Currency derivatives for hedging: New evidence on determinants, firm risk, and performance

• Author: Hyeon Sook Kim,Taek Ho Kwon,Sung C. Bae
• Published date: 01 April 2018
• Date: 01 April 2018
• DOI: http://doi.org/10.1002/fut.21894

Received: 15 October 2017

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Accepted: 17 October 2017

DOI: 10.1002/fut.21894

RESEARCH ARTICLE

Currency derivatives for hedging: New evidence

on determinants, firm risk, and performance

Sung C. Bae

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Hyeon Sook Kim

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Taek Ho Kwon

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Department of Finance, College of

Business, Bowling Green State University

in Bowling Green, Bowling Green, Ohio

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School of Business, Chungnam National

University in Daejon, Daejon, Korea

Correspondence

Sung C. Bae, Department of Finance,

College of Business, Bowling Green State

University, Bowling Green, OH 43403.

Email: bae@bgsu.edu

Employing firm-level data for Korean firms, we find that firms with more export,

more foreign currency debt, and higher exchange rate exposures are likely to use more

currency derivatives for hedging. 2SLS regressions reveal that as more currency

derivatives use does not lead to lower firm risk, such transactions, especially sell

transactions, bring in higher firm values. Further, currency derivatives use by firms

with high exposures is associated with lower firm risk but lower firm values as well.

These findings suggest that currency derivatives work in hedging risk and protecting

values for firms with low and manageable exposures.

KEYWORDS

currency derivatives, determinants, firm risk and performance, hedging, Korean firms

JEL CLASSIFICATION

F31, G15

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INTRODUCTION

Corporate management of foreign exchange rate exposure generally involves financial activities as well as operating activities.

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The financial activities for hedging include currency derivatives, financings through foreign-currency (FC, hereafter)

denominated debt, and internal transactions with foreign subsidiaries, among others. Existing studies offer mixed evidence on

the effectiveness of currency derivatives. As several studies show positive hedging effects of financial derivatives (e.g.,

Allayannis & Ofek, 2001; Allayannis & Weston, 2001; Bartram, Brown, & Conrad, 2011; Bartram, Brown, & Minton, 2010;

Clark & Judge, 2009; Graham & Rogers, 2002; Guay, 1999), other studies cast doubt on their effectiveness in exposure

management (e.g., Bali, Hume, & Martell, 2007; Guay & Kothari, 2003; Hentschel & Kothari, 2001).

In this paper, we revisit the current literature on currency derivatives by exploring two pertinent issues to the usage of

currency derivatives for hedging: (i) What firm-specific factors influence the different level of currency derivatives use; and (ii)

whether hedging with currency derivatives reduces firm risk and enhances firm performance.

First, we examine what firm attributes contribute to the usage of currency derivatives for hedging. As the degree of a firm's

hedging need would depend on various firm attributes such as levels of FC income and payment, positions of FC assets and

liabilities relative to domestic-currency assets and liabilities, the extent of exporting and importing activities, FC borrowing,

foreign exchange risk, we differentiate buy and sell transactions of currency derivatives and examine how firm-specific factors

are related to each of these transactions. In this analysis, we further compare the determinants of currency derivatives use among

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Operating activities for managing exchange rate exposure include domestic-currency invoicing, matching and offsetting, and exchange rate pass-through,

among others.

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firms with different levels of exchange rate exposure. Existing studies show that firms with greater foreign exchange rate

exposures are more likely to use currency derivatives (e.g., Bae & Kwon, 2013; Geczy, Minton, & Schrand, 1997).

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As our

dataset enables us to measure the expected exchange rate exposure which reflects inherent exchange rate risk associated with

firms' business activities prior to the usage of hedging tools and thus differentiate firms with different levels of the expected

exchange rate exposure, we are able to make new inferences about the nature of hedging activities with currency derivatives for

our sample firms. We use this classification to investigate how firm characteristics explain the currency derivatives use for

hedging.

