133, issued in 1998, requires
US firms to report the fair values of derivatives in their financial statements. Although the effective date of this
standard was postponed several times during 1998-2000, early implementation was encouraged. Many US firms
prepared their financial statements to conform to this new standard as early as after passage. When examine
closely, most S&P firms started to report both notional values and fair values of derivatives in their annual reports
in 1998. After 2000, firms are not required to enclose the notional values in their financial statements. This paper
is organized as follows: Section II presents review of the literature. Section III describes the data and methodology.
Results are shown in Section IV. Section V concludes.
REVIEW OF THE LITERATURE
Prior studies show that hedging is related to the underinvestment problem associated with costly external
financing (Nance, Smith, and Smithson, 1993; Geczy, Minton, and Schrand, 1997; Gay and Nam, 1998), the
expected costs of financial distress (Mian, 1996; Stulz, 1996; Hausshalter, 2000), and expected taxes (Froot,
Scharfstein, and Stein, 1993; Mian, 1996). The extent of hedging can also be affected by the forms of management
compensation.
Management Compensation
Since risk management can increase the firm value, derivative use is predicted to increase with
compensation when agency conflict between managers and shareholders is not presented. However, in case of
agency conflict, hedging decision can be affected by the forms of management ownership. Management whose
large proportion of compensation is in the form of stock options may reduce derivative use because it can lower the
value of options they own. On the other hand, managers with more wealth in the form of stock equity may actively
engage in risk management activity because reducing stock price volatility can result in increase stock price. In
addition, it is less costly to use the firms assets to manage the risk. Recent studies show correlation between

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

16

compensation and risk management in gold mining industry (Tufano 1996) and savings and loans (Schrand and
Unal 1998). However, in oil and gas industry, the relationship is not clear (Haushalter, 2000).
Control Variables
Investment opportunity (MKBK). Froot, Scharfstein, and Stein (1993) find that risk management can
reduce underinvestment problem. By alleviating unnecessary fluctuations in cash flows, hedging helps ensure that a
firm will not increase the use of expensive external financing or bypass positive NPV projects (Geczy, Minton and
Schrand, 1997; Gay and Nam, 1998). I use market-to-book ratio to represent growth opportunity.
Financial distress costs (LTDTA). Risk management decreases the expected cost of financial distress by
reducing the volatility of a firm's cash flows or earnings (Smith and Stulz, 1985; Geczy, Minton and Schrand, 1997;
Berkman and Bradbury, 1998). It also increases a firms value by reducing its probability of default and increasing
its leverage (Froot, Scharfstein and Stein, 1993; Haushalter, 2000). Financial distress is measured by the ratio of
long-term debt to total assets.
Taxes (TAX). Hedging can reduce earning fluctuation, which leads to the increase in present value of tax
shields (i.e. tax loss carry forwards) and lower tax payments. It helps ensures that a firms income falls within the
optimal range of tax rates (Froot, Scharfstein and Stein, 1993). I use dummy variable equals 1 if firms report the tax
loss carry forward and 0 other wise.
Currency exposure (TFSALES). Firms with sales in foreign currencies should have great incentives to use
derivatives to reduce fluctuations in exchange rates. They can benefit for both dollar appreciation and depreciation
(Allayannis and Weston, 2001). Currency exposure or degree of international involvement is measured by total
foreign sales to total sales.
Liquidity (DIVY and QUICK). Liquidity is measured by the dividend yield and the quick ratio. Highlyliquid firms may have low incentives to hedge due to their flexibility to meet the cash flow needs (Berkman and
Bradbury, 1996; Howton and Perfect, 1998).
Firm size (SIZE). The relationship between firm size and derivative use is still ambiguous. Financial
distress theory predicts a negative relationship; while recent studies (Geczy, Minton, and Schrand, 1997; Haushalter,
2000) predict a positive relationship due to economies of scale in hedging costs for large firms. In practice, larger
firms have greater incentives to hedge (Stulz, 1996). Firm size is measured by natural logarithm of sales.
Profitability (NITA). Firms with higher level of cash are predicted to have lower incentive to hedge due to
their lower needs for external financing (Froot, Scharfstein, and Stein, 1993). Profitability is calculated by the ratio
of net income to total assets.
CEO tenure (TENURE). CEOs who serve for long time periods may have high influence though their
control over the officers and the nomination of board members. Tufano (1996) find a negative relationship between
hedging and a firms tenure of senior executives in gold mining industry. I use dummy variable equals 1 if an
executive is being a CEO less than or equal to 1 year, and 0 otherwise.
Vega-to-Delta (VEGADELTA). This ratio measures the risk-taking incentives of management and is
expected to be negatively related to hedging. The nature of options (in-the-money or out-of-the-money) can affect a
firms hedging decision (Carpenter, 2000). Knopf, Nam and Thorton (2002) find that hedging increases with delta
(sensitivity to price change) and decreases with vega (sensitivity to stock volatility). Rogers (2002) also show a
negative relationship between the ratio of vega to delta and derivatives use.
DATA AND MODEL SPECIFICATION
The sample consists of 138 industry firms from the S&P500 that has complete information and use
derivatives during 1998-2000 for hedging purpose. The sample starts in 1998 since this coincides with SFAS 133,
Accounting for Derivatives Instruments and Hedging Activities, which requires firms to disclose the fair values in
their financial statements. Before 1998, firms were required to enclose only the notional values of the derivative use
in their financial statements. Based on the data, most S&P firms adopted SFAS 133 as early as 1998. During 19982000, they reported both the notional value and the fair value. After 2000, firms were not required to report the
notional value. The data on derivatives are collected from the Annual Reports (Form 10-K) that firms filed for SEC.

