Master Thesis Finance 2012

Foreign Currency Exposure, Financial Hedging Instruments and Firm Value

Author : P.N.G Tobing

Student number : U1246193
ANR : 187708
Department : Finance
Supervisor : Dr.M.F.Penas
Faculty name : School of Economics and Management
Year of graduation : 2012
Word count : 13308

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Abstract
This paper examines whether the foreign currency exposure influences firm’s choice among
financial hedging instruments. This paper used various measures of currency exposure with
different characteristics in order to distinguish between each financial hedging instrument. By
using newer dataset that consists of 188 manufacturing firms in the US during 2006 , this paper
finds that various proxy of currency exposure is positively and significantly associated with a
particular type of financial hedging instruments. Further, the results also show that each financial
hedging instrument is a complement to one another in reducing the currency risk exposure. In
addition, by differentiating type of financial hedging instrument this paper is also able to
investigate the effect of hedging on firm value in clearer ways. After the inclusion of foreign
debt in the definition of financial hedging activity, this paper does not find evidence that
financial hedging increase firm value.

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Table of Contents

Abstract .................................................................................................................................................. 2
1. Introduction ........................................................................................................................................ 4
1.1 Background.................................................................................................................................... 4
1.2 Research questions ........................................................................................................................ 7
1.3 Structure of the thesis.................................................................................................................... 8
2. Foreign currency exposure................................................................................................................... 9
3. Hedging behavior .............................................................................................................................. 11
3.1 Rationale of hedging behavior ..................................................................................................... 11
3.2 Financial hedging instruments ..................................................................................................... 13
3.3 Valuation effect of hedging .......................................................................................................... 18
4. Sample selection and methodology ................................................................................................... 20
4.1 Sample selection .......................................................................................................................... 20
4.2 Methodology ............................................................................................................................... 23
4.2.1 Foreign currency exposure and financial hedging instruments............................................... 23
4.2.2 Relationship between financial hedging instruments ............................................................. 25
4.2.3 Financial hedging and firm value ........................................................................................... 25
4. 3 Variable construction .................................................................................................................. 26
4.3.1 Financial hedging instruments ............................................................................................... 26
4.3.2 Foreign currency exposure .................................................................................................... 30
4.3.3 Firm value ............................................................................................................................. 30
4.3.4 Control variables ................................................................................................................... 31
5. Empirical results ................................................................................................................................ 35
5.1 Logit regression result.................................................................................................................. 35
5.2 Multinominal logit regression result............................................................................................. 41
5.3 OLS regression ............................................................................................................................. 45
6. Conclusion ......................................................................................................................................... 51
7. References ........................................................................................................................................ 54

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1. Introduction

1.1 Background
A substantial amount of theories for optimal hedging have been developed based on the
Modigliani and Mihedgingller paradigm. Those optimal hedging theories provide explanation for
hedging behavior based on the capital market imperfection. Various earlier empirical researches
have examined the determinant of foreign currency hedging, but the focus of the earlier
empirical researches are on whether the usage of derivatives conforms with the managerial risk
aversion, financial distress, tax liability and underinvestment problem theories discussed by
Mayers & Smith (1990), Smith & Stulz (1985) and Froot, Stein & Scharfstein (1993). Moreover,
earlier researches also limited the sample by taking data during 1990s (Allayannis & Ofek, 2001;
Geczy, Minton & Schrand, 1997; Graham & Rogers, 2002; Mian, 1996), where only limited
amount of studies have analyzed the hedging strategies by using more recent data. This paper
addresses this gap, by using newer dataset to analyze the financial hedging activity in US. The
sample consists of 188 manufacturing firms in the US during 2006. FASB issued Statement no.
133, “Accounting for Derivative Instruments and Hedging Activities” in June 1998 that is
mandatory for fiscal years beginning 2000. Due to the implementation of FASB 133 disclosure
for hedging and derivative instrument in 2006 become more transparent and as a result facilitates
the hand collected data method used by this paper.

This paper argues there are other factors besides those that conform to the optimal hedging
theory, which also influence the firm hedging behavior. This argument is based on another
stream of theory developed by Ederington (1979). He argue that a firm’s decision to hedge the
exposure reduce as the firm face greater basis risk. Basis risk is defined as the difference
between the characteristics of exposure being hedged and characteristics of hedging instrument
(Ederington, 1979) Therefore, in the context of foreign currency hedging activity, this paper
argues that the foreign currency exposure itself that influences the choice among hedging
instruments. Size, frequency and timing of the exposure are example of important currency
exposure characteristics that must be consider in order to choose a particular hedging instrument.
Therefore, consistent with Ederington (1979), this paper argue that the higher the correlation

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between the source of exposure and the hedging instrument, the lower the basis risk faced by the
firm and as a result the probability of using particular hedging instrument also increase.

Similar research has been made by Clark & Judge (2009) in the sample of UK non-financial
firms during 1995. Clark & Judge (2009) provided evidence that the currency exposure is an
important determinant for currency hedging activity in the UK. The motivation for conducting
similar research in US is that there are several major differences in the firm characteristic among
the US and UK firms that might influence the firm hedging activity in each country. The short
liquidity factor (measured by quick ratio and dividend yield ratio) and growth opportunities
factor (measure by RnD expense/total assets) highlighted those major differences in
characteristics between the US and UK firms. The short term liquidity factor captures the
availability of firm internal fund, while RnD ratio indicates firm growth opportunities. The
summary statistic of this paper shows that the quick ratio for firm in the US sample is above the
sample mean reported by Clark & Judge (2009). Consistent with this, the dividend yield ratio for
firm in the US sample is also below the dividend yield ratio in the UK sample reported by Clark
& Judge (2009). The growth opportunities on average is similar to those reported by Allayannis
& Weston (2001) and Elliot, Huffman & Makar (2003) in the context of US firm, but the ratio is
far below the number reported by Clark & Judge (2009) in the sample of UK firms. Therefore
although similar research have been made in UK, it is still interesting to see whether the currency
exposure is an important determinant of hedging behavior in the context of US firms.

The data related to the use of derivatives is published by the Bank of International Settlements
and BIS (2007) shows that the notional amount outstanding of over-the-counter derivatives
increased from US$257.9 billion in December 2004 to US$415.8 billion in the same month in
2006 (BIS, 2007). Further, there percentage of hedger in US from 1990 to 2006 also increases.
Geczy et al. (1997) show that more than half of firms in 1990 are non-hedgers, while in 2006 this
paper report that only 18 % of firm in the US sample is non-hedgers. Interestingly, Clark &
Judge (2009) report that 30 % of firm in the UK sample is non-hedgers. The growing number of
hedgers in the US during 2006 is somewhat contradict the prediction of earlier optimal hedging
theory. Consistent with the cost of financial distress and the underinvestment problem theories,

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higher liquidity factor and lower growth opportunities reduce the need for hedging, while in the
reality the currency hedging activity in the US is going in the opposite direction.

This contradiction also provides support for the earlier argument of this thesis that there are other
factors, besides those that conform to the theory prediction, that influence the firm hedging
behavior. Therefore it is interesting to see in multivariate setting analysis, whether the currency
exposure itself that influences a firm choice’s among hedging instruments.

By analyzing the relationship between the foreign currency exposure and choices among
different type of hedging instruments, this paper is also able to determine the relationship
between each type of financial hedging instrument; whether they act as complement or substitute
to one another. If a type of exposure is an important determinant for a particular type of
instrument, therefore each instrument is unique to a particular exposure, providing evidence for
the complementary relationship between each financial hedging instrument. On the contrary if a
particular type of exposure is an important determinant for various hedging instrument, then each
financial hedging instrument is a substitute to one another. Therefore, the result of this paper
extend the work of Allayannis & Ofek (2001) and Geczy et al. (1997) that examined the
determinant of foreign currency hedging activity based only on the optimal hedging theory.

Further, by differentiating type of financial hedging instrument this paper is also able to
investigate the effect of hedging on firm value in clearer ways. Various studies have investigated
the valuation effect of hedging by examining the relationship between foreign currency
derivative (FCD) and firm value. Majority of the existing studies find positive relationship
between FCD and firm value (Allayannis & Weston, 2001; Carther, Rogers & Simkins, 2006).
The more recent studies made by Allayannis, Lel & Miller (2011) and find that the usage of FCD
increase firm value only for firm that have strong corporate governance. Overall, in examining
the valuation effect of hedging, the focus of the earlier empirical researches is on the FCD. Only
limited amount of studies are known for investigating the valuation effect of foreign debt (FD).
This paper argues that the positive relationship between hedging and firm value is due to what is
included in the definition of financial hedging. The inclusion of FD user in the hedging definition
may change the valuation result of financial hedging activity and further, challenge the result
made Allayannis et al. (2011), Allayannis & Weston (2001) and Carther et al. (2006). Therefore,

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this paper raises another interesting research question on whether the usage of FCD in
combination with FD will contribute differently to firm value.

1.2 Research questions

Instead of looking at the foreign currency derivatives (FCD) alone this thesis also extends the
definition of financial hedging by including the foreign debt (FD) users. The main question to be
addressed in this thesis is whether the currency exposure influences firm’s choice among
hedging instruments. By analyzing the relationship between the currency exposure and choice
among different types of hedging instruments, this paper hopes to answer the question as to
whether each financial hedging instrument act as a complement or substitute to one another.

Furthermore, by differentiating the types of financial hedging instruments, this paper addresses
another interesting research question whether the financial hedging activity contributes to firm
value, even after the inclusion of FD user in the financial hedging definition.

To test the first and second hypotheses, this paper uses logit regression model that is similar to
Allayannis & Ofek (2001). Further in order to investigate the relationship between each hedging
instrument, this paper also uses the multinomial logit regression model similar to Clark & Judge
(2009) and Geczy et al. (1997). The logit and multinominal logit regression show the probability
of a firm using a particular hedging instrument given its exposure factor. Therefore, each of the
hedging instruments will be regressed to the various proxy of foreign currency exposure also by
controlling for other variables that influence hedging activity. For the firm value regression, this
paper will use OLS basic model similarly used in Allayannis, Ihrig & Weston (2001), Allayannis
et al. (2011), Allayannis & Weston (2001), Carther et al. (2006) and Kim, Mathur & Nam (2006)
who regressed the firm value with hedging activities in the multivariate settings analysis. Similar
to those earlier studies, Tobin’s q will be used as proxy for firm’s market value.

Overall, by using sample of U.S multinational manufacturing firms during 2006, this paper finds
several result. Firstly, this paper shows that currency exposures is an important determinant for a
firm’s choice among financial hedging instruments, consistent with the basis risk theory and
provide supporting evidence for the hypotheses. Secondly, the paper also shows that each
financial hedging method is a complement to one another in reducing the currency risk as the

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usage of a particular financial hedging method is appropriate for a particular type of currency
exposure.

Thirdly, the paper shows that after the inclusion of FD, the financial hedging activity do not
increase firm value. Interestingly, even after this paper control for the usage of foreign debt, the
result provides no evidence that the usage of FCD alone increase value of the firm. These
findings contradict the earlier empirical studies made by Allayannis et al. (2001), Allayannis et
al. (2011), Allayannis & Weston (2001), Carther et al. (2006) and Kim et al. (2006). One
possible explanation for this is that those manufacturing firms are multinationals that are
diversified geographically. Firms that are diversified geographically are more likely to match the
revenue and cost, as a result the level of currency exposure reduces as the firms are more
geographically diversified. Therefore the usage of financial hedging is not found to be beneficial
to firm value.

