The choice of hedging techniques and the characteristics of UK industrial firms

Transcription

1 Journal of Multinational Financial Management 10 (2000) The choice of hedging techniques and the characteristics of UK industrial firms Nathan Lael Joseph * Manchester School of Accounting and Finance, Uni ersity of Manchester, Manchester M13 9PL, UK Received 8 August 1998; accepted 15 April 1999 Abstract This study presents the empirical results for the relationship between the use of hedging techniques and the characteristics of UK multinational enterprises (MNEs). All the firms in the sample hedge foreign exchange (FX) exposure. The results indicate that UK firms focus on a very narrow set of hedging techniques. They make much greater use of derivatives than internal hedging techniques. The degree of utilisation of both internal and external techniques depends on the type of exposure that is hedged. Furthermore, the characteristics of the firms appear to explain the choice of hedging technique but the use of certain hedging techniques appears to be associated with increases in the variability of some accounting measures. This adverse impact of hedging has not been emphasised in the finance literature. The results imply that firms need to ensure that the appropriate techniques are used to hedge exposures Elsevier Science B.V. All rights reserved. JEL classification: F23; F30; G10 Keywords: Multinational enterprises; Foreign exchange exposure; Hedging techniques 1. Introduction Most theoretical studies that seek to explain why industrial firms hedge exposure focus on differences in the financial characteristics of users and non-users of hedging techniques 1. The empirical work which seeks to test the theoretical predic- * Tel.: address: nathan.joseph@man.ac.uk (N.L. Joseph) 1 For a review of the literature see Levi and Sercu (1991), Nance et al. (1993) and Joseph and Hewins (1997) X/00/$ - see front matter 2000 Elsevier Science B.V. All rights reserved. PII: S X(99)

2 162 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) tions takes a similar focus. However, the findings for certain hypothesised relationships are often weak in both univariate and multivariate statistical tests (see Dolde, 1993; Nance et al., 1993). One possible explanation for the weak empirical results of certain theoretical predictions relates to research design. For example, to identify US industrial firms as hedgers (users) and non-hedgers (non-users), both Nance et al. (1993) and Dolde (1995) used a questionnaire survey which required respondents to indicate whether or not they use one (or more) of four currency derivatives, i.e. forward, futures, swap and/or option contracts. In contrast, Berkman and Bradbury (1996) choose to categorise the firms in their study in terms of the hedging information contained in their audited financial reports (see also Francis and Stephan, 1993; Geczy et al., 1997). Since firms are only required to disclose exposure information if such information is material, this latter approach may not fully capture the hedging activities of firms. However, both approaches seem restrictive since firms use a wide range of internal and external techniques (including derivatives) to hedge foreign exchange (FX) and interest rate exposures (see Stanley and Block, 1980; Khoury and Chan, 1988). Furthermore, some firms may not hedge simply because they have no exposure while others may not hedge or partially hedge depending on their perception about FX rate behaviour and/or their confidence in using derivatives (see Dolde, 1993). These considerations therefore have important implications for the empirical results of prior studies. This study seeks to provide additional insights into the hedging behaviour of UK firms by focusing on: (i) the degree of utilisation of a broad set of hedging techniques; (ii) the maturity structures of those hedging techniques; and (iii) the sources or types of exposures that are hedged. Those aspects are examined because firms are known to make use of a wide range of techniques when hedging exposure and to exercise substantial flexibility in hedging decisions (see Hakkarainen et al., 1998). Although newer financial innovations can reduce the demand for traditional types of hedging techniques (see Tufano, 1995), empirical evidence indicates that firms are not very receptive to the newer and more complex types of derivatives. This is because firms are concerned about the banks commitment to those products and their ability to provide real solutions to exposure problems (see Fairlamb, 1988; Glaum and Belk, 1992). Furthermore, managers can always adjust their hedging decisions to reflect their expectations of changes in financial prices. Thus, if the forward rate is a biased predictor, managers can alter their hedging strategies to accommodate this effect. Here, a partial or no hedge or fully hedged strategy can be optimal for both transaction and economic exposures (see Berg and Moore, 1991; Schooley and White, 1995). Since firms tend to place more emphasis on transaction exposure than on economic and translation exposures (Khoury and Chan, 1988; Joseph and Hewins, 1991), their use of hedging techniques may reflect the types of exposures they hedge. An examination of a broad set of hedging techniques is also warranted since in certain situations, the use of some techniques can give rise to adverse