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

17

Compensation data are collected from the Proxy Statements (Form Def-14A). Firm characteristic data are obtained
from COMPUSTAT.
Derivatives Hedging and Compensation Proxies
The derivative variables are: (a) the notional values of currency contracts (FXN) used for hedging purpose,
and (b) the gain/loss resulting from currency derivative use (FXF), standardized by total sales. The sample firms
reported the use of forwards, options, and currency swap to hedge their foreign exchange risk. To measure the
extent of hedging, I net the long and short positions of the derivatives notional value. These net derivatives values
are more precise measures than the aggregated notional values because the aggregated values are not modified for
offsetting long and short payoffs. The exchange rates at the fiscal year end are used to convert foreign currency
derivatives to US dollars.
To calculate the average compensation awarded to each officer, I divided total amount of top executive
compensation by number of top executives. Managements long-term compensations are measured by total options
(OPTIONX) and common shares (SHAREX) owned by an officer. The short-term compensation consists of an
officers average salary (SALARYX) and bonus (BONUSX). All compensation data are measured as fractions of
total compensation. I also calculate the sensitivity of options to changes in the underlying stock prices (delta) and to
changes in the underlying standard deviation (vega) (1).
Model Specification
I employ a two-stage instrument variable (IV) approach and use firm characteristics as the instruments. (2)
OLS is not an appropriate method due to a simultaneous equation bias. The instrument variable approach can avoid
the bias and correct for endogeneity problems. I also correct for possible heteroscedasticity using White
Heteroscedasticity Test. The estimated equations are as follows:
FXNi,t = + b1 CompensationFi,t + b2 FXFi,1 + b3 Zi,t + i,t
FXNi,t = + b1 CompensationFi,t + b2 FXFi,t-1 + b3 Zi,t + i,t

(1)
(2)

where, Zit comprises the list of the following control variables: investment opportunity (MKBK), financial distress
(LTDTA), taxes (TAX), firm size (SIZE), currency exposure (TFSALES), dividend yield (DIVY), quick ratio
(QUICK), profitability (NITA), CEO tenure (TENURE), and vega-to-delta ratio (VEGADELTA). The derivative
data are notional values of currency contracts (FXN) and gain/loss from using derivatives (FXF) standardized by
sales. The compensation data (CompensationF) are the forecasted values of options, shares, salary and bonus.
Derivatives used for hedging purpose are expected to be free from gain/loss resulted from hedging. If the coefficient
of the FXF variable is statistically different from zero (b2=0), it implies that derivatives gain/loss affects the firms
decision to use derivatives. Since hedging and compensation decision are done simultaneously, I also investigate
whether derivatives gain/loss affect long-term and short-term compensation. The estimated equations are:
Compensationi,t = + b1 FXFi,t + b2 Zi,t + i,t