1.3 Structure of the thesis

The organization of this thesis is as follows: Chapter 2 discusses the different characteristic of
foreign currency exposure. Chapter 3 discusses the hedging behavior based on existing theories
and literature. Chapter 4 provides the sample selection criteria, methodology used for testing the
hypotheses, as well as the summary statistic and pearson correlation coefficient. Chapter 5
presents the result of the empirical research of this paper and the answers for the research
question. Chapter 6 provide provides concluding remarks on the thesis as well as the
contributions of this paper for organizations as a whole, annual report users as well as the
accounting standard bodies that set disclosure requirement for hedging, derivative and financial
instruments. Lastly various limitations of this paper and opportunities for future research will
also be provided in the last chapter.

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2. Foreign currency exposure
Ederington (1979) and Haushalter (2000) emphasize the importance of determining the
characteristics of each currency exposure. The motivation for this argument is that each currency
exposure has specific characteristic that eventually impact the usefulness of each financial
hedging instrument in reducing that particular exposure.

For instance the exposure arising from foreign debt is generally long term in nature and requires
multiple subsequent payments from the determination until the maturity of the contract. Further,
the size and the timing of the payment also depends on the initial agreement between the two
parties (pre-determined), therefore the exposure is characterized by multiple and certain
transactions. On the other hand, currency exposure resulted from foreign transaction such as
purchase of raw materials are considered to be uncertain with respect to size and timing, as the
purchase quantity, price per unit and timing of installment varies for each purchase transaction.
A firm’s purchase of raw material is also considered to be a short term transaction as it generally
requires a single subsequent payment or in the context of payment on credit (e.g. trade payable
account balance) the installment generally settles within one year. Therefore although the
purchase transaction is frequent but the transaction is also uncertain with respect to amount and
timing.

By determining the characteristics of each exposure, firms are able to match the characteristics of
the exposure being hedged with the financial hedging instrument used to hedge. The motivation
is based on the basis risk argument developed by Ederington (1979). He argues that a firm’s
decision to hedge exposure reduces as the firm faces greater basis risk from using a particular
instrument. Basis risk is defined as the difference between characteristic of the underlying
currency exposure being hedged and characteristic of underlying hedging instrument such as
maturity and price (Ederington, 1979). The lower the correlation between hedging instrument
and source of exposure, the higher the basis risk faced by the firms, therefore the less useful is
hedging instrument, consequently the less extensive firm should hedge the exposure. Therefore
this paper argues that firm should identify all components of their business that affected by the
exchange rate movement and understand the characteristics of each exposure as the exposure
factor is an important determinant of firm’s choice for particular hedging instruments. Later on

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this paper use various measure of currency exposure with different characteristic in order to
distinguish between each financial hedging instrument.

Hypothesis 1:

The foreign currency exposure affects firm choice among hedging instrument.

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3. Hedging behavior
This chapter discusses the firm’s hedging behavior based on existing theories and literature.
Section 1 discusses the rationale for hedging behavior based on existing theories. Section 2
discusses the type of financial hedging instruments and reviews progress of previous studies that
investigated the relationship between each financial hedging instruments. Section 3 discusses
previous studies that examined the linkage of hedging and firm value as well as the potential
channels through which hedging may affect differently on firm value.

3.1 Rationale of hedging behavior

For the purpose of this research hedging refers to the usage of financial instruments or
restructuring business activities to create natural hedge, both activities aim at reducing or
eliminating adverse effect on cash flow due to exchange rate movement (Adler & Dumas, 1984).
Optimal hedging theories rely on the capital market imperfection to explain firm incentive to
hedge. In these theories, the hedging activity employed by the firm is assumed as a strategy to
reduce the variability of cash flow.

Smith & Stulz (1985) argue the tax liability theory. The argument is based on the firm ability to
reduce the variability in income via hedging and as a result the expected tax liability born by the
firm is also reducing. Empirical studies find mixed results regarding to the relationship between
hedging and tax reduction (Graham & Rogers, 2002; Nance, Smith & Smithson, 1993).

Managerial risk aversion theory looks at the impact of managerial wealth and managerial stock
option on corporate hedging decision (Mayers & Smith, 1990; Smith & Stulz, 1985) The
probability of hedging increases as the manager owns large number of firm shares and in contrast
the probability of hedging decreases as the manager own more stock options. Empirical research
such as Schrand, Catherine & Unal (1998) and Tufano (1996) find supporting evidence for the
managerial risk aversion theory, but majority of the empirical research such as Allayannis &
Ofek (2001), Geczy et al. (1997), Graham & Rogers (2002) and Haushalter (2000) find no
evidence showing that managerial risk aversion affect the corporate hedging decision.

Smith & Stulz (1985) also point out the cost of financial distress theory. A firm with higher
probability of financial distress is more likely to hedge as hedging decreases the variance in firm

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cash flow. Empirical studies on this theory use debt ratio as a proxy of financial distress and
quick ratio and dividend yield as proxies for short term liquidity. Bartram, Brown & Fehle
(2004), Dolde (1995) and Graham & Rogers (2002) find evidence that showing hedging
increases as firms have more leverage and lower liquidity, thus support the cost of financial
distress theory. While, Nance et al. (1993) find no supporting evidence showing that hedging
increase as leverage increase. Further they argue that the insignificant relationship between
leverage and hedging indicate that other than hedging, a firm is also able to reduce the
probability of financial distress by maintaining higher liquidity and lower dividend yield.

Moreover, Smith & Stulz (1985) also argue that by decreasing the probability of distress,
hedging raise the ability of firm to obtain external finance. As a result the probability of firm to
underinvest is also decrease. In conjunction with this, Froot et al. (1993) argue that by reducing
variance in cash flow, hedging also reduces firm dependency on external finance. Thus, in the
situation where external finance is costly, firm is able to take the investment opportunities as
hedging help firm to maintain sufficient internal fund. Explanatory variables such as size and
investment opportunities are used to explain the relationship between firm characteristics and
hedging (Dolde, 1995; Geczy et al., 1997; Mian, 1996). Majority of the empirical studies find a
positive relationship between hedging and proxies of investment opportunities such as RnD and
Capex spending (Geczy et al. 1997), thus supporting the notion that hedging helps companies to
maintain adequate funds available for good investment opportunities.

Other stream of research also argues that size is as an important determinant of corporate
hedging. The cost of entering and maintaining FCD might be too high for small firms, therefore
limiting their ability to use FCD (Allayannis & Ofek, 2001; Geczy et al., 1997; Mian, 1996;
Tufano, 1996). Therefore, hedging activity decreases for smaller firms and increases for bigger
firms. However, consistent with the underinvestment theory, Froot et al. (1993) also provide
supporting argument that smaller firms are more likely to employ hedging activity as smaller
firms have higher expected growth compare to the larger firms which generally are more mature
thus have lower growth opportunities.

Overall, the consensus among those earlier theories and empirical researches is that they largely
focus on understanding why firm’s hedge. This paper argues that those existing empirical

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researches overlook the optimal hedging theory. Furthermore, there are other factors such as the
currency exposure, which is also an important determinant of firm hedging decision. The basis
risk theory discussed earlier in Chapter 2 motivates this argument.

3.2 Financial hedging instruments

Despite focusing on understanding why firm’s hedge, the existing empirical studies of currency
hedging has also focused on the usage of foreign currency derivatives (FCD) with no distinction
on the different types of hedging method employed by firm. In this section this paper discusses
different type of financial hedging methods that will be used in this paper; short term financial
hedging in one hand that include the usage of FCD such as forwards and options as well as swap
and foreign debt on the other1.

Among all instruments, forward and options are the most popular instrument used in practice to
hedge the currency exposure. Geczy et al. (1997) examine the FCD usage for 372 firms in US
during 1990 and finds that 29.3 % of firms in the sample are forwards users. Clark & Judge
(2009) finds that among 412 firms in the UK during 1995, 48.4 % of the firms use forwards only
and 22 % of firms use forward in combination with other instrument. Risk management
literatures state that forwards protect the holder from unfavorable changes in exchange rate but
do not permit the holder to obtain the benefit from the favorable movement in exchange rate,
while options is more expensive than the other derivative instruments, as the options feature
permit the holder to benefit from favorable movement in exchange rate (Sundaram & Das, 2011).
Various studies on currency hedging in the past have examined the usage of FCD but the
majority of them tend to exclude the usage of currency swap (Allayannis & Weston, 2001;
Bodnar & Gentry, 1993).

The reason is due to the characteristics of swap that is not consistent with forward. In swap the
two parties exchange fund directly rather than traded with banks or other OTC market. Further,
Geczy et al. (1997) argue that in swap both parties are able to customize the contract based on
their needs. Forward allows the firms to take opposite position to its spot market position by
buying or selling a specified amount of a currency at a predetermined rate on a particular date in

1
None of the firm in the sample provide any indication of future usage, therefore future contract is excluded from
the scope of this study

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the future. Therefore, similar to swap, forwards can be customized to meet the needs of the firms,
but the maturity is seldom above one year. Therefore, the customization cost is relatively lower
for single long term contract (swap) than for series of short term contract (forward). Therefore,
risk management literatures argue that swaps provide long term flexible hedge with relatively
low transaction cost.

Other earlier studies also argue that the exclusion of swap in the regression do not provide
significant difference to the result as there are very limited number of firms used swap to hedge
currency risk (Allayannis & Weston, 2001; Bodnar et al., 1993). However, Clark and Judge
(2009) and Elliot et al. (2003) find that currency swaps is used by those firms that have foreign
denominated debt. JOHNSON & JOHNSON in its 2006 annual report stated that: “The
Company uses forward exchange contracts to manage its exposure to the variability of cash
flows, primarily related to the foreign exchange rate changes of future intercompany product and
third party purchases of raw materials denominated in foreign currency. The Company also uses
currency swaps to manage currency risk primarily related to borrowings. Both of these types of
derivatives are designated as cash flow hedges” (p. 56). Therefore, the quote above supports the
importance of swaps and the inclusion of that instrument in the definition of financial hedging
method employed by firm.

Among all studies in currency hedging, Geczy et al. (1997) specifically examine the usage of
FCD and the choice of hedging instruments in the sample of US firms during 1990. They argue
that the source of exposure affect the level of benefit that can be realized from hedging.
However, Geczy et al. (1997) limit the definition of hedging into the usage of derivatives and as
a result they differentiate between the forwards and options only users with the swap only users
and exclude the users of foreign currency debt (FD). In a univariate analysis, Geczy et al. (1997)
find that currency swaps are more cost-effective for hedging foreign debt risk, while forward
contracts are more cost-effective for hedging foreign transaction risk. The reason is due to the
notion that foreign debt payment fits the long-term nature of currency swap contract. While the
frequency and uncertainty of transactional exposure need to be managed dynamically by short
term forward contract. However, in the multivariate setting they still find mixed results on the

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relationship between currency exposure and the choice among financial currency derivative
instruments.

The study on natural hedging such as foreign debt (FD) has received less attention. In examining
the choice of financial hedging instruments, this paper argues that the exclusion of foreign
currency debt in the definition of financial hedging activity might bias the result, as a firm might
be classify as non-hedgers when it uses FD to hedge. This argument based on the evidence found
by Allayannis & Ofek (2001) and Elliot et al. (2003) showing that FD is also used as a hedging
strategy in mitigating currency risk exposure. The usage of FD illustrated by the following
example, an exporter who will received revenue in foreign currency bearing the risk that the
foreign currency will be depreciate against the domestic currency. Therefore, the exporter is able
take a loan in foreign currency and converts the loan to domestic currency. By assuming that the
gain realized by investing the proceeds from the loan will match the interest rate payment, at the
maturity date the foreign denominated loan will be payback with the amount from foreign
revenue. Therefore, FD creates stream of cash outflow in a foreign currency that match the
company foreign revenue. Hagelin & Pramborg (2004) for a sample of Swedish firm provide
supporting evidence that FD is an effective tool for risk reduction. Therefore, if the derivatives
market is too expensive, a company has the alternative of using a FD, providing evidence that
FD is a substitute of FCD in reducing the currency risk (substitution hypothesis).