3 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) effects 2. For example, the use of both forward and futures contracts to hedge translation exposure can give rise to economic (cash flow) gains/losses which are not off-set by losses/gains from the underlying exposure. Giddy and Dufey (1995) (p. 51) also show that FX options are not ideal hedging instruments for corporations since the gains/losses which arise from their use are not linearly related to changes in the value of the currency, thereby, increasing the variability of the firm s real cash flow. But forward contracts can only hedge economic exposure optimally if managerial decisions regarding inputs and outputs are fixed; otherwise, FX options may be more appropriate (see Ware and Winter, 1988). In the absence of default, the use of forward contracts to hedge transaction exposure does not result in any gain or loss. However, both (long-term) economic and translation exposures tend to have maturities which exceed those of FX forward, futures and option contracts (see also Neuberger, 1996) such that a mis-match of the cash flows from the derivatives and the gain/loss from the underlying exposures will arise. Further, because of basis risk, a one-to-one hedge ratio can increase the variability of the firm s cash flow if short-dated futures contracts are used to hedge (see Mello and Parsons, 1995). Firms can also hedge with internal techniques, such as, leads and lags which do not give rise to the maturity problems of external techniques. In this case, the impact on the financial measures would depend on the hedging effectiveness of the internal techniques that are used. Finally, Glaum and Belk (1992) also examined the use of hedging techniques of 17 UK firms but they did not link the degree of usage to the characteristics of their firms. This present study focuses on a much larger sample of UK firms across a broader set of hedging techniques. The degree of utilisation is also linked to the characteristics of the firms. The remaining sections of this study are as follows: Section 2 describes the theoretical framework and the research methodology. The empirical measures are also described and the hypotheses are formulated in that section. Section 3 presents the empirical results. The results are summarised and their implications are evaluated in the Section Background 2.1. Theoretical framework for the use of hedging techniques To construct the theoretical framework for this study, we rely on existing work which suggests that firms hedge to reduce: (i) the agency problem (Bessembinder, 1991); (ii) effective corporate taxes (Smith and Stulz, 1985); (iii) risk aversion 2 The recent case of Metallgesellschaft (see Financial Times, 16th November 1994) arguable, illustrates the inappropriate use of futures and swap contracts to hedge economic exposure and the associated adverse effects of their use on leverage and liquidity. In theory, the FX futures price is a biased predictor of the realised spot price. Under risk neutrality, the amount of bias depends on the covariance between the reinvestment rate premium and the realised spot rate. Under risk aversion, the amount of the bias depends on three premia terms. (see Tucker, 1991, pp ).

4 164 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) among managers and other contracting parties (Stulz, 1984); (iv) the probability of financial distress (Smith and Stulz, 1985), and (v) the adverse information content of earnings (DeMarzo and Duffie, 1995). The theoretical explanations identify those incentives for hedging which are likely to benefit contracting parties. However, hedging might not benefit all parties equally and therefore the hedging strategies of firms will vary (see e.g. Tufano, 1996). In theory, shareholders can implement terms of compensation which limit both the incentive to hedge and the choice of hedging technique Sources of data To obtain measures of the degree of utilisation of internal and external hedging techniques, a questionnaire survey was mailed to either the finance director or the corporate treasurer 4 of UK (industrial) multinational enterprises (MNEs) during October Two hundred and ten firms were targeted within the top 300 category of The Times 1000: 1994 (hereafter The Times) companies. The MNEs were all quoted on the London International Stock Exchange. A total of 109 responses were obtained, of which 75 were satisfactorily completed (11 are anonymous). The response rate (35.71%) compares favourable with those of other related studies (see Nance et al., 1993). The firms in our sample are typically large. Their 5-year average sales value (sample size, N=64) to 1994 is million (US$ million). Also, 76.56% of the firms are quoted in The Times top 200 category. On average, the firms hedged between 61 and 70% of their global exposure (N=68) and they generated between 41 and 50% of their total sales (N=74) overseas. In addition to the firms total sales, other financial data was obtained for the non-anonymous firms from the Datastream. This data set spans five financial year-ends to 1994 for most of the firms Internationalisation measures A firm s degree of internationalisation can affect the extent to which it uses hedging techniques (see Mathur, 1985). Since firms appear to initially use internal techniques to hedge exposure (see Hakkarainen, et al., 1998), a positive relationship is expected between the measures of internationalisation and the degree of utilisa- 3 Recent evidence indicates that institutional investors are attempting to monitor and control the operations of firms. Gaved (1997) reports that UK institutional investors can instigate change when the firm s performance is not consistent with their expectations. Smith (1996) also provides evidence on the success of US institutional investors the California Public Employees Retirement System (CaLPERS) who were able to ensure that targeted firms adopt specific performance-related resolutions. 4 The degree of utilisation was requested for each type of exposure. To save space, the hedging techniques and the types of exposures are not specifically defined here. McRae and Walker (1980) provide useful definitions of some of the techniques and how they can be used for hedging. Also, this study adopts the standard definitions of exposures that are found in the finance literature (see McRae and Walker, 1980). A copy of the questionnaire survey as well as the statistical results that are not fully presented can be obtained from the author.