(3)

If the coefficient of the FXF variable is zero (b2=0), it implies that management are not rewarded based
on the results of derivatives use. If the coefficient of the variable is significantly different from zero, it implies
that management compensation depends on derivatives gain/loss.
EMPIRICAL RESULTS
Descriptive statistics are presented in Table 1. The sample firms hedge foreign exchange risk about 9.5%
of their total sales and have derivative gain about 0.002% on average. Twenty seven percent of their sales are
denominated in foreign currencies. The mean and median of long-term compensation (options and shares) are
higher than that of annual compensation (salary and bonus). An average officer holds options and shares less than
1% of total shares outstanding. Options compensation is a popular awarding method for management during 1990s.
Managements wealth can rely heavily on the value of options, which increases with the volatility in the stock price.
Thus, management who hold larger number of options is expected to reduce hedging to the absolute minimum level.

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

18

Table 1 Descriptive Statistics

This table presents descriptive statistics of dependent and independent variables. The variables are: FXN , notional values of currency contracts;
FXF, gain/loss from using derivatives; LTDTA, the ratio of long-term debt to total assets; MKBK, market-to-book ratio; TAX, tax loss carry
forward dummy (dummy equal to 1 if a firm reports tax losses and 0 otherwise); TFSALES, the ratio of foreign sales to total sales; DIVY,
dividend yield; QUICK, quick ratio; SIZE, natural logarithm of sales; TENURE, dummy variable for tenure (dummy equal to 1 if being a CEO
for less than or equal to 1 year and 0 otherwise); NITA, the ratio of net income to total assets; VEGADELTA, the ratio of vega to delta;
OPTIONX, average value of options held by an officer; SHAREX, average value of shares owned by an officer; SALARYX, average salary per
officer; and BONUSX, average bonus per officer. All compensation data are measured as percentage of total compensation. Derivatives are
standardized by sales. The data on derivatives are collected from Annual Report (Form 10-K) that firms filed for SEC. Compensation data are
collected from Proxy Statement (Form Def-14A). Others are from COMPUSTAT. The sample consists of 138 firms for 1998-2000.