If each hedging instrument have its own characteristics as describe above, then each instrument
can be match with the characteristics of each exposure, thus currency exposure is an important
determinant for corporate hedging activity as the firm’s choice among a particular hedging
instruments is depend of the types of exposure (Hypothesis 1). Furthermore, the matching
concept also raises another argument that each financial instrument is also appropriate hedge
certain type of exposure consistent with the basis risk theory describe earlier (Chapter 2) and
provide supporting argument for the complementary relationship between each financial hedging
instruments. For instance, exposure arising from possession of asset in foreign countries is
obviously a long term exposure. Mismatch between the duration of the foreign asset and hedging
instrument, will increase the basis risk discussed earlier. Therefore, the basis risk from using
short term financial hedging instrument will be higher relative to the usage of swap or FD. Swap

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and FD are relatively a low cost method for hedging the long term type of exposure, provide
evidence for the complementary relationship between the usage of forward and options and the
usage of Swap or FD.

Another stream of studies has attempted to directly examine the relationship between FD and
FCD by incorporating FD into the analysis of FCD. Fok, Carroll & Chiou (1997) use the logit
model to find evidence showing that convertible debt serves as substitute for derivative used.
Allayannis & Ofek (2001) use the logit model and test a model of choice between FCD and FD
of U.S non-financial firm. They find evidence showing that exporters prefer to use FCD than FD
but do not find significant evidence multinationals prefer to use FD over FCD. However, their
results might be limited due to the exclusion of swap. Bratham et al. (2004) include swap in the
definition of financial derivatives and find a positive relationship between FCD and FD, provide
evidence on the complementary hypothesis. Elliot et al. (2003) examine the relationship of FD
and FCD for sample of U.S MNC during 1994-1997. Unlike other studies that use binary
variable as measure for FCD and FD usage, this study uses continuous variable. By using the
national value of FCD as a proxy for FCD and book value of FD as a proxy for FD usage, Elliot
et al. (2003) find a negative relationship between FD and FCD. This result implies that both FD
and FCD used to hedge the currency risk and FD used interchangeably with FCD to hedge the
currency risk. The result is consistent with Allayannis & Ofek (2001), Fok et al. (1997) and
Hagelin & Pramborg (2004) and provides evidence to support the substitution hypothesis.

Clark & Judge (2009) in the sample of UK firms during 1995 investigate the relationship
between FCD and FD by examining whether a particular financial instrument is unique to a
particular exposure or associated with all type of exposure. In the research, Clark & Judge (2009)
distinguish swap from other financial derivatives such as forward and options and further divide
the financial hedging become two elements; the usage of forwards, futures and options that
classified as short term FCD on one hand and the usage of FD or swap (independently or in
combination with short term FCD) that classified as long term financial hedging method on the
other hand. This classification is based on the characteristics of swap that are more similar to
foreign debt which are long term in nature. For example PROCTER & GAMBLE CO in its 2006
annual report supported the use of swap and FD to hedge the long term currency risk and stated

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that: “We hedge certain net investment positions in major foreign subsidiaries. To accomplish
this, we either borrow directly in foreign currency or designate all or a portion of foreign
currency debt as a hedge of the applicable net investment position or enter into foreign currency
swaps that are designated as hedges of our related foreign net investments” (p. 53). By using
multinominal logit regression model, Clark & Judge (2009) find evidence for the complementary
hypothesis.

In examining the relationship between each financial hedging instrument, this paper will follow
Clark & Judge (2009) that regress each of the hedging instrument with various measure of
currency exposure and investigate whether each hedging method is specific to hedge a particular
or appropriate to hedge all types of exposure. However, instead of distinguishing financial
hedging become two elements, this paper distinguish firm that use forwards, futures and options
only, firm that disclose the use FD only and firm that disclose the use swap (independently or in
combination). The intuition behind this argument is that consistent with the basis risk theory, a
particular instrument is unique to a type of exposure, therefore each hedging instruments is a
complement to one another. But if all instruments can be used interchangeably to hedge all types
of exposure, then each hedging instrument is a substitute to one another, therefore support the
earlier empirical results made by Allayannis & Ofek (2001), Elliot et al. (2003), Fok et al. (1997)
and Hagelin & Pramborg (2004).

Hypothesis 2:

If each source of foreign currency exposure is positively related to a particular type of hedging
instrument then each financial hedging instrument is a complement to one another in reducing
the currency risk exposure. But if a particular type of exposure is an important determinant for
various hedging instrument, then each financial hedging instrument is a substitute to one another
in reducing currency risk exposure.

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3.3 Valuation effect of hedging
Given the fact that companies make extensive use of various hedging methods raises further
question on the valuation effect of those hedging methods employed by the firms; whether or not
financial hedging method employed by the firm contribute to the firm value.

Various studies have examined directly the valuation effect of hedging strategies on firm value.
Allayannis & Weston (2001) who use a linear model for the U.S. data, find the usage of FCD
increases total firm value as much as 4.8 percent on average. Further, Nain (2004) also show that
FCD increases value of the firm by 5% on average. Moreover, he also shows that a firm that
remained unhedge will suffer a value discount if the competitors in the industry hedge their
foreign currency exposure. Allayannis et al. (2001) find that operational hedging increases firm
value when combined with FCD, while Kim et al. (2006) find that both operational and FCD
strategies are positively associated with firm value. Operational hedging adds 4.8-17.9% on
average, while financial hedging adds 5% on average to firm value.

Interestingly, Bartram et al. (2004) examine large sample of multi industry companies from 48
countries. They find that although the majority of derivative user is dominated by FCD users
(35.9%), the use of interest rate derivatives (not the currency derivatives) that associated with
firm value. Therefore, there are no value effect of FCD. Furthermore, Allayannis et al. (2011)
find that the hedging premium is statistically significant and economically large only for firms
that have strong internal and external corporate governance.

Clark & Judge (2009) using sample of UK non-financial firms show that different hedging
strategies make different impact to the firm value. When hedging strategy broken down into
FCD and FD user, the usage of FCD is associated with higher firm value by 14% on average.
However, FD is associated with higher firm value only when the usage of FD is combined with
FCD. Interestingly while other studies exclude swap from the definition of FCD, Clark & Judge
(2009) find that the usage of swap is found to be more effective in increasing firm value than FD
and any FCD instruments.

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Overall, there are still mixed results on the valuation effect of hedging. Furthermore, the focus of
the earlier empirical researches are on the valuation effect of FCD and there are only limited
amount of studies investigate the valuation effect of FD. Similar to those UK paper, this paper
provides clearer test on the valuation effect of hedging in the context of US firm by looking at
the impact of each type of hedging instrument specifically the role of FCD in combination of FD
in increasing firm value. The intuition behind differentiating types of financial hedging
instrument is that the effect of hedging and firm value is influence by what is included in the
definition of financial hedging. Therefore, this paper argues that the inclusion of FD in the
definition of financial hedging activity may provide different result from the earlier empirical
paper and contradict the result made by Allayannis et al. (2001), Allayannis et al. (2011),
Allayannis & Weston (2001) and Kim et al. (2006).

Hypothesis 3:

A positive and significant relationship between each hedging instrument and firm value would
indicate that hedging increases firm value and a negative and significant relationship between
each hedging instrument and firm value would indicate that hedging decreases firm value.

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4. Sample selection and methodology
The first section explains the sample selection criteria and summary statistic for firms in the
sample. The second section explains the econometrics methodology. The third section presents
description of the variables used in the analysis as well as the correlation between variables.

4.1 Sample selection

Following Kim et al. (2006), the initial sample is obtained from Compustat Geographic Segment
files for year 2006. The firm included in the sample must be non-oil related manufacturing
industry, thus this paper only include those firms that within 2000-2899 or 3000-3999 SIC codes
range (Kim et al., 2006). There are 482 firms with foreign sales or export sales within those SIC
codes range. Export sales are defined as the revenue generated from production domestically but
sold outside the U.S (Kim et al., 2006). This paper only focuses on firm that the main (domestic)
operation is in the U.S area, which reduces the sample size into 340 firms. Further, firm in the
sample must also be exposed to foreign involvement above 20% (Elliot et al., 2003) and the size
of the firm is above $500 million (Allayannis & Weston, 2001). Finally the sample is also
restricted to December year end in order to facilitate consistent assumption about the exchange
rate (Guay and Kothari, 2003). Therefore the sample reduces into 200 firms.

After the size, industry and foreign exposure matching requirements, only a firm that has 10-
K/annual report available from EDGAR Database is included in the sample. Further the data on
market value must be also available from the Datastream. After those selection criteria, the final
sample consists of 188 US manufacturing firms.

Table 1 provides the summary statistics for the sample of 188 US multinationals firms during
2006. Panel A shows the international characteristics of the firms. The foreign sales ratio (Fsales)
proxy for currency exposure arising from possession of foreign assets ranges from 30% to 98%,
with mean (median) of 52% (49%).This percentage is greater than the percentage reported by the
earlier researches such as Allayannis & Weston (2001) and Geczy et al. (1997) in the sample of
US firms and further, Clark & Judge (2009) in the sample of UK firms, that indicate the mean
level of foreign sales is 18% and 38% of total sales for the sample of US non-financial firms and
35% of total sales for the sample of UK non-financial firms. However, this percentage is slightly

20 | P a g e
above the number reporter by Elliot et al. (2003) that indicate the exposure through foreign sales
for U.S multinationals from 1995 to 1997 is 44.3% on average. Therefore, the firm in the sample
exposed to higher foreign currency exposure as compare to other earlier US and UK firms. One
possible explanation is that firms in 2006 are more engage in the international activities compare
to firms in the 1990s.

Panel B shows the general firm characteristics. The mean (media) book value of total assets is
$10.18 billion ($2.5 biilion). The total assets are below the number reporter by Elliot et al. (2003)
that indicate the total asset is $ 14 billion ($3.7 biilion). But this number is greater than reported
by Allayannis & Weston (2001) with $7.7 million ($2.5 million).

The mean market value of equity is $13.47 billion. Tobin’s Q is the proxy of firm value. The first
measure of Tobin’s Q is book value of total assets minus the book value of equity plus market
value of equity divided by the book value of total assets for the year ended 2006. The median
value (0.54) of Tobin’s Q is smaller than the mean (0.60), which indicate that the distribution of
Tobin’s Q in the sample is skewed. Thus, this paper use natural log of Tobin’s Q to control for
this.

The mean (median) for quick ratio is 76% (40%) which is above the sample mean (media) by
Clark & Judge (2009) with 48% (30%), although that the mean of long term debt to total assets
ratio (Tdebt) is 20%, which is slightly higher than reported by Clark & Judge (2009) and Elliot et
al. (2003) with 18% and 17% on average. This is an interesting point as although the US firm is
less financially flexible due to the higher debt ratio, but on average firm in the sample is cash
rich company, which unnecessary to have foreign borrowing. The higher cash holding status is
also consistent with the relatively low dividend yield ratio of 1 % on average which is extremely
below the dividend yield ratio in the UK sample reported by Clark & Judge (2009) of 3.5% on
average. Thus, given its high cash status, the majority of firm might have preference on FCD
instead of foreign debt to hedge the risk; consistent with the argument that firm with higher level
of liquidity might have greater ability for using foreign currency derivatives (Allayannis & Ofek,
2001; Geczy et al., 1997; Mian, 1996; Nance et al,. 1993; Tufano, 1996). However, the

21 | P a g e
relationship between firm liquidity and derivative usage can also be negative. According to the
financial distress theory (Smith & Stulz, 1985) firm with greater probability of financial distress
is more likely to use derivatives, thus the higher quick ratio and lower dividend yield ratio reduce
the need to use derivative to reduce the expected cost of financial distress (Smith & Stulz, 1985)
and external financing (Froot el at., 1993).