5 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) tion of internal techniques. In contrast, a negative relationship is expected between the rate of utilisation of external techniques and the internationalisation measures since the greater use of internal techniques implies less use of external techniques. To measure the degree of internationalisation, 5 the following measures are used: (i) the number of foreign countries in which the group operates (NCOUNT); (ii) the number of foreign subsidiaries within the group (NSUBS); (iii) the percentage of the groups total sales that is generated overseas (PERSALE); and (iv) the percentage of the groups global exposure that is hedged (PERHEDGE). These measures also proxy for the effects of the firm s size and scale economies on the choice of the hedging technique used (see Shirreff, 1994) Financial measures Smith and Stulz (1985) suggest that hedging can reduce the potential for financial distress by reducing the variability of certain financial measures. But the choice of the hedging instrument can increase the variability of the firms cash flow. Firms that make greater use of: (i) foreign currency borrowing/lending; (ii) cross-currency interest rate swaps; and (iii) foreign currency swaps are expected to exhibit greater variability on cash flow, liquidity and leverage. The cash flow and liquidity measures are the coefficient of variation of: (i) gross cash flow to market value (GCASHMV); (ii) cash and marketable securities to market value (CASHMV); (iii) quick asset ratio (QAR); and (iv) working capital ratio (WCR). The leverage measures are the coefficient of variation of: (i) interest charges to operating and non-operating income (IGEAR); (ii) preference capital and total borrowing to total capital employed (CGEAR); (iii) total borrowing to ordinary shareholders equity plus reserves (TLBOR), and (iv) long-term borrowing to market value (LT- BORMV). Since foreign currency borrowing can increase the probability of financial distress, firms with greater variability in their leverage measures are expected to make greater use of internal techniques. Hedging can also mitigate the under-investment problem by reducing both the cost of external funds and the firm s dependence on external finance (Froot et al., 1993). In the absence of hedging, the greater the growth opportunities of the firm the more it will depend on external finance. Thus firms are more likely to hedge the greater their growth options (Lessard, 1991). Since the returns from growth options are likely to have long leads, firms with more variability in their growth options are expected to make greater use of internal hedging techniques thereby reducing the adverse cash flow impacts of derivatives and the associated default risk. This 5 The measures of internationalisation were provide by our respondents as part of their responses to the same questionnaire survey. The aggregate index of the degree of internationalisation of Sullivan (1994) was not applied because there were insufficient variables to implement it (see Ramaswamy et al., 1996, for a critique). However, PERSALE and NSUBS which are used in the study are contained in Sullivan s index in one form or another. Also, no information was requested about operational hedges such as, currency sourcing of inputs/outputs and the relocation of operating facilities. Both anecdotal evidence (see Lewent and Kearney, 1990; Dolde, 1993) and current thinking (see Glaum, 1990) suggest that the transaction costs that are associated with those hedging strategies are likely to outweigh the potential benefits of the hedge.