Mean
Median
Std Dev

FXN
0.0949
0.0305
0.4716

FXF
0.0000
0.0000
0.0061

LTDTA
0.1984
0.1853
0.1172

MKBK
4.7775
3.1890
19.7911

Mean
Median
Std Dev

TAX
0.2598
0.0000
0.4388

TFSALES
0.2758
0.2662
0.2151

DIVY
0.0186
0.0178
0.0144

QUICK
0.0082
0.0072
0.0047

Mean
Median
Std Dev

SIZE
22.5670
22.5105
1.1105

TENURE
0.1066
0.0000
0.3088

NITA
0.0742
0.0675
0.0706

VEGADELTA
0.1953
0.2042
0.0553

OPTIONX
0.4047
0.3968

SHAREX
0.4292
0.3625

BONUSX
0.0663
0.0470

0.2954
138

0.3004
138

SALARYX
0.0929
0.0600
0.0985
138

Mean
Median
Std Dev
No. of Firms

0.0685
138

The forms of compensation can have an impact on the firms hedging decision. Agency conflict may
occur when management are compensated in the form of stock options. In this study, I examine the effect of shortterm (salary and bonus) and long-term (options and shares) compensation on hedging separately. Results in Table 2
provide evidence of agency conflict. The negative sign in the variables OPTIONXF (total options) and OPEXXF
(exercisable options) indicates that hedging decreases with the value of options held by an officer. This finding is
consistent with the theory that links managerial compensation to hedging. Managers that are compensated with
stock options have lower incentives to manage risk because the decrease in volatility can negatively affect the value
of their options (Smith and Stulz, 1985; Froot, Scharfsteinand and Stein, 1993; Tufano, 1996; Schrand and Unal,
1998). The negative sign in the variable SHAREXF also indicates that top executives cannot be motivated to act in
shareholders best interest by share awarding.
I next examine the effect of short-term compensation (salary and bonus) on risk management. Since
hedging does not reduce the value of salary and bonus, incentives to manage the firms risk should not be negatively
affected by salary and bonus. Management with higher short-term paid is expected to employ more derivative
tools, or at least the extent of hedging should not be affected by annual compensation. The results in Columns 4
and 5 support this viewpoint that agency problem can be corrected by short-term compensation. Hedging shows a

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

19

Table 2 Effect of Gain/loss on Hedging

The variables are: FXN , notional values of currency contracts; FXF, gain/loss from using derivatives; LTDTA, the ratio of long-term debt to total
assets; MKBK, market-to-book ratio; TAX, tax loss carry forward dummy (dummy equal to 1 if a firm reports tax losses and 0 otherwise);
TFSALES, the ratio of foreign sales to total sales; DIVY, dividend yield; QUICK, quick ratio; SIZE, natural logarithm of sales; TENURE, dummy
variable for tenure (dummy equal to 1 if being a CEO for less than or equal to 1 year and 0 otherwise); NITA, the ratio of net income to total
assets; VEGADELTA, the ratio of vega to delta; OPTIONXF, the estimated value of options held by an officer; OPEXXF, the estimated value of
exercisable options held by an officer; SHAREXF, the estimated value of shares owned by an officer; SALARYXF, the estimated value of salary
per officer; and BONUSXF, the estimated value of bonus per officer. All compensation data are measured as percentage of total compensation.
Derivatives are standardized by sales. The data on derivatives are collected from Annual Report (Form 10-K) that firms filed for SEC.
Compensation data are collected from Proxy Statement (Form Def-14A). Others are from COMPUSTAT. The sample consists of 138 firms for
1998-2000.
FXN
(1)
LTDTA
MKBK
TAX
TFSALES
DIVY
QUICK
SIZE
VEGADELTA
TENURE
NITA
OPEXXF

(2)

(3)

(4)

(5)

(6)

-0.0613***

-0.0522***

0.1890***

0.0538***

0.4398***

0.1290***

-18.2036

-26.6348

51.1665

22.9598

48.0542

30.4000

9.5E-06***

-1.6E-05***

3.7E-06***

4.8E-05***

0.0002***

0.0001***

6.8437

-80.2818

11.5221

41.2150

45.1612

33.3665

0.0106***

0.0022***

0.0034***

0.0107***

-0.0081***

0.0087***

19.8104

7.6525

10.1486

26.3907

-24.5171

22.7956

0.0446***

0.2962***

0.0134***

0.2220***

0.2913***

0.2439***

15.2579

47.5066

5.3950

68.5950

56.3434

53.3382

-2.1827***

-11.5811***

3.2536***

-12.7670***

-13.1905***

-17.0867***

-16.3795

-45.2619

62.7623

-55.2845

-47.2884

-40.6468

-2.0848***

-3.6157***

-1.8858***

-2.5917***

-6.7909***

-3.5569***

-44.5658

-73.7729

-81.9064

-74.2238

-67.5831

-59.5846

-0.0145***

-0.0484***

0.1036***

0.0819***

0.1200***

0.1017***

-21.3896

-39.0667

66.0494

73.4559

48.5474

47.3845

-0.0038

-0.0179***

0.0008

0.0260***

-0.0354***

0.0184***

-1.3490

-9.4872

0.2561

5.6922

-15.9190

4.2884

0.0066***

0.0068***

0.0078***

0.0084***

0.0065***

0.0079***

8.2451

9.3699

15.1332

11.6380

9.9554

11.1721

-0.1502***

-0.1454***

-0.2674***

-0.0774***

-0.3750***

-0.1891***

-44.5804

-60.7163

-45.2232

-20.3194

-54.8367

-38.5715

-0.4507***
-15.9741

OPTIONXF

-1.2373***
-44.6275

SHAREXF

-1.2481***
-64.1126

SALARYXF

3.0368***
55.7153

BONUSXF

9.4294***
46.5532

FXF

-2.3436***

-2.6621***

-2.3539***

-2.4360***

-2.4004***

-11.1145
-16.2940
-15.4141
-8.5520
-11.8289
The table reports the coefficient and t-statistics. ***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.