Further, the growth opportunities measured by RnD expenses divided by total assets is 4% on
average similar to reported by Elliot et al. (2003) with 4.4 % on average and Allayannis &
Weston (2001) with 3% on average, although that this ratio is far below the number reported by
Clark & Judge (2009) with 80.4%. This is also another difference between firm characteristic in
US and UK. According to Froot el at. (1993) hedging should be greater for firm with higher
investment opportunities to reduce the underinvestment problems. Based on above data, UK
firms have extremely higher investment opportunities compare to US. Thus, consistent with the
underinvestment theory Froot el at. (1993), the usage of derivative in the US is expected to be
lower compare from the UK.

Table 1: Summary statistics

This table provides summary information for all variables used in the regression.

Variable Mean Median sd max min N

Panel A: Firm international characteristics
STexp .85 1 .36 1 0 188
Fsales (%) .52 .49 .15 .98 .30 188
Netinvestm~k .82 1 .38 1 0 188
FDrisk .21 0 .41 1 0 188

Panel B: General firm characteristics

AT (million) 10180.31 2520.34 25405.45 278554 511.603 188
MVE (million) 13478.69 2767.68 29618.01 191011 41.8552 188
Tobin’s Q (LNQ1) .60 .54 .39 2.06 -.32 188
Leverage .20 .13 .19 1.26 0 188
Tdebt .20 .16 .18 1.61 0 188
DivDummy .53 1 .49 1 0 188
DivYield .01 0 .01 .04 0 188
Profitabil~y .14 .13 .07 .49 -.03 188
GrowthOpp .04 .03 .03 .20 0 188
TaxDummy .86 1 .34 1 0 188
Quickratio .76 .40 1.01 7.18 .012 188

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4.2 Methodology
This section aims to construct empirical model in order to test each of the hypotheses mentioned
in Chapter 2. Firstly, this section explains the methodology use to test whether the currency
exposure is an important determinant of hedging activity and secondly whether each particular
exposure specific for a particular instrument or appropriate for all types of financial hedging
instruments in order to determine the relationship between each financial instrument. Lastly, this
section explains methodology use to test the valuation effect of hedging.

4.2.1 Foreign currency exposure and financial hedging instruments

This paper divides the financial hedging instrument users become three categories: the user of
short term foreign currency derivatives (SHFCD), the user of cross currency swap (SWAP), and
the user of foreign debt (FD). The grouping is designed to differentiate types of hedging
instrument based on its characteristics such as maturity, degree of customization and cost. The
grouping is similar with Clark & Judge (2009) that distinguish forwards, futures and options
users and long term foreign currency hedging users that include swap or FD users. Therefore, the
dependent variable is those three types of financial hedging instrument categories (Finhedge).
The first dependent variable is the SHFCD dummy that equal to 1 if firm indicate any forwards
or options usage and 0 otherwise. The second dependent variable is SWAP dummy that equal to
1 if firm indicate any swap usage and 0 otherwise. The third dependent variable is FD dummy
that equal to 1 if firm indicate any foreign debt usage for hedging purpose and 0 otherwise. For
each of these hedging instrument categories, this paper examine whether the different measure of
currency exposure are important determinant of financial hedging instrument.

The most common method for analyzing data with binary response variable is the logit
regression method. The logit model in this paper is use to examine whether the various measure
of currency exposure are important determinant of currency hedging activity. Further, this logit
model is also use to estimate the probability of using a particular hedging instrument given its
exposure type. This logit model is similar to the model used by Allayannis & Ofek (2001) that
examine the determinant of FCD based on firm characteristics.

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The general form of logit regression model is as follow:

P (y = 1) = α + β1 x1 + β2 x2 + ....+ βk xk

Βi are the coefficient of the model and xi is the characteristics of firm i

Therefore, in order to test the first and second hypotheses, this paper uses the following logit
regression model:

P (y = 1) = α + β1 ST exp+ β2 Fsales + β3 Net investment risk + β4 FD risk + ∑ Control + Ƹ

The main independent variables are the various measures of foreign currency exposure. STexp is
the short term transaction dummy that equals to 1 if company’s operations generate any non-
functional currency transaction, such as vendor payments, sales of goods and services and any
repatriation of income profits, dividends, fees, royalties and interest from foreign subsidiaries
that eventually raises the firm’s short term exposure. Foreign sales by origin ratio (Fsales) are
used as a proxy for exposure arises from possession of foreign asset (Geczy et al., 1997).
Further, this paper also uses indicator variable that equals to 1 (Net investment risk) if a firm
indicates any of its major foreign subsidiaries have non US dollar-functional currency. Changes
in the functional currency of major foreign subsidiaries raises the volatility in stockholders’
equity of a firm, therefore net investment in foreign subsidiary is also a proxy for currency risk.
Lastly, Fdebtrisk is the foreign borrowing dummy that equals to 1 if firm indicates any
existence of foreign denominated debt for purpose other than hedging activity. This variable is
also a proxy for currency risk as firm is able to raise capital by issuing debt in foreign currency.
Consistent with the basis risk theory describe earlier, the currency exposure variables is expected
to be positive and significantly associated with any category of financial hedging instrument
dummy.

24 | P a g e
4.2.2 Relationship between financial hedging instruments
In order to determine the relationship between each financial hedging instruments, this paper also
use the multinomial logit regression in order to test the probability of firm choose one of the
categories of financial hedging instruments given its exposure type. This multinominal logit
regression is use to confirm the result from the earlier logit regression for the second hypothesis.
The multinominal logit regression is similar with Clark & Judge (2009) and Geczy et al. (1997)
and can be written as follow:

P (y1= j) = α + β1 ST exp+ β2 Fsales + β3 Net investment risk + β4 FD risk + ∑ Control + Ƹ

j=1,2,3,4 , for j is the groups of financial hedging method.

For the multinomila logit regression, this paper identifies four groups of financial hedging
method. Group 1 is those firms that hedge currency risk by using short term foreign currency
derivatives (SHFCD) only that include the forwards or options users. Group 2 is those firms
hedge that hedge currency risk by using cross currency swap only or swap in combination with
other instrument. Group 3 is those firm that hedge currency risk by using foreign currency debt
(FD) only (exclude those that used FCD). Group 4 is those firms that hedge currency risk by
using both FCD and SHFD. All financial hedging groups are normalized to non-hedgers (Group
0). Similar to the previous logit regression, the main independent variables are the various
measures of foreign currency exposure. Each currency exposure variables is expected to be
positive and significantly associated with a particular group of financial hedging methods, to
provide supporting evidence for the complementary hypothesis.

4.2.3 Financial hedging and firm value

In this section this paper investigates the impact of financial hedging on firm value, measured by
Tobin’s q. This paper undertakes similar basic model with as Allayannis et al. (2001), Allayannis
et al. (2011), Allayannis & Weston (2001), Carther et al. (2006) and Kim et al. (2006) that
regress the firm value with financial hedging dummy and control variables that also give impact
to firm value. The basic OLS regression model is as follow:

Tobin’s g = α0 + β1 Finhedge + β2 ST exp+ β3 Fsales + β4 Net investment risk + β5 FD risk + ∑ Control + Ƹ

25 | P a g e
The dependent variable is firm value measure by Tobin’s q, consistent with the earlier literature
Allayannis & Weston (2001), Chung & Pruitt (1994) and Jim & Jorison (2006). Finhedge is the
indicator variable of financial hedging activity of the firm. As mentioned earlier, unlike previous
studies those focus on FCD users, this paper incudes the FD users in the definition of financial
hedging instrument. In order to provide comparison with other earlier studies, in the different
specification, this paper also examines the impact of FCD on firm value. A positive (negative)
coefficient of Finhedge dummy on Tobin’s q is consistent with financial hedging increase
(decrease) firm value. The expected sign of Finhedge variable are not predetermine, as the
inclusion of foreign debt in the definition of financial hedging activity may change valuation
effect of financial hedging activity. Further, the various measures of foreign currency exposure
are also included in the regression and all of the exposure measures are expected to be negatively
related to firm value.

4. 3 Variable construction

4.3.1 Financial hedging instruments

FASB issued Statement no. 133, Accounting for Derivative Instruments and Hedging Activities
in June 1998 that gave better direction to companies about quantitative and qualitative
derivatives and other financial instruments needed to be disclosed by firms. The new accounting
standard is mandatory for all companies and effective for fiscal years beginning after June 15,
2000 (January 1, 2001, for companies with calendar-year fiscal years). FASB rules mandate the
firms to disclose their use of hedging activities as well as the reason of using them on the 10-K
form. Due to the implementation of FASB 133, the disclosure for hedging and derivative
instrument during the sample period (2006) become more transparent and as a result facilitate the
hand collected data method used by this paper.

Data on currency derivative position and FD for 2006 are obtained by reading “The Management
Discussion and Analysis” of SEC 10-K, “Quantitative and Qualitative disclosure about market
risk” and “Financial Instruments and Derivatives” disclosure of SEC 10-K filings or Annual
report. Further the financial hedging instrument data is also obtained by searching for text strings
such as “hedge”, “derivatives”, “forwards”, “swap”, “foreign denominated debt”, “foreign

26 | P a g e
borrowing” from 10-K filings or Annual report. The 10-K filings or Annual report is available
from EDGAR database. The types of hedging securities held, the notional principal of each
derivative instrument held, purpose of hedging instrument and whether the usage of hedging
instrument meet the criteria of hedging describe by the FASB 133 are example of information
obtained from the 10-K filings or Annual report.

For FCD data, Guay & Kothari (2003) state that the reported derivatives positions held by the
firms at fiscal yearend may differ somewhat from the average derivatives positions held by the
firms during the year. Similar to Nain (2004), in the case that firm engage on risk management
strategy during the year but there were no contract outstanding at year end, the firm is classified
as users in that year. Firm is classified as non-users when there is no reference made to the
keywords. This paper examines only derivatives held for non-trading purposes. Table 2 below
provides summary of financial hedging method employed by the U.S manufacturing firm during
2006.

Table 2: Financial hedging use by US manufacturing firms during 2006

This table presents data on the use of financial hedging by US manufacturing firms during 2006. Panel A provides
data on hedgers and non-hedgers; a firm defines as hedger if it provides qualitative disclosure of any hedging
activities employed in its annual reports. Panel B provides data on the FCD users; a firm defines as FCD user if it
provides qualitative disclosure of any forwards, futures, options or swap in its annual reports. Panel C provides data
on the FD users; a firm defines as FD user if it provides qualitative disclosure of any foreign debt or foreign
borrowing in its annual reports. Panel D further classify whether the use of FD is to hedge the risk or increase firm
exposure to exchange rate based on the qualitative information disclosed in the annual reports. Panel E presents data
on the choice of financial hedging method by distinguishing between FCD and FD. Panel F presents data on the
choice of financial hedging method by distinguishing between short term FCD and long term financial hedging
users; a firm classify as short term FCD user if it provide qualitative disclosure of any forwards, futures or options
used in the annual reports, or classify as long term financial hedging user if it provide qualitative disclosure of any
swap or FD used in the annual reports, or classify as both if the usage of as short term FCD is in conjunction with
long term financial hedging method. Panel G provides information of type of derivatives instrument used by FCD
users only.