6 166 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) relationship is tested by using the coefficient of variation of: (i) sales to market value (SALESMV); (ii) the firm s book value to its market value (BOOKMV); and (iii) dividend yield. Here, a negative relationship between the degree of utilisation of derivatives and our growth option measures is expected. Following DeMarzo and Duffie (1995), high quality managers are more likely to hedge. But the choice of hedging technique and the type of exposure that is hedged can reflect managers perceptions of the economic effects of hedging. Titman (1992) also shows that a firm that has an optimistic outlook can use interest rate swaps to benefit from borrowing and the expected cost of financial distress will not increase. Thus a positive relationship is predicted between the use of cross-currency interest rate swaps and variability of the leverage measures. The tax treatment of both the exposure and the hedging technique can have important implications for the firm s hedging strategy (see Kramer et al., 1993). Under UK tax laws, the use of derivatives to hedge translation exposure may give rise to cash flow gains which are taxable and losses which are not tax allowable (see Buckley, 1992). To avoid the adverse impacts of asymmetry in taxation, firms are likely to place more emphasis on internal techniques when hedging translation exposure. The use of forward contracts to hedge the transaction exposure emanating from re enue transactions, results in taxable/tax allowable gains and losses in the UK. All those impacts will in turn affect the level of profitability. Assuming that the tax credits can be utilised, a lower degree of variability is expected on the tax measures for firms that use forward contracts to hedge transaction exposure. The tax and profitability measures are the coefficient of variation of: (i) tax charge on profit/loss to pre-tax profit/loss (TAXRATIO); (ii) tax charge on profit /loss to market value (TAXMV); (iii) operating profit to sales (OPM); and (iv) trading profit to sales (TPM). The terms of managers and employees compensation plans can also impact on the choice of hedging technique (see Smith, 1993). Managers will use those derivatives, e.g. FX options, which increase the volatility of the firm s stock price if a large part of their compensation is in the form of stock options. Following Smith and Stulz (1985) a positive relationship is expected between both managers and employees wealth and the extent to which the firms use derivatives, particularly when hedging economic and translation exposures. The measures of wealth are the coefficient of variation of: (i) directors remuneration to market value (DIRECMV); (ii) employees remuneration to market value (EMPMV); and (iii) BOOKMV. The predictions are further summarised in Appendix A. 3. Empirical results 3.1. Some general results Since the firms are large, one would expect them to make much greater use of internal hedging techniques than external techniques. Further, much greater use of internal techniques would be expected because of the transaction cost, biased pricing, default risk, etc. (see Riehl and Rodriguez, 1977) that are associated with

7 Table 1 Summary statistics for the extent to which hedging techniques are used by the firms a Hedging techniques Transaction exposure Economic exposure Translation exposure Percentage rating Percentage rating Percentage rating N Mean 1 3 N Mean 1 3 N Mean 1 3 Panel A. The degree of utilisation of internal hedging techniques by type of exposure (a) Leads and lags (b) Matching inflows and outflows with respect to timing of settlement (c) Inter-company netting of foreign receipts and payments (d) Domestic currency invoicing (e) Adjustment clause in sales contract (f) Asset/liability management (g) Transfer pricing agreements Panel B. The degree of utilisation of external hedging techniques by type of exposure (a) Foreign currency borrowing/lending (b) Forward exchange contracts (c) Foreign exchange options (d) Foreign exchange futures (e) Factoring bills receivable (f) Cross-currency interest rate swaps (g) Foreign currency swaps (h) European currency unit (i) Special drawing rights (j) Other currency blocs (k) Government exchange risk guarantee, e.g. ECGD a The summary statistics relate to the scores obtained on a 3-point scale where 1 denotes not used; 2 denotes occasionally used; and 3 denotes frequently used. N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000)