-2.3956***
-8.3269

positive correlation with annual compensation. This finding suggests that managers have higher interest in
managing risk when their wealth is not binding to the firms equity. When look at the signs of control variables, I
find mixed evidence to support the financial distress theory. The relationships between long-term debt and foreign
exchange hedging are mixed. Tufano (1996) also finds no

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

20

Table 3 Lagged Effect of Gain/loss on Hedging

The variables are: FXN , notional values of currency contracts; FXF, gain/loss from using derivatives; LTDTA, the ratio of long-term debt to total
assets; MKBK, market-to-book ratio; TAX, tax loss carry forward dummy (dummy equal to 1 if a firm reports tax losses and 0 otherwise);
TFSALES, the ratio of foreign sales to total sales; DIVY, dividend yield; QUICK, quick ratio; SIZE, natural logarithm of sales; TENURE, dummy
variable for tenure (dummy equal to 1 if being a CEO for less than or equal to 1 year and 0 otherwise); NITA, the ratio of net income to total
assets; VEGADELTA, the ratio of vega to delta; OPTIONXF, the estimated value of options held by an officer; OPEXXF, the estimated value of
exercisable options held by an officer; SHAREXF, the estimated value of shares owned by an officer; SALARYXF, the estimated value of salary
per officer; and BONUSXF, the estimated value of bonus per officer. All compensation data are measured as percentage of total compensation.
Derivatives are standardized by sales. The data on derivatives are collected from Annual Report (Form 10-K) that firms filed for SEC.
Compensation data are collected from Proxy Statement (Form Def-14A). Others are from COMPUSTAT. The sample consists of 138 firms for
1998-2000.
FXN
(1)
LTDTA
MKBK
TAX
TFSALES
DIVY
QUICK
SIZE
VEGADELTA
TENURE
NITA
OPEXXF

(2)

(3)

(4)

(5)

(6)

-0.0249***

-0.0166***

0.1128***

0.0367***

0.1889***

0.0809***

-8.2154

-7.0364

22.6714

18.6659

14.9308

22.3831

6.2E-06***

-1.0E-05***

-1.0E-07

2.6E-05***

0.0001***

3.7E-05***

4.8601

-49.2523

-0.2026

18.6860

14.2389

17.7698

0.0040***

0.0009**

-0.0028***

0.0007

-0.0028***

-0.0003

10.1233

2.3645

-3.7501

1.0802

-5.3278

-0.4872

0.0327***

0.1292***

0.0080***

0.1334***

0.1411***

0.1448***

19.7926

17.9619

15.8784

32.3802

21.8360

26.9496

-1.5562***

-4.3798***

1.7963***

-7.2678***

-5.7887***

-9.7694***

-14.7963

-13.9023

20.6109

-29.2692

-16.0440

-24.2768

-2.3494***

-2.4764***

-1.6241***

-2.0981***

-3.6310***

-2.7463***

-73.7429

-41.3049

-59.2868

-53.8246

-24.1858

-51.8894

-0.0142***

-0.0296***

0.0446***

0.0395***

0.0402***

0.0519***

-20.7782

-29.6214

17.1785

21.1058

11.2937

19.0946

-0.0515***

-0.0610***

-0.0429***

-0.0369***

-0.0611***

-0.0391***

-23.8658

-32.8279

-23.4333

-13.6476

-33.3297

-14.5149

0.0072***

0.0061***

0.0071***

0.0090***

0.0071***

0.0088***

33.7511

35.5680

35.3139

27.2973

35.6107

27.8466

-0.1172***

-0.1056***

-0.1814***

-0.0706***

-0.2063***

-0.1360***

-40.7410

-20.9462

-26.0969

-11.5717

-25.0275

-23.1074

-0.3047***
-13.1335

OPTIONXF

-0.4590***
-13.4447

SHAREXF

-0.6821***
-22.0254

SALARYXF

1.7331***
29.0147

BONUSXF

4.0937***
15.7050

FXF(-1)

-2.5874***

-2.6926***

-2.8350***

-2.2615***

-2.8436***

-10.2458
-11.8782
-9.4585
-7.3309
-19.0024
The table reports the coefficient and t-statistics. ***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.