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 Panel A: Hedging Activity
Hedging FX 155 82%
Not hedging FX 33 18%
Total 188 100%

Panel B: FCD users

FCD users 151 80%
non FCD users 37 20%
Total 188 100%

Panel C: FD users
FD users 63 34%
FD non users 125 66%
Total 188 100%

Panel D: FD users and the reason for FD use

FD used for hedging 27 40%
FD debt increase currency exposure 41 60%
Total 100%

Panel E: FC Hedging Method employ

FCD and FD 23 15%
FCD only 128 83%
FD only 4 3%
Total 155 100%

Panel F: FC Hedging Method employ based on basis cost

Short term Hedging only 98 63%
Long term Hedging only 6 4%
Short and Long term Hedging 51 33%
Total 155 100%

Panel G: Type of FCD instrument employed by

FCD users
Forward Only 84 56%
Forward Options 28 19%
Forward Options Swap 20 13%
Forward swap 17 11%
Swap Only 2 1%

Total 151 100%

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Table 2 Panel A shows that 82% of the firms are classified as hedgers (those firms that provide
qualitative disclosure of any hedging activities employed in its annual reports). There are no
cases where firms indicate the use of hedging for speculative purpose.

Table 2 Panel B and Panel C give breakdown for the FCD and FD users. Panel B shows 80% of
the firms use FCD. Further Panel C shows 34% of firms report the use of FD. Table 2 Panel D
further breakdowns the sample of FD users by reasons and shows that in 40% of cases use FD
for hedging purpose and 60% of cases use FD for reasons other than hedging activities.

By bringing together the use of FCD (include swap) and FD, Table 2 Panel E show 15% of firms
use both FCD and FD. Further, it also shows 83% of firms use FCD only. While there is 3%
case where firm use FD only.

Lastly, Panel G breakdown the sample of FCD hedgers by type of derivatives instrument
employed. 56% of FCD users used forwards, 19% of firms use combination of forwards and
options, 13% of firms use combination of forwards options and swaps, 11% of firm use forwards
in combination with swaps and lastly 1% of firm use swap only. Further, Table 2 Panel F control
for the usage of foreign debt (FD) and finds that among those firm that hedge with forward or
combinations of forwards and options, 63% of the firms also do not use foreign currency debt
which further classified as short term hedgers (SHFCD). While 33% of firms use swap in
combination with foreign debt and 4% of firm use swap or foreign debt only that classify as the
long term hedger.

This breakdown for hedging instrument used by type is above the number reported by Geczy et
al. (1997) that find 29.3% of the firms report the usage of forward only or forward and
combination with options (SHFCD), while 12.1% of the firm report the usage of swap only or
swap in combination with other instrument, while more than half of the sample do not provide
disclosure on currency derivative usage. The growing number of hedger is consistent with data
from Bank for International Settlements that show the national value2 for OTC derivative market
raises in 2006 (BIS, 2007).

2
The size of the derivatives market is most commonly measured in terms of notional value, which is defined as the
principal amount used to calculate payments on contracts

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4.3.2 Foreign currency exposure
As mentioned earlier, this paper uses various measure of foreign currency exposure. The data on
export, import, repatriation of income from foreign subsidiaries, net investment in foreign
subsidiary and foreign debt are hand gathered from the firm’s annual reports. The data collected
by reading the “Quantitative and Qualitative disclosure about market risk”, “Financial
Instruments and Derivatives” disclosure and searching the keywords within the annual report.
For the net investment in foreign subsidiary measure, this paper also check the location of
subsidiary for each firm, the list of firm subsidiaries and location is obtained from Exhibit 21 on
the 10-K report. Data on foreign sales by origin ratio is obtained from Compustat geographical
segment.

4.3.3 Firm value

This paper uses two measure of Tobin’s q. The first numerator is the book value of total assets
minus the book value of common equity plus the market value of common equity. The market
value of equity is calculated as of the calendar year end. The denominator is the book value of
total assets. This measure of Tobin’s q is consistent with Clark & Judge (2009) and Jim &
Jorison (2006). For the second measure of Tobin’s q, this paper use measurement developed by
Chung & Pruitt (1994). The numerator is calculated as the sum of market value of equity plus
liquidation value of preferred stock plus the book value of long term debt minus the current
liabilities and plus book value of inventory (Carter, Rogers & Simkins, 2002). Again, the
dominator is book value of total assets. Both measurement of Tobin’s q are chosen due to the
accounting figure and stock price data required to construct the numerators and denominator are
readily available using Compustat and Datastream.

The following formulas are used to calculate Tobin’s q:

LN (Q1) = (Book value of total assets – Book value of equity + Market value of equity) /
Book value of total assets

Q2 = (Market value of equity + Liquidation value of preferred stock + Book value of

long term debt – Book value of current liabilities + Book value of inventory) /
Book value of total assets

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4.3.4 Control variables

As mentioned earlier, optimal hedging theory show various firm characteristics that also
influence the decision to hedge. Therefore, this paper include a set of control variables that are
based on the optimal hedging theory and similar to earlier literature such as Allayannis & Ofek
(2001), Clark & Judge (2009) and Geczy et al. (1997). This paper exclude the proxy for
managerial risk aversion as the variable is constantly insignificant in the earlier research
(Allayannis & Ofek, 2001; Geczy et al., 1997; Graham & Rogers, 2002; Haushalter, 2000).
Those entire variables are used to control for factors other than currency exposure that
potentially affects the likelihood of using a particular hedging instrument. Further for the
hedging and firm value regression, this paper uses similar control adopted in the Allayannis &
Weston (2001). The source for the control variables data is the Compustat Database. The
rationale and predicted magnitude of control variables summarize in the table 3 below. Table 4
provides an overview of definition and source of all variables used in this paper.

Table 5 above presents the Pearson correlation coefficient for financial hedging method variables
used in the empirical research. The coefficient of foreign currency derivative (FCD) variable and
foreign debt (FD) variable is positive. Thus support the complementary relationship between
foreign currency derivatives (forwards, options and swaps) and foreign debt methods. Further,
the foreign currency derivative (FCD) variables positively related to firm value, but there is
negative relationship between foreign debt (FD) and firm value. As expected, there is negative
relationship between both FSales and net investment variable as proxy for currency exposure to
firm value. Although that the ST exp and foreign debt risk measure are positive, contradicting
the predicted magnitude.

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Table 3: Rationale and predicted magnitude of control variable

This table provides rationale and predicted magnitude for control variables used in the analysis.

Control Variable Measurement Predicted Rationale

Logit and Multinominal Logit Regression
Size Log TA
Leverage Total debt/Total assets
Liquidity or Financial distress Dividend Yield
Quick ratio = total cash and cash
equivalents divided by total current
liabilities (cash ratio)
Profitability ROA=EBITD/TA
Growth Opportunities Capex/Total assets
Reduction on tax expenses Tax dummy; 1 if firm has tax loss
carry forwards or tax investment
OLS Regression
Size Log TA
Leverage Total debt/Total assets
Liquidity or Financial distress Dividend Yield
Quick ratio = total cash and cash
equivalents divided by total current
liabilities (cash ratio)
Profitability ROA=EBITD/TA
Growth Opportunities Capex/Total assets
Magnitude
+/- Large firms are more likely to hedge due to startup
cost for hedging. However smaller firms will be
benefit ore from hedging.
+/- To control for firm’s capital structure
+/- Financial distress firms will be benefit more from
hedging instrument. However financial distress firms
have low ability to implement and monitor hedging
activities.
+/- Cash rich companies have higher ability to
implement the hedging instrument.
+ Firms with higher profitability have greater ability to
implement the hedging instrument.
+ Firms with more growth options will be benefit more
from hedging to avoid the underinvestment problems
+ Hedging use to increase the tax benefit.
+/- There are mixed results on the effect of size on firm
value.
- To control for firm’s capital structure
+ Firms that are more financially constraint may have
+ higher Q, due to its only undertake positive NPV
project
+ A more profitable firm will be more likely to be trade
at premium, therefore will have higher Q
+ Firm value depend of the future investment
opportunities (Myers 1977 and Smith and Watts
1992)

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Table 4 : Variable definition

This table presents variable definitions and sources for all variable used in the regressions. All variables are obtained for year ended 2006.

Variable name Variable description (Source)

Market value of equity (MVE)
Share price multiplied by number of ordinary shares in issue. (CRSP)
Tobin’s q (LNQ1) Book value of total assets minus the book value of equity plus market value of equity divided by the book value
of total assets for the year ended 2006. (Compustat)
Tobin’s q (Q2) The sum of market value of equity plus liquidation value of preferred stock plus the book value of long term
debt and current liabilities minus the current liabilities and plus book value of inventory divided by the book
value of total assets for the year ended 2006. (Compustat)
Short term exposure dummy (STexp) A dummy variable that equals to 1 if firm indicate any export or import or any repatriation of income from
foreign subsidiaries or 0 otherwise. (Annual report 2006)
Foreign sales by origin ratio (Fsales) Foreign sales by origin divided by total sales. Foreign sales by origin are the sales from which countries
good/services have been produced. (Compustat Geographical Segment)
Net investment dummy A dummy variable that equals to 1 if the US parent company indicate any net investment in the foreign
subsidiary that have Non-U.S dollar functional currency. (Annual report 2006)
Foreign currency debt dummy (Fdrisk) A dummy variable that equals to 1 if firm indicate any company’s foreign currency denominated debt that used
for reason other than hedging. (Annual report 2006)
Firm size Natural logarithm of book value of total assets. (Compustat)
Leverage Book value of total debt and preference capital as a proportion of book value of total debt plus market value of
equity. (Compustat)
Debt ratio (Tdebt) Total debt divided by total assets. (Compustat)
Dividend Yield Ratio of cash dividend per share divided by closing price per share as of fiscal year end 2006. (Compustat)
Dividend dummy (Divdummy) A dummy variable that equals to 1 if firm indicate any dividend payment during the year. (Compustat)
Profitability Earnings before interest, taxes and dividend (EBITD) divided by total assets. (Compustat)
Growth opportunities (GrowthOpp) Ratio of RnD expneses divided by total assets. (Compustat)
Tax dummy
A dummy variable that equals to 1 if firm has tax loss carry forward or investment tax credits or 0 otherwise.
(Compustat)
Quick ratio A ratio of cash and short term investment divided by the current liabilities as of fiscal year end 2006
(Compustat)

33 | P a g e
 Table 5: Pearson correlation coefficient

This table reports Pearson correlation coefficient for all variables used in the multivariate analysis.. * denote the significance.