8 168 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) external techniques. Table 1 shows that the degree of utilisation of internal and external hedging techniques varies with the type of exposure 6. However, there is preliminary evidence to suggest that the firms place more emphasis on certain external techniques a finding which has been noted elsewhere (see McRae and Walker, 1980, p. 101). In particular, Panel A shows that inter-company netting and domestic currency invoicing (in that order) are the most commonly used techniques when hedging transaction exposure. Matching inflows/outflows and asset/liability management are respectively the most commonly used techniques when hedging economic and translation exposures. Evidence from Khoury and Chan (1988) shows that matching is the most popular internal technique used by US firms. Here, US firms consider matching to be the most flexible and self-reliant way to hedge. Panel B also shows that the firms use a limited set of external techniques to hedge the exposures. The FX forward contract is the most commonly used hedging technique. This finding is similar for US firms (see Phillips, 1995). Forward contracts are mainly used to hedge transaction exposure. While foreign currency borrowing/ lending is the most commonly used technique when hedging both economic and translation exposures, it is the second most commonly used technique when hedging transaction exposure. The use of foreign currency borrowing/lending may reflect the desire of the firms to reduce the amount of investment that is abroad (see Belk and Glaum, 1990), but the degree of usage is stronger for translation exposure than for economic exposure. Cross-currency interest rate swaps and foreign currency swaps are not commonly use by the firms. This is consistent with the findings of Glaum and Belk (1992). The utilisation rates of both FX options and futures are low for all types of exposures but FX options tend to be more widely used than FX futures (see also Glaum and Belk, 1992; Phillips, 1995). The low utilisation of FX futures may be due to the effects of daily resettlement which can adversely affect the liquidity of firms. In general, external techniques appear to play a much more important role in hedging decisions then internal techniques. As the firms are large, scale economies in the use of external techniques and the availability of skilled treasury personnel may contribute to their greater use (see Geczy et al., 1997). However, the firms do not appear to be very selective in their use of the techniques when hedging different types of exposures Hedging exposures with similar internal techniques To test for a link between the utilisation rates of internal techniques, a 2 test was applied 7. The test was applied to determine whether or not: (i) the firms are selective 6 The 3-point scale identified the degree of usage as: 1=not used; 2=occasionally used; and, 3=frequently used. The occasional use of hedging techniques may be associated with partial hedging and/or hedging strategies which reflect expected changes in the behaviour of the financial markets. Since the aim is to capture the degree of utilisation, it would appear that the use of a larger point scale would not have altered the results (see Lehmann and Hulbert, 1972). 7 The results where the statistical test yields a value whose associated probability under the null hypothesis is 5% or less (P-value 0.05) are reported. This cut-off point is applied throughout this study unless explicitly stated otherwise.

9 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) in their use of the hedging techniques; and (ii) certain techniques are perceived to have special attributes such that they would only be used to hedge specific exposures. The null hypothesis that there is no difference in the utilisation rate of matching when the firms hedge transaction and economic exposures is rejected ( 42 =13.996; P-value=0.007). The contingency table suggests that the firms make greater use of matching when hedging transaction exposure compared with economic exposure. For example, 32 of the 45 firms (71.11%) that do not use matching to hedge economic exposure, also use matching (occasionally and frequently) to hedge transaction exposure. Using the Cramer test statistic, C (see Siegel and Castellan, 1988) the association appears to be moderate (C=0.333). The null hypothesis of no difference in the degree of utilisation of matching when hedging economic and translation exposures is also rejected ( 42 =33.668; C=0.521; P- value=0.000). Here, 50 of the firms do not use matching to hedge translation exposure and 90.00% of those firms do not hedge economic exposure with this technique either. However, the firms have a much stronger preference for intercompany netting when hedging transaction exposure compared with economic exposure (overall 42 =13.910; C=0.332; P-value=0.008). While 43 of the firms do not use inter-company netting to hedge economic exposure, 72.10% of those firms hedge transaction exposure with inter-company netting. Similar inference can be made for the use of asset/liability management and leads and lags across exposures, but in general, the firms appear to prefer to use those techniques to hedge transaction exposure Hedging exposures with similar external techniques External techniques such as currency swaps and foreign currency borrowing/lending, allow firms to borrow more cheaply than would otherwise have been possible. Those techniques also enable firms to reduce or eliminate the amount of their foreign investments (see Glaum and Belk, 1992). Cross-currency interest rate swaps also share those attributes. In general, if those techniques enable firms to reduce the amount of their foreign investment, one would expect their use to be more strongly associated with economic and translation exposures. The 2 test provided some support for this prediction. The null hypothesis of no difference in the degree of utilisation of foreign currency borrowing/lending when hedging economic and translation exposures is rejected (overall 42 =16.904; C=0.355; P-value=0.002). Of the 39 firms that hedge translation exposure with foreign currency borrowing/ lending, 35.89% of them frequently hedge economic exposure with the same technique. However, more than half of those firms (21 out of 39) do not use foreign currency borrowing/lending to hedge economic exposure. Thus it seems that the firms prefer to hedge translation exposure with foreign currency borrowing/lending. In contrast, the firms make much greater use of currency swaps when hedging economic exposure compared with transaction exposure (overall 42 =20.680; C= 0.387; P-value=0.001) but most of the firms do not use cross-currency interest rate to hedge their exposures. If managers believe that FX options provide a genuine hedge (but see, Giddy and Dufey, 1995), they are more likely to use them to hedge economic and translation