-2.2900***
-7.4493

support for financial distress theory. For market-to-book ratio, most regressions show a positive sign, indicating
that firms with higher investment opportunity are more interested in managing the risk compared to their
counterpart. I also find that risk management is positively related to tax loss carry forwards, which lend support to
the tax theory (Stulz, 1985; Froot, Scharfsteinand and Stein, 1993; and Berkman and Bradbury, 1996). Present
value of tax shields can increase by reducing earnings fluctuation, which leads to lower tax payments.

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

21

The positive relationship between TFSALES and FXN indicates that firms with higher foreign sales have greater
incentives to manage foreign exchange risk. High foreign sales in other currencies than US dollar can have a negative impact on
a firms earnings due to dollar appreciation or depreciation. Reducing currency risk can help the firm predict its earnings
precisely. Liquidity is negatively related to derivative use. Highly liquid firms are more flexible to meet their cash flow needs.
The negative correlation between hedging and income also supports Froot, Scharfstein, and Stein (1993) that level of cash
available for investment is negatively related to the level of derivative use because of the lower needs for external financing.
The positive sign of the variable TENURE (1 = new; 0 = old) indicates that hedging reduces with CEOs tenure. Thus, the
decision to reduce hedging can be influence by CEOs who serve for long time periods. Tufano (1996) also finds that new CEOs
engage in more hedging activities than CEOs who hold longer tenure. He notes that this relationship reflects managerial
interests, skills, or preferences.
Table 4 Effect of Gain/loss on Managerial compensation
The variables are: LTDTA, the ratio of long-term debt to total assets; MKBK, market-to-book ratio; TAX, tax loss carry forward dummy (dummy
equal to 1 if a firm reports tax losses and 0 otherwise); TFSALES, the ratio of foreign sales to total sales; DIVY, dividend yield; QUICK, quick
ratio; SIZE, natural logarithm of sales; TENURE, dummy variable for tenure (dummy equal to 1 if being a CEO for less than or equal to 1 year
and 0 otherwise); NITA, the ratio of net income to total assets; VEGADELTA, the ratio of vega to delta; FXF, gain/loss from using derivatives;
OPTIONX, average value of options held by an officer; OPEXX, average value of exercisable options held by an officer; SHAREX, average value
of shares owned by an officer; SALARYX, average salary per officer; and BONUSX, average bonus per officer. All compensation data are
measured as percentage of total compensation. Derivatives are standardized by sales. The data on derivatives are collected from Annual Report
(Form 10-K) that firms filed for SEC. Compensation data are collected from Proxy Statement (Form Def-14A). Others are from COMPUSTAT.
The sample consists of 138 firms for 1998-2000.