FCD FDhedger STexp Fsales Netinv~k FDrisk LogAT Leverage Tdebt DivDummy Profitabil~y InvOpp TaxDummy LNQ1

FCD 1.0000

FDhedger 0.0501 1.0000

STexp 0.6948* 0.0009 1.0000

Fsales 0.0184 0.0453 0.1105 1.0000

Netinvestm~k 0.0178 0.1491* -0.0752 -0.2009* 1.0000

FDrisk 0.1318 -0.0326 0.1124 0.1059 -0.1965* 1.0000

LogAT 0.2295* 0.2548* 0.1110 0.0419 0.1759* 0.0139 1.0000

Leverage -0.0268 0.1013 0.0301 -0.0090 -0.0873 0.1108 0.0426 1.0000

Tdebt -0.0878 0.1003 -0.0050 0.0127 -0.1487* 0.1966* -0.0752 0.6280* 1.0000

DivDummy 0.0772 0.1063 0.0312 -0.1637* 0.2167* -0.0782 0.2766* -0.1254 -0.0849 1.0000

Profitabil~y 0.0099 0.0141 0.0530 0.0125 -0.0264 0.0984 0.0880 -0.3810* -0.1301 0.2256* 1.0000

InvOpp 0.1466* -0.0360 0.1737* 0.2042* -0.2172* 0.0900 -0.0295 0.0511 0.1039 -0.0792 0.2737* 1.0000

TaxDummy 0.0031 -0.0183 -0.0318 -0.0204 -0.0572 0.0172 -0.0152 0.0854 0.1542* 0.1078 0.0166 0.0495 1.0000

LNQ1 0.0172 -0.0332 0.0098 -0.0055 -0.0132 0.0463 0.0384 -0.5319* -0.1324 0.0599 0.7497* 0.0833 -0.1194 1.0000

34 | P a g e
5. Empirical results

5.1 Logit regression result

This paper starts the analysis by estimating the logit regression model to test whether the
currency exposure is an important determinant of firm’s hedging activity. Each model in Table 6
presents logit estimation result for different categories of financial hedging instrument. For each
category hedging instrument, this paper examines whether various currency exposure variables
are important determinant of financial hedging instrument usage. Table 2 Panel F shows the
frequency of derivative instrument used by firms and categories the derivative instruments based
on basis cost. As previously reported, 63% of firm classified as SHFCD user (forward only or
forward combination with option). Model 1 compares the firms that use SHFCD only with firms
that use SHFCD in combination with other instrument or firm that use no SHFCD. Therefore, the
dependent variable is SHFCD dummy that equals to 1 if there is indication of the usage of
SHFCD only and 0 if there is no indication on FCD activities or if the usage of SHFCD is
combine with other instruments. The control variables are those factors that have been
consistently important in distinguishing between hedging and non-financial hedging firms. Those
control variables are consistent with the earlier literature controlling for factors that affect the
incentive of hedging such as firm size, leverage, long term debt ratio, quick ratio, dividend
dummy, profitability, growth opportunity and tax dummy.

Further, in Model 2, this paper examines various measures of currency exposure variables for
cross currency swap users. The dependent variable is binary that equals to 1 if firms use cross
currency swap only or in combination with other instrument and 0 otherwise. Again the
independent variables are measure for risk exposure and the control variables that are similar to
previous models. Further, in Model 3, this paper also examines the currency exposure variables
for cross currency swap users that do not use FD. The dependent variable is binary that equals to
1 if firms use cross currency swap only or in combination with SHFCD (no FD usage) and 0
otherwise.

Lastly, Table 2 Panel C shows breakdown of FD users by reasons and finds that 40% of firms
used FD for hedging activity. Therefore, in Model 4 the dependent variable is the foreign
currency debt (FD) dummy that equals to 1 if firms give indication of hedging activity by issuing

35 | P a g e
foreign borrowing and 0 otherwise. However, as both foreign debt and currency swap are
considered to be long term in nature, thus this paper exclude those firms that use foreign debt
user in combination with currency swap from the regression. Model 5 presents the result, the
dependent variable is the FD only dummy that that equals to 1 if firms give indication of hedging
activity by issuing foreign borrowing but no swap.

Table 6 presents the logit estimation result. The paper reports the coefficient estimate and the
marginal probability of using financial hedging instruments. The marginal effect measures the
marginal changes in the probability of employing a given hedging strategy resulting from a
change in the independent variables. The logit regression model shows that the coefficient and
marginal effect of the currency exposure measures is positive and significant on at least one
category of financial hedging instruments. For instance ST exp proxy for short term transaction
is positive and significant in model 1, while the FD risk and Net investment risk measures are
important in Model 2 and 4, respectively. The results provide evidence that the currency
exposure is an important determinant on firm choice among hedging instrument. However,
Fsales variable as a proxy of firm’s possession of foreign assets is insignificant in all regression
result. One possible explanation is due to possession of foreign asset can also be a proxy for
operational hedging activity; therefore the greater foreign assets indicate that firms are more
geographically diversified. Geographical diversification might reduce the probability of hedging
with financial instrument.

Further, by using the same logit regression result, this paper analyze whether decision to hedge
with a particular financial hedging instrument is related to a particular type of currency exposure
consistent with the basis risk theory discussed earlier. As discussed earlier, the motivation for
choosing different type of hedging instrument is due the characteristics associated with each
hedging instrument and the characteristics of currency exposure that ultimately give impact to
the benefit obtained by firm from using that particular hedging instrument.

Model 1 shows that for firms that use SHFCD only, the coefficient and marginal effect of STexp
dummy are positive and significant, but none of the other exposure measures are significant.
Further, Model 2 and 3 shows that for firms that use cross currency swap only or swap

36 | P a g e
combination, the coefficient and marginal effect of FD risk variable are positive and significant.
But none of other exposure measure variables are significant. Model 4 shows that the coefficient
and marginal effect for net investment dummy are positive and significant for firms that used FD
or combination of FD. However, Model 5 also shows that the net investment dummy is not
important determinant of FD usage for firms that user FD but do not use swap. This indicates
that swap and FD act as substitute for hedging exposure arising from net investment in foreign
countries. However, as reported earlier in Model 2 and 3, the net investment variable is
insignificant in both models.

The results indicate that firm with currency exposure arising from purchase and sell commitment
dominated in foreign currency, are more likely to hedge with SHFCD, while firm with higher
level of currency exposure arising from foreign operation or foreign borrowing show no
preference on using SHFCD. The results also suggest that firms with foreign borrowing are more
likely to be hedge with cross currency swap to convert the foreign debt into domestic debt.
Finally, the results also show that firm with long term transaction exposure arising from
investment located in foreign countries is more likely to use FD to hedge exposure.

Overall, the results are consistent with the basis risk theory discussed earlier, that certain
instrument is appropriate for certain type of exposure. The motivation behind this is that foreign
exposure from transaction in non-functional currency such as purchase of new material generally
requires single subsequent payment and the amount and timing of payment varies across
purchase transactions. Thus this type of exposure is considered to be short term in nature.
Forward and options (SHFCD) is a low cost method to hedge this type of exposure. While,
foreign debt payment represents multiple and certain subsequent payment in term of timing and
size, thus this exposure is considered to be long term in nature. Thus, this type of exposure is
more effective to be hedge by using swap as swap have long term duration and have higher
customization feature with lower cost. Thus, firms with greater long term exposure are more
likely to choose use swap than series of forward contract.

37 | P a g e
Further, consistent with the optimal hedging theory, the liquidity factor measure by quick ratio is
an important determinant of hedging activity. But the magnitude is contradicting the theory. The
results show that firms with higher liquidity prefer to use SHFCD and less likely to use FD to
hedge the exposure as the coefficient and marginal effect of quick ratio is significantly positive
for firm that used FCD (Model 1) and significantly negative for firm that used FD (Model 4 and
5). The result contradicting the cost of financial distress theory (Smith & Stulz, 1985). One
possible explanation is that firms with higher level of liquidity have greater ability for using
foreign currency derivatives and might find it unnecessary to have foreign borrowing.

Further, unlike Allayannis & Ofek (2001) and Geczy et al. (1997) the coefficient and marginal
effect for growth opportunities is insignificant, which indicate that investment opportunities are
not an important determinant of FCD usage. Other control variable such as size is significantly
positive related to long term hedging such as swap and FD (Model 2, 4 and 5), while
insignificant determinant for the usage of SHFCD (Model 1). Further, the firm capital structure
measure by leverage and debt ratio is insignificant except for Model 3 and 4.

Overall, the result provides strong support for the first and second hypotheses, that the foreign
currency exposure is an important determinant for firm’s choice among financial hedging
instruments. Further, each financial hedging instrument is a complementary to one another in
managing the currency risk exposure.

38 | P a g e
Table 6: Logit regression estimate the likelihood of using particular financial hedging method.

This table presents the result of Logit regression estimation that relates foreign currency risk factors and the likelihood of firms choose a particular financial
hedging method to hedge by also controlling for other factors consistent with theories of optimal hedging. The coefficients (Coeff.) and marginal effect
(M.E) are estimated using logit regression. The dependent variable is different type of financial hedging instrument category (Finhede) that equals to 1 if
firm provides qualitative disclosure of any particular financial hedging method usage in its annual reports or 0 otherwise. STexp is dummy variable that
equals to 1 if firm indicate any export or import or any repatriation of income from foreign subsidiaries or 0 otherwise. Foreign sales by origin ratio
calculated as foreign sales by origin divided by total sales. Net investment dummy that equals to 1 if firm has net investment in the foreign subsidiary that
has non U.S dollar functional currency. Fdrisk is dummy that equals to 1 if firm has long term borrowing dominated in foreign currency. LNAT is the log of
total assets. Leverage is the book value of total debt and preference capital as a proportion of book value of total debt plus market value of equity. Tdebt is
the total debt divided by total assets. Quick ratio is a ratio of cash and short term investment divided by the current liabilities as of fiscal year end 2006.
DivYield is ratio of cash dividend per share divided by closing price per share as of fiscal year end 2006. Profitability is the ROA ratio defined as earnings
before interest, taxes and dividend (EBITD) divided by total assets. Growthopp is capex ratio calculated by capital expenditure divided by total assets.
TaxDummy is equals to 1 if firm has tax loss carry forward or investment tax credits or 0 otherwise. The data are presented as coefficients (Coeff.) and
marginal effect (M.E). Marginal effect is calculated as the means of independent variable across all observations. The P-Value are at the parentheses,
***,**,* denote the significance at 1%, 5% and 10% levels, respectively.

LOGIT ESTIMATES
Financial Hedging Instrument Choice
Dependent Var: MODEL 1 MODEL 2 MODEL 3 MODEL 4 MODEL 5
SHFCDonly Swap and combination Swaponly FD and combination FDonly

Indipendent Coeff. M.E Coeff. M.E Coeff. M.E Coeff. M.E Coeff. M.E
Var:

STexp 2.382*** 0.482*** 0.000 0.000 0.160 0.009 -0.386 -0.017

(0.000) (0.000) (.) (.) (0.815) (0.805) (0.591) (0.645)
Fsales -1.774 -0.443 0.151 0.023 0.078 0.009 2.806 0.168 3.512 0.140
(0.143) (0.143) (0.918) (0.918) (0.960) (0.960) (0.131) (0.138) (0.115) (0.123)
Netinvestm~) 0.228 0.057 0.059 0.009 -0.389 -0.051 2.424* 0.086*** 1.231 0.036
(0.636) (0.636) (0.921) (0.920) (0.529) (0.562) (0.065) (0.008) (0.347) (0.216)
FDrisk -0.055 -0.014 1.317*** 0.245** 1.038** 0.150* -0.451 -0.024 -2.237* -0.059**
(0.892) (0.892) (0.005) (0.010) (0.036) (0.068) (0.478) (0.443) (0.073) (0.036)
LogAT -0.111 -0.028 0.443** 0.069*** 0.211 0.025 0.628*** 0.038** 0.393* 0.016
(0.425) (0.425) (0.011) (0.009) (0.254) (0.248) (0.003) (0.011) (0.100) (0.118)
Leverage 1.292 0.322 -2.480 -0.385 -5.866** -0.699** 0.142 0.009 -1.028 -0.041
(0.340) (0.340) (0.208) (0.199) (0.048) (0.026) (0.933) (0.933) (0.634) (0.635)
Tdebt -2.328* -0.581* 1.626 0.252 2.762 0.329* 3.035* 0.182* 3.540 0.141