Second, we investigate the effects of hedging with currency derivatives on firm risk and performance. The effectiveness of

hedging with currency derivatives rests on two aspects of outcome. The first one is the risk management aspect of whether the

usage of currency derivatives lowers exchange rate exposures associated with variabilities of cash flows and stock returns. The

second one is the firm performance aspect of whether this hedging activity affects firm performance and value positively through

the reduced firm risk. In order to assess the effectiveness of hedging with currency derivatives, it is crucial to examine both

aspects of hedging activities in a coherent manner.

Our paper focuses on firms in manufacturing and service industries in Korea, one of the premier developing countries, for

empirical evidence. Korean firms have long depended on international trades and foreign capital over the last decades, which

have made their firm values highly sensitive to exchange rate changes. In addition, the current accounting system has also

contributed to the exchange rate exposure of Korean firms as it requires firms to report the translation gains and losses in asset

values associated with exchange rate changes in the concurrent year's balance sheets. Consequently, with larger swings in the

exchange rates, Korean firms have had much greater needs to manage their exchange rate risk than ever. It is well documented

that Korean firms employ various hedging tools including currency derivatives products (see, e.g., Jung & Kwon, 2007). In this

regard, Korean firms are ideal research targets for the examination of the effectiveness of currency derivatives for hedging.

Our firm-level data over the period of 2005–2010 reveal that sample Korean firms on average engage in the transactions of

currency derivatives equivalent to 3.75% of total assets and are more geared to hedge long positions, or receipts, of FCs by taking

short positions in currency forwards. Our regression results show that firms with a higher export ratio, more FC debt, and higher

exchange rate exposure are likely to use more transactions of currency derivatives, but firms with a higher import ratio, more

intra-firm transactions with foreign subsidiaries are likely to engage in less transactions of currency derivatives. Our results also

show that firms tend to take more short positions of currency derivatives when they have less intra-firm transactions with foreign

subsidiaries but take more long positions when they have more FC debt.

After controlling for possible endogeneity issues, our 2SLS regression analyses show that although more usage of currency

derivatives by Korean firms does not lead to lower firm risk, such transactions, particularly sell transactions, bring in higher

market-based firm values measured by Tobin's q and industry-adjusted q. Our results further show that currency derivatives use

by firms with high exchange rate exposures is associated with lower firm risk but also with low firm value, indicating that the

lower firm risk resulting from hedging with currency derivatives for firms with high exposures is not materialized into higher

firm value. This evidence may be attributed to the mismanagement of hedging strategies either due to the implementation of non-

optimal hedges (e.g., under- or over-hedges) or due to the excessive costs associated with hedging. The flipped side of this

evidence is that when firms have relatively low and manageable exchange rate exposures, currency derivatives work as an

effective tool in hedging foreign exchange risk and protecting firm values. A robustness test using market-based risk-adjusted

performance measures offers confirmatory evidence on the positive, though weak, effect of currency derivatives use on firm

performance.

Our paper is organized as follows. section 2 reviews related studies and presents main research issues of our paper. Section 3

presents the research design and data including regression models to investigate the two main research issues. Section 4 reports

empirical results, with the summary and conclusion in section 5.

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LITERATURE REVIEW AND MAIN RESEARCH ISSUES

Although there is evidence supporting that firms use currency derivatives for hedging purposes, not for investing or speculating

purposes,

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extant studies offer mixed evidence on the effectiveness of currency derivatives in reducing foreign exchange risk. In

a study of S&P 500 non-financial firms, Allayannis and Ofek (2001) report that the usage of currency derivatives reduces

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Geczy et al. (1997) show that firms with greater growth opportunities, tighter financial constraints, and economies of scale in hedging activities are also

more likely to use currency derivatives.

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See, for example, Allayannis and Ofek (2001) and Brown (2001).

BAE ET AL.

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