LTDTA
MKBK
TAX
TFSALES
DIVY
QUICK
SIZE
VEGADELTA
TENURE
NITA
FXF

OPEXX

OPTIONX

SHAREX

SALARYX

BONUSX

-0.0567***

-0.0045

0.0428***

-0.0638***

-0.0127***

-4.9584

-0.2118

3.3959

-17.7063

-3.0900

-0.0001***

-3.9E-05***

2.3E-05***

-5.3E-06*

1.5E-05***

-19.2708

-8.5659

5.7082

-1.6547

15.6687

-0.0037

-0.0269***

0.0136***

0.0044***

0.0011

-0.9696

-3.3640

3.0991

6.3345

1.0845

-0.0935***

-0.1995***

0.0916***

0.0565***

0.0660***

-11.7984

-6.8379

6.1602

5.0792

21.8884

-4.3897***

-6.3282***

1.1679***

3.6819***

0.8639***

-58.7702

-12.3621

13.0706

65.3152

73.7564

-0.1792

0.0880

-1.6906***

-0.1470*

1.5153***

-0.5874

0.0959

-3.8142

-1.9411

12.9446

0.0386***

0.0631***

-0.0237***

-0.0230***

-0.0227***

20.0762

17.2463

-10.6949

-13.9401

-87.6096

0.3502***

0.7184***

-0.4113***

-0.1238***

-0.1664***

18.6537

25.0538

-41.3352

-21.9828

-24.9092

-0.0179***

-0.0163***

0.0098***

0.0040***

0.0050***

-14.8005

-15.0583

6.1285

8.1902

17.2719

0.0991***

-0.0512***

-0.1358***

0.0110***

0.1246***

13.4008

-2.8878

-12.7179

3.8113

15.9397

-0.9150***

-1.3913***

0.4099***

0.3994***

0.3049***

-7.3984
-8.3006
5.0523
59.1530
9.5940
The table reports the coefficient and t-statistics. ***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.

I also control the sensitivity of options to changes in the underlying stock prices (delta) and changes in the underlying
standard deviation (vega). Managerial incentives to increase shareholder value can vary over time. Managers have high
incentives when options are deep in-the-money, and low incentives when stock price declines. As predicted, the ratio of vega to
delta shows negative sign for most regressions, indicating that management with greater risk-taking incentives are more inclined
to reduce the extent of hedging. Then, I examine the effect of derivative gain/loss on a firms decision to hedge. Previous
studies (Geczy, Minton, and Schrand, 1997; Gay and Nam, 1998; Mian, 1996; Haushalter, 2000) ignore the effect of gain/loss
from using risk management tools. Since the purpose of using derivatives is to reduce risk, not to speculate, gain/loss should not
be a factor that determines the extent of hedging. Firms should continue to use derivative to manage their risk whether gain/loss
occurs. However, the results in Table 2 show a negative sign in the variable FXF, implying that gain/loss can significantly
decrease (increase) the derivative use. Firms will employ more derivative tools during the year only if their derivative contracts
lose value in the market. I further examine the effect of gain/loss on the following years hedging decision. I lagged the value of

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

22

gain/loss from using derivatives for 1 period and reran the regressions on FXN using the same set of independent variables.
Results are presented in Table 3. I find that a firms hedging decision during the current year can be significantly affected by the
gain/loss occurred from previous year. The variable FXF(-1) shows negative sign for all regressions. These findings suggest
that executives may not use derivatives to benefit the firm or for hedging purpose as stated in their financial statements. Agency
conflict is still shown significantly when look at the signs of total options and exercisable options awarded to each officer in
Table 3.
I next test whether the relationship between gain/loss and currency derivative use can be explained by managements
expectation of compensation. If management expects to receive lower compensation when their hedging contracts gain value,
they may want to reduce hedging. Since hedging and compensation decision are simultaneous, I use compensation as dependent
variables to test whether derivative gain/loss can affect managerial compensation. Results in Table 4 show negative signs option
variables, implying that management expect their options value to be decreasing if hedging gain occurs, which may significantly
hurt them. As a result, management who hold options may decrease hedging to protect their wealth. On the other hand, an
executive who is awarded in term of salary and bonus may continue to engage in risk management activities because they
believe that hedging gain can help improve their pay package. These findings suggest that management may not use derivatives
for hedging purpose if they are not correctly rewarded. Top executives may continue to reduce hedging activities due to the
inappropriate pay-package. Management who expect to receive stock options may reduce hedging in order to preserve their
option value.