10 170 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) exposures. The null hypothesis of no difference in the extent to which the firms use FX options to hedge economic and translation exposures cannot be rejected. However, the null hypothesis can be rejected for transaction and translation exposures ( 42 =10.224; C=0.272; P-value=0.037). Here, FX options are primarily used to hedge transaction exposure. Up to 37 of the 56 firms that do not use FX options to hedge translation exposure use the derivative to hedge transaction exposure Hedging transaction exposure with different techniques Since it is more difficult to match the maturity of derivatives with those of the underlying economic and translation exposures, firms would be expected to make much greater use of internal techniques. Although, the preliminary evidence suggests that the firms place a stronger emphasis on external techniques, the hypothesised relationships are directly tested here. The null hypothesis of no difference in the extent to which the firms use foreign currency borrowing/lending and asset/liability management when hedging transaction exposure is easily rejected ( 42 = ; C of 0.308; P-value=0.011). Thirty-nine firms do not use asset/liability management to hedge transaction exposure and more than half of those (56.41%) do not use foreign currency borrowing/lending either. Indeed, the contingency table suggests that there is a stronger preference for foreign currency borrowing/lending. The null hypothesis is also rejected for the extent to which forward contracts are used compared with matching and domestic currency invoicing 8. The results are similar for the extent to which the firms use FX options compared with other internal techniques 9. 8 The test statistics for the extent to which FX contracts and the relevant internal hedging techniques are used when hedging transaction exposure are as follows: Use of FX forward contracts Use of: 2 4 C P-value Matching Domestic currency invoicing The test statistics for the extent to which FX options and the relevant internal hedging techniques are used when hedging transaction exposure are as follows: Use of FX options Use of: 2 4 C P-value Leads and lags Domestic currency invoicing Transfer pricing arrangements

11 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) Hedging economic exposure with different techniques Some significant results were also found for the degree of utilisation of certain techniques when hedging economic exposure. For example, the null hypothesis for the degree of utilisation of foreign currency borrowing/lending and asset/liability management is rejected ( 42 =24.199; C=0.453; P-value=0.000). Most of the 29 firms (86.21%) that do not use foreign currency borrowing/lending use asset/liability management. The results are also significant for the relationship between the degree of utilisation of: (i) FX options and certain internal techniques; and (ii) foreign currency swaps and certain internal techniques 10. The relationships are weak to moderate and reflect the stronger emphasis on external techniques Hedging translation exposure with different techniques Evidence from Collier et al. (1990) indicates that some treasury managers of both UK and US firms are concerned about the adverse impacts of translation risk on leverage, distributable reserves and the overall balance sheet value. One implication of this finding is that managerial attitudes towards translation exposure would vary, particularly when firms are faced with hedging techniques which increase the variability of those measures. The results indicate a moderate association between the degree of utilisation of foreign currency borrowing/lending and asset/liability management ( 42 =15.525; C=0.348, P-value=0.004). The firms generally make much greater use of foreign currency borrowing/lending to hedge translation exposure. For example, of the 34 non-users of asset/liability management, up to 61.77% of them are occasional (17.65%) and frequent (44.12%) users of foreign currency borrowing/lending. Most firms that use forward contracts also use match- 10 The test statistics for the extent to which FX options and the relevant internal hedging techniques are used when hedging economic exposure are as follows: Use of FX options Use of: 2 4 C P-value Matching inflows/outflows Inter-company netting Invoicing in domestic currency Transfer pricing arrangements For economic exposure, the test statistics for the extent to which foreign currency swaps and the relevant internal hedging techniques are used are as follows: Use of foreign currency swaps Use of: 2 4 C P-value Inter-company netting Domestic currency invoicing Asset/liability management