39 | P a g e
 (0.083) (0.083) (0.264) (0.259) (0.121) (0.098) (0.076) (0.081) (0.102) (0.101)
Quickratio 0.606** 0.151** -0.584 -0.091 -0.636 -0.076 -1.277* -0.077** -1.362* -0.054**
(0.020) (0.020) (0.130) (0.108) (0.129) (0.101) (0.060) (0.016) (0.086) (0.037)
DivYield -1.343 -0.335 -9.250 -1.435 -0.271 -0.032 -32.482 -1.949 -27.188 -1.084
(0.937) (0.937) (0.649) (0.647) (0.990) (0.990) (0.210) (0.206) (0.397) (0.392)
Profitabil~y -4.082 -1.019 3.237 0.502 1.485 0.177 3.057 0.183 1.691 0.067
(0.164) (0.164) (0.354) (0.349) (0.675) (0.676) (0.512) (0.510) (0.745) (0.745)
GrowthOpp 7.587 1.894 -8.753 -1.358 -1.424 -0.170 -4.491 -0.269 3.868 0.154
(0.216) (0.216) (0.281) (0.276) (0.857) (0.857) (0.647) (0.649) (0.688) (0.690)
TaxDummy -0.021 -0.005 0.412 0.058 0.776 0.076 -0.258 -0.017 -0.074 -0.003
(0.967) (0.967) (0.545) (0.502) (0.346) (0.238) (0.712) (0.735) (0.933) (0.935)
_cons -0.289 -5.212*** -3.228 -10.628*** -7.884**
(0.849) (0.009) (0.126) (0.000) (0.011)

Log likelihood of -130.14141 -75.200133 -77.21241 -77.357391 -59.338663

constant only
model (Slope=0)
Log likelihood at -109.37837 -76.300091 -67.975156 -62.855177 -49.469311
convergence (full
model)
2 Log likelihood 41.53 25.12 18.47 29.00 19.74
ratio (Chi square)
Pseudo R2 0.1595 0.1413 0.1196 0.1875 0.1663
No observation 188 160 160 188

40 | P a g e
5.2 Multinominal logit regression result
In order to determine the relationship between different types of financial hedging instrument,
this paper also uses the multinomial logit regression to test the probability of firm choose one of
the categories of financial hedging instrument given its exposure type. This multinominal logit
regression is used to confirm the result from the earlier logit regression for the second
hypothesis.

Table 7 below presents the regression result for multinominal logit regression. Similar to earlier
finding, Model 1 shows that for firm hedge with SHFCD only, the STexp is an important
determinant in decision to use forward and options. Consistent with the earlier result, firms
prefer to use SHFCD to hedge the short term exposure. Further, Model 2 shows that for firm
hedge with cross currency swap, the coefficient for FD risk is also positive and significant. This
indicate firm’s preference to use swap in order to hedge long term exposure arising from foreign
borrowing. However, Model 3 and 4 show that for firm’s hedge with FD only or FD in
combination with SHFCD, none of the measures of currency exposure are significant. This
provides evidence that foreign currency exposure is not an important determinant in decision to
used FD, contradicting earlier logit regression result.

Consistent with the earlier result from logit regression, firm size is an important determinant of
swap usage, as the coefficient is significant for firm hedge with swap only and swap combination
(Model 2). However, firm size is also significant for the SHFCD usage (Model 1) and
insignificant for foreign debt usage, contradicting the logit regression result. Further unlike the
earlier findings, the coefficient of quick ratio as measured of liquidity is insignificant for all
models. Although that the magnitude of the coefficient is consistent with the earlier logit
regression results, positively related to choice of SHFCD (Model 1) and negatively related to
choice of FD (Model 3). The remaining results are generally consistent with those reported in
the logit regressions earlier.

Overall, the multinominal logit regression result show mixed evidence on whether a particular
underlying exposure is an important determinant of a particular financial hedging instrument.
Although that the result provide evidence that firm with higher short term exposure arising from
foreign purchase and sale commitment are more likely to use SHFCD while firm with greater

41 | P a g e
exposure arising from foreign borrowing is more likely to choose cross currency swap consistent
with the basis risk theory. But there is no evidence that any particular type of exposure determine
the usage of FD, which contradicts the earlier logit regression result.

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Table 7: Multinominal logit estimate the likelihood of using different foreign currency (FC) hedging method

This table presents the result of a Multinominal logit regression estimate the relation between firm choose one of the four categories of FC hedging method
and proxies for measuring FC exposure and other factors consistent with theories of optimal hedging. The coefficients (Coeff.) are estimated using
multinominal logit regression. The categories of financial hedging method (FinHedge) presented below are expressed relative to decision not to hedge
(group 0). Group 1 is those firms hedge using only short term foreign currency derivatives (SHFCD). Group 2 is those firms hedge using cross currency
swap. Group 3 is that firm hedge using foreign currency debt (FD) but exclude those that used FCD. Group 4 is those firms hedge using both FCD and FD.
Stexp is dummy variable that equals to 1 if firm indicate any export or import or any repatriation of income from foreign subsidiaries or 0 otherwise. Foreign
sales by origin ratio calculated as foreign sales by origin divided by total sales. Net investment dummy that equals to 1 if firm has net investment in the
foreign subsidiary that has non U.S dollar functional currency. Fdrisk is dummy that equals to 1 if firm has long term borrowing dominated in foreign
currency. LNAT is the log of total assets. Leverage is the book value of total debt and preference capital as a proportion of book value of total debt plus
market value of equity. Tdebt is the total debt divided by total assets. Quick ratio is a ratio of cash and short term investment divided by the current liabilities
as of fiscal year end 2006. DivYield is ratio of cash dividend per share divided by closing price per share as of fiscal year end 2006. Profitability is the ROA
ratio defined as earnings before interest, taxes and dividend (EBITD) divided by total assets. Growthopp is capex ratio calculated by capital expenditure
divided by total assets. TaxDummy is equals to 1 if firm has tax loss carry forward or investment tax credits or 0 otherwise. The P-Value are at the
parentheses, ***,**,* denote the significance at 1%, 5% and 10% levels, respectively.

MULTINOMINAL LOGIT ESTIMATES

Dependent Var: Financial Hedging Instrument Choice
MODEL 1 MODEL 2 MODEL 3 MODEL 4
Group 1 Group 2 Group 3 Group 4
SHFCDonly Swap FD only FD and FCD
Indipendent Var:
STexp 4.079*** 21.243 0.971 20.458
(0.000) (0.994) (0.614) (0.997)
Fsales -3.427* -2.421 1.892 -0.512
(0.082) (0.283) (0.758) (0.863)
Netinvestm~k 0.732 0.728 13.656 1.782
(0.330) (0.409) (0.988) (0.222)
FDrisk 0.845 1.933** -13.229 -0.750
(0.297) (0.029) (0.989) (0.602)
LogAT 0.674** 1.085*** 1.010 1.034***
(0.020) (0.001) (0.132) (0.007)
Leverage 0.091 -2.742 1.457 -1.849
(0.963) (0.312) (0.779) (0.552)
Tdebt -1.902 0.584 5.500 1.957
(0.283) (0.764) (0.543) (0.468)
Quickratio 0.630 -0.074 -8.382 -0.450

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 (0.138) (0.895) (0.240) (0.597)
DivYield -9.714 -16.828 -50.180 -21.304
(0.748) (0.624) (0.609) (0.624)
Profitabil~y -4.872 -0.586 15.715 -3.451
(0.281) (0.909) (0.336) (0.622)
GrowthOpp 12.425 2.453 -76.671 16.826
(0.289) (0.855) (0.226) (0.241)
TaxDummy 0.456 0.815 -1.070 1.057
(0.594) (0.431) (0.673) (0.441)
_cons -6.364** -28.657 -23.150 -30.521
(0.022) (0.992) (0.979) (0.995)
Log likelihood of -236.51726
constant only
model (Slope=0)
Log likelihood at -163.00142
convergence (full
model)
2 Log likelihood 147.03
ratio (Chi square
No observation 188

44 | P a g e
5.3 OLS regression
Table 8 presents the result of OLS regression that is used to determine the valuation effect of
financial hedging. Model 1 examines all financial hedging users. The first dependent variable
(LNQ1) is Tobin’s Q is similar to Tobin’s Q measurement used by to Allayannis & Weston
(2001) and Jim & Jorison (2006). The independent variable is financial hedging (Finhedge)
dummy that equals to 1 if firm use any financial hedging instrument to hedge the exposure and 0
otherwise. Model 2 examines only those firm that use FCD, the dependent variable is the FCD
dummy that equals to 1 if firms indicate any forward, options or swap usage and 0 otherwise.

Further, in Model 3 and 4, a firm is only classified as hedger when it satisfies the requirement
made by the FASB 133. This information is available from firm annual reports. The dependent
variable is effective financial hedging dumy (Effective Finhedge) that equals to 1 if firms use
any financial hedging instrument to hedge the exposure and those hedging activities meet the
criteria made by the standard and 0 if firm do not indicate any hedging activity or the hedging
activity do not satisfy the requirement of FASB 133. Further model 4 examines only those firms
that use FCD and satisfy the hedging requirement made by FASB 133 (Effective FCD).

Table 2 Panel F provides details of financial hedging method after controlling for the use of
swap. 33% of the firms use both short term foreign currency derivatives (SHFCD) in
combination long term hedging activity to reduce the exposure. While, 63% use SHFCD only
and further 4% use FD long term hedging only. In order to evaluate the valuation effect of each
hedging method employ by the firm, this paper construct three financial hedging dummies for
those group of firms which equals to 1 for the use of given hedging method and 0 otherwise. A
significant and positive effect for any of this financial hedging dummy would indicate that the
particular financial hedging method create value to the firm. The result is presented in model 5.

Unlike Allayannis & Weston (2001), the result shows that the coefficient of financial hedging
dummy is insignificant. Even after the regression model control for the usage of foreign debt.
The coefficient of finhedge dummy and FCD dummy in model 1, 2 and 3 are insignificant. One
possible explanation for this is due to most of the firm are multinationals, thus they are
geographically diversified. Therefore, the effect of currency exposure reduces when the firms are
more geographically diversified. However, after controlling for the usage of foreign debt and

45 | P a g e
effectiveness criteria under FASB 133, Model 4 shows that the coefficient of foreign currency
derivatives dummy is significant. The FCD dummy generates a value increase by around 8.5%.

Further, model 5 evaluates the valuation effect of each hedging method employed by the firms
and show that the coefficient of short term foreign currency derivatives (SHFCD) is positive and
significant related to firm value. Which indicate that the use of forwards and options create firm
value. The SHFCD generate a value increase by around 8.2%. The hedging premium reported in
this paper is higher than hedging premium reported by Allayannis & Weston (2001) that find the
usage of FCD increases total firm value as much as 4.8 percent on average and Nain (2004) that
also show that FCD increases value of the firm by 5% on average. The higher hedging premium
is consistent with the argument that due to the implementation of FASB 133, investors have
better information to determine the effectiveness of hedging activity employed by the firms.
Model 5 further shows that none of other financial hedging methods affect the firm value as the
coefficient for firm that used SHFCD in combination with FD or for firms that used FD only are
insignificant. This indicate that investors do not find the positive signal from using foreign
borrowing and thus the multi hedging strategy (combination of FCD with FD) employed by the
firms are not seen as effective way for managing risk by investors. The potential explanation is
that, although that investors have better information due to the new accounting requirement, the
disclosure for non-derivative hedging activity (foreign borrowing) is generally less transparent as
compare to the derivatives used, thus make it difficult for investors to distinguish between
borrowing that designed for hedging or for other financial activities of the firms.

Further, the coefficient for all measures of risk exposure, except for the net investment risk
variable is negative although that none of them are significant. This consistent with the
implication that currency exposure decreases firm value. Further, most of the control variable
appears to be significant except for firm size variable. The coefficient of profitability (ROA) is
positive and significant in all regression models, consistent with Allayannis & Weston (2001).
Although that the coefficient of dividend dummy and growth opportunity is negative and
significant, contradicting the result from earlier literatures.

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The results do not change after this paper use different measurement of Tobin’s q following
Carter et al. (2002) and Chung & Pruitt (1994). In model 9 and 10, the coefficient of FCD
dummy (Model 9) and SHFCD (Model 10) remain positive and significant, and generate the
value increase by around 11.4% and 12.9%.

Overall, this paper do not find evidence that FCD increase firm value, the result contradict the
earlier empirical researches (Allayannis & Weston, 2001; Nain, 2004). Consistent with this, the
paper also finds no evidence that the usage of FCD in combination with FD contribute to firm
value. Only after controlling for the usage of foreign debt and hedge effectiveness criteria under
FASB 133, this paper finds that the usage of FCD generate a value increase by around 8.5%-
11.2%. The hedging premium reported in this paper is higher than hedging premium reported by
earlier studies such as Allayannis & Weston (2001). Therefore, invetsors only reward those
derivative users that meet the requirement under FASB 133.

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Table 8: OLS regression for firm value test

This table presents the result of OLS regression on the effect of particular financial hedging method on firm’s market value. The coefficients (Coeff.) are
estimated using OLS regression. The dependent variable is the various proxies for Tobin’s q. For Q1 the numerator is the book value of total assets minus
the book value of common equity plus the market value of common equity. The market value of equity is calculated as of the calendar year end. For Q2 the
numerator is calculated as the sum of market value of equity plus liquidation value of preferred stock plus the book value of long term debt and current
liabilities minus the current liabilities and plus book value of inventory. The denominator is the book value of total assets. Financial hedging (Finhedge)
equals to 1 if firm use any financial hedging instrument to hedge the exposure and 0 otherwise. FCD dummy equals to 1 if firm indicate any forward, options
or swap usage and 0 otherwise. The effective Finhedge and FCD dummy are those firm that indicate their hedging activity satisfy the hedging requirement
under FASB 133 in the annual report. Group 1 is those firms hedge using only short term foreign currency derivatives that exclude swap users (SHFCD).
Group 2 is those firms hedge SHFCD and FD. Group 3 is that firm hedge using foreign currency debt (FD) only. The categories of Financial hedging
method (Finhedge) presented below are expressed relative to decision not to hedge (group 0). Stexp is dummy variable that equals to 1 if firm indicate any
export or import or any repatriation of income from foreign subsidiaries or 0 otherwise. Foreign sales by origin ratio calculated as foreign sales by origin
divided by total sales. Net investment dummy that equals to 1 if firm has net investment in the foreign subsidiary that has non U.S dollar functional currency.
Fdrisk is dummy that equals to 1 if firm has long term borrowing dominated in foreign currency. LNAT is the log of total assets. Leverage is the book value
of total debt and preference capital as a proportion of book value of total debt plus market value of equity. Tdebt is the total debt divided by total assets.
Quick ratio is a ratio of cash and short term investment divided by the current liabilities as of fiscal year end 2006. DivYield is ratio of cash dividend per
share divided by closing price per share as of fiscal year end 2006. Profitability is the ROA ratio defined as earnings before interest, taxes and dividend
(EBITD) divided by total assets. Growthopp is capex ratio calculated by capital expenditure divided by total assets. The P-Value are at the parentheses,
***,**,* denote the significance at 1%, 5% and 10% levels, respectively.

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 OLS REGRESSION
Dependent Var: TOBIN’S Q
LN(Q1) Q2
Indipendent Var: Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8 Model 9 Model 10

Finhedge 0.013 0.049

Dummy
(0.811) (0.717)
FCD Dummy 0.042 0.122
(0.494) (0.404)
Effective 0.063 0.123
Finhedge
Dummy
(0.136) (0.227)
Effective FCD 0.085* 0.173*
Dummy
(0.058) (0.078)
Group 1 0.082* 0.172 *
(0.078) (0.089)
Group 2 0.019 -0.009
(0.792) (0.957)
Group 3 0.062 0.137
(0.484) (0.518)
STexp 0.001 -0.022 -0.031 -0.057 -0.041 -0.027 -0.088 -0.076 -0.132 -0.099
(0.982) (0.744) (0.571) (0.335) (0.483) (0.850) (0.578) (0.564) (0.351) (0.484)
Fsales -0.088 -0.080 -0.084 -0.076 -0.083 -0.256 -0.234 -0.252 -0.235 -0.246
(0.469) (0.511) (0.484) (0.526) (0.493) (0.380) (0.423) (0.383) (0.415) (0.395)
Netinvestm~k 0.009 0.007 0.010 0.011 0.015 0.093 0.089 0.097 0.100 0.112
(0.852) (0.880) (0.837) (0.815) (0.759) (0.422) (0.441) (0.400) (0.386) (0.335)
FDrisk 0.000 -0.003 -0.004 -0.007 -0.007 -0.107 -0.115 -0.113 -0.120 -0.120
(0.993) (0.950) (0.931) (0.865) (0.871) (0.292) (0.258) (0.263) (0.232) (0.240)
LogAT 0.023 0.022 0.020 0.019 0.022 0.021 0.017 0.016 0.014 0.021
(0.112) (0.134) (0.165) (0.179) (0.128) (0.548) (0.616) (0.642) (0.680) (0.538)
Leverage -0.803*** -0.801*** -0.791*** -0.784*** -0.780*** -1.463*** -1.456*** -1.440*** -1.425*** -1.410***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Tdebt 0.497*** 0.502*** 0.489*** 0.492*** 0.497*** 1.104*** 1.117*** 1.087*** 1.092*** 1.105***

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 (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Quickratio 0.034* 0.033* 0.037** 0.038** 0.038** 0.048 0.045 0.056 0.057 0.058
(0.069) (0.078) (0.044) (0.040) (0.040) (0.277) (0.305) (0.208) (0.195) (0.194)
DivYield -4.249** -4.235** -3.964** -3.965** -3.929** -12.694*** -12.675*** -12.194*** -12.166*** -12.083***
(0.012) (0.012) (0.018) (0.018) (0.020) (0.002) (0.002) (0.003) (0.003) (0.003)
Profitabil~y 3.723*** 3.739*** 3.707*** 3.716*** 3.717*** 10.016*** 10.059*** 9.977*** 9.993*** 10.000***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
GrowthOpp -1.153** -1.189** -1.127** -1.150** -1.114* -2.127 -2.226 -2.059 -2.103 -2.028
(0.045) (0.040) (0.048) (0.043) (0.051) (0.122) (0.107) (0.132) (0.123) (0.138)
_cons 0.036 0.041 0.051 0.058 0.022 0.256 0.270 0.281 0.298 0.206
(0.795) (0.767) (0.715) (0.674) (0.874) (0.443) (0.419) (0.399) (0.371) (0.542)
R2 0.6901 0.6908 0.6939 0.6963 0.6967 0.6989 0.6999 0.7012 0.7031 0.7048
Adj R2 0.6688 0.6696 0.6729 0.6755 0.6722 0.6783 0.6793 0.6807 0.6828 0.6809
No. observation 188 188 188 188 188 188 188 188 188 188

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6. Conclusion

FASB issued Statement no. 133, “Accounting for Derivative Instruments and Hedging
Activities” that mandated for fiscal years beginning 2000. Due to the implementation of FASB
133, disclosure for hedging and derivative instrument in 2006 becomes more transparent. By
using more recent and clearer data in the analysis of hedging behavior in US, this paper argues
that there are other factors besides those that conform to the optimal hedging theory, which also
influence the firm hedging behavior. Specifically, this paper examines whether the currency
exposure itself that influence firm’s choice among financial hedging instruments. The argument
is based on the basis risk theory that highlights the importance of understanding and matching
the characteristics of currency exposure and the hedging instruments. This paper used various
measures of currency exposure with different characteristics in order to distinguish between each
financial hedging instrument. By using logit regression, this paper finds that various proxy of
currency exposure is positively and significantly associated with a particular type of financial
hedging instruments. Therefore, the result is consistent with the hypothesis that the currency
exposure is an important determinant of firm’s choice among various types of financial hedging
instrument. Further, the results also provide evidence that each financial hedging instrument is a
complement to one another. The results remain robust after the multinominal logit regression
model used to test the hypothesis.

Unlike those earlier empirical researches that find positive relationship between the usage of
FCD and firm value, this paper does not find evidence that FCD increase firm value. Consistent
with this, the paper also find no evidence that the usage of FCD in combination with FD
contribute to firm value. One possible explanation for this is that those manufacturing firms are
diversified geographically, thus the usage of financial hedging is not found to be beneficial to
firm when firm is more geographically diversified.

Interestingly, only after controlling for the usage of foreign debt and hedge effectiveness criteria
under FASB 133 this paper finds that the usage of FCD generate a value increase by around
8.5%. The hedging premium reported in this paper is higher than hedging premium reported by

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earlier studies such as Allayannis & Weston (2001). This might due to the implementation of
FASB 133 that provides better information to investors in order to evaluate the effectiveness of
hedging activity. Therefore, investors only reward those derivative users that meet the
requirement under FASB 133.

The results provide important implication for the organizations especially for those
manufacturers that have high level of foreign activities. Foreign exchange risk affected the firms
differently depending on their involvement in foreign activity; therefore it is rationale to expect
that exposure factors find to be important for company hedging activity, consistent with the
result found in this paper. Therefore performing sensitivity analysis in continuous basis in order
to determining what would happen to the cash flow if one currency falls or rises against another
currency as well as having timeframe for receivable and payable, are example of consideration
that should be made by the manager or CFO of the firms before choosing the financial
instrument to be used and designed the overall hedging strategy of the firms. The size and the
maturity of the exposure should correspond to the characteristics of the instrument in order to
minimize the hedge ineffectiveness. Especially with the tighter regulation in hedging and
derivative instrument made by the accounting standard bodies, that provide necessity for firms to
have routine sensitivity analysis.

The relationship between each financial hedging instrument indicates that in practice, there is a
possibility of multi hedging activities. However, despite the usefulness of FD, the usage of FD is
not rewarded by higher value by the investor. One possible explanation might due to investors do
not find any positive signal associated with the issuance of long term borrowing. Therefore,
similar to the usage of FCD, it is also important for company to be more transparent in their
usage of foreign debt so that investors are better informed on the purpose of the debt, whether it
used as a hedging or borrowing for investing activity

The results also provide important implication for the annual report users that using the
derivative and financial hedging instrument disclosure. Lack of disclosure on currency exposure
and higher portion of firm’s hedge ineffectiveness might as well indicate the speculative reason
of using the financial instrument rather than hedging purpose. Therefore, in this case, it is
important for the annual report users to be aware that not all hedging benefit the shareholders.

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The result also provide important implication for the accounting standard bodies, as the new
accounting standard might have influence on the hedging behavior of the firms. Higher and more
complicated requirement provide better information for investors but at the same time it might
cause firms to limit the usage of hedging, therefore might have negative influence on cash flow
and eventually shareholder value.

Lastly, this paper is exposed to various limitations. Firstly, the sample selection criteria limit the
sample into non-oil related manufacturing industry, However, foreign exchange risk affected the
firms differently, the same firm in different industry might affected differently to exchange rate
risk depend on their level of foreign involvement. Therefore it is always interesting to see how
the result might be differ by including firm from different industrial background and to have
comparison of hedging behavior between different industry.

Secondly, the results of this paper omit other factor such as industry diversification and
competition in the industry that might as well affect the choice among particular hedging
instrument. The omitted variables that are outside the scope of this paper provide opportunity for
future research. For example, firm in the industry where the majority is hedger will have greater
incentive to use FCD despite their level of currency exposure.

The valuation effect of financial hedging contradict the earlier findings made by Allayannis and
Weston (2001). As mentioned earlier one possible argument is the financial hedging become less
beneficial when the firm is more geographically diversified. This provides opportunity for future
researches in the currency hedging field.

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