CONCLUSIONS
The use of stock options to compensate top executives has grown tremendously during the past decade. Large US
firms rely on stock option plans, which can result in enhancing or destroying shareholder value. Managers who are compensated
in the form of stock options will reduce hedging activity to preserve their option value. I also find evidence that awarding an
executive with short-term compensation can yield the positive effect on the firms hedging decision. The results also show that
gain/loss from using currency derivatives can affect both the extent of hedging and managerial compensation. Management do
not use derivatives for hedging purpose if their pay package are affected by hedging result. When the value of the derivative
contract increases, management who hold stock options will reduce hedging because they expect to be less awarded. Thus, firms
should reevaluate the managerial pay package. Hedging decision should be free from compensation decision. Management
performance should not be measured by gain/loss from managing risk.
NOTES:
1. I follow Guay (1999) and Core and Guay (2002) in calculating delta and vega.
2. I use the following instruments in the simultaneous model: financial distress, growth, tax, business risk, total risk, currency exposure, liquidity,
profitability, size and time.

REFERENCES
Allayannis, George, and James P. Weston. (2001). The Use of Foreign Currency Derivatives and Firm Market Value. Review of Financial Studies 14, 243-276.
Berkman, Henk, and Michael E. Bradbury. (1996). Empirical Evidence on the Corporate Use of Derivatives. Financial Management (Summer), 5-13.

Carpenter, Jennifer. (2000). Does options compensation increase managerial risk appetite? Journal of Finance, 55, 2311-2331.
Core,J., and W. Guay. (2002). A new, lost-cost proxy for the incentive effects of stock option Portfolios. Working paper Wharton Business School.

DeMarzo, Peter M. and Darrell Duffie. (1995). Corporate Incentives for Hedging and Hedge Accounting. Review of Financial Studies 8, 743-771.
Financial Accounting Standards Board. (1998). Accounting for Derivatives Instruments and Hedging Activities. Financial Accounting Standards No. 133.

Froot, Kenneth, David Scharfstein, and Jeremy Stein. (1993). Risk Management: Coordinating Investment and Financing Policies. Journal of
Finance 48, 1629-1658.
Gay, Gerald D. and Jouhan Nam. (1998). The underinvestment problem and corporate derivatives use. Financial Management 27, 53-69.
Geczy, Christopher, Bernadette Minton and Catherine Schrand (1997). Why Firms Use Currency Derivatives. Journal of Finance 52, 1323-1354.
Guay, Wayne R. (1999). The Sensitivity of CEO wealth to equity risk: An Analysis of the Magnitude and Determinants. Journal of Financial
Economics 53, 43-71.
Haushalter, David. (2000). Financing Policy, Basis Risk, and Corporate Hedging: Evidence from Oil
and Gas Producers. Journal of Finance 55, 107-152.
Howton, Shawn D. and Steven B. Perfect. (1998). Currency and Interest-Rate Derivatives Use in US Firms. Financial Management 27, 111-121.
Knopf, J., J. Nam, and J.H. Thornton. (2002). The Effect of Managerial Incentives to Bear Risk on Corporate Capital Structure and R&D
Investment. Journal of Finance, 57, 801-814.
Mian, Shezad L. (1996). Evidence on Corporate Hedging Policy. Journal of Financial and Quantitative Analysis (September), 419-439.
Myers, S., and N. Majluf. (1984). Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have. Journal
of Financial Economics (June), 187-221.
Nance, Deana R., Clifford W. Smith, Jr. and Charles W. Smithson. (1993). On the Determinants of Corporate Hedging. Journal of Finance 48, 267-284.

Rogers, Daniel A. (2002). Does Executive Portfolio Structure affect Risk Management? CEO risk-taking incentives and Corporate Derivatives
Usage. Journal of Banking & Finance 26, 271-295.
Schrand, Catherine and Haluk Unal. (1998). Hedging and Coordinated Risk Management: Evidence from Thrift Conversions. Journal of Finance 53, 979-1014.
Smith, Clifford W. and Rene M. Stulz. (1985). The Determinants of Firms Hedging Policies. Journal of Financial and Quantitative Analysis 20, 391-405.

Stulz, Rene M. (1996). Rethinking risk management. Journal of Applied Corporate Finance (Fall), 8-24.
Tufano, Peter. (1996). Who Manages Risk? Journal of Finance 51, 1097-1137.
Tufano, Peter. (1998). Agency costs of corporate risk management, Financial Management 27 (Spring), 67-77.

The Journal of American Academy of Business, Cambridge * Number 2 * March 2005

23