12 172 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) ing, inter-company netting and domestic currency invoicing 11 although the emphasis on forward contracts is not strong. Similarly, the null hypothesis that there is no difference in the degree of utilisation of foreign currency swaps and asset/liability management is rejected ( 42 = ; C=0.312; P-value=0.015). In general, the firms place a much weaker emphasis on translation exposure Bi ariate test of hedging techniques and firms characteristics In this sub-section, the extent to which cross-sectional variation in the characteristics of the firms can explain the degree of utilisation of the hedging techniques is assessed. The data for the characteristics of the firms is not normally distributed. Therefore, the distribution-free Kruskal Wallis statistic has been used. To illustrate the testing procedure, the test statistics associated with the use of FX options and the characteristics of the 64 non-anonymous firms are shown for the case of transaction exposure (see Table 2). If the degree of utilisation of FX options is associated with the financial measures, one would expect to observe differences in the variability of the financial measures. The table shows, for example, that frequent users of FX options exhibit less variability on dividend yield compared to both occasional and non-users; the associated Kruskal Wallis test statistic is significant (P-value=0.015). Thus the null hypothesis that the k samples are from identical populations with the similar medians can be rejected and it can be inferred that the degree of usage is associated with differences in the variability of the measure Internal hedging techniques and firms characteristics In most cases, the degree of utilisation of internal techniques is positively related with the measures of internationalisation. In the case of transaction exposure, the Kruskal Wallis statistic indicated that both occasional and frequent users of matching, domestic currency invoicing and transfer pricing tend to be larger in terms of both NCOUNT and NSUBS. As expected, a higher degree of internationalisation appears to be associated with an increase in the use of internal techniques. Similarly, firms that use inter-company netting are larger in terms of both measures, but in addition, the magnitude of PERSALE is also larger. As expected, firms that use asset/liability management to hedge transaction exposure exhibit less variability on QAR. However, PERHEDGE and the leverage measures were not found to be 11 The test statistics for the extent to FX forward contracts and the relevant internal hedging techniques are used when hedging translation exposure are as Use of FX forward contracts Use of: 2 4 C P-value Matching inflows/outflows Inter-company netting Domestic currency invoicing

13 Table 2 The characteristics of the firms conditioned on the degree of utilisation of foreign exchange (FX) options when hedging transaction exposure a FX options not used FX options occasionally used FX options frequently used Test statistic Combined sample N Mean S.D. N Mean S.D. N Mean S.D. K W P-value N Mean S.D. 1. Coefficient of ariation of financial measures SALESMV BOOKMV Dividend OPM TPM GCASHMV CASHMV QAR WCR CGEAR IGEAR LTBORMV TLBOR TAXRATIO TAXMV DIRECMV EMPMV Internationalisation measures NSUBS NCOUNT PERSALE PERHEDGE a The summary statistics are conditioned on the degree of usage of foreign exchange options and are also given for the firms combined. The variable representing firm characteristics are described in the appendix. S.D. is the standard deviation. K W is the Kruskal Wallis test statistic which tests the null hypothesis that the characteristics of the firms conditioned on the degree of usage have the same median. The P-values 0.05 are show in bold. For both PERSALE and PERHEDGE, respondents were asked to tick one percentage value or range of values from [0], [1 10], [11 20] [91 100%]. None of the firms recorded a score of 0%. The statistics reported are based on the mid-point of those ranges. This table is for illustrative purposes only. N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000)

14 174 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) significantly associated with any hedging technique. The results for translation and economic exposure are insignificant and reflect the low priorities the firms give to those exposures External hedging techniques and firms characteristics The Kruskal Wallis test statistic also indicated that the use of external techniques varies with the characteristics of the firms. One interesting result is that occasional users of currency lending/borrowing tend to hedge a much larger percentage of PERHEDGE than frequent users, when transaction exposure is hedged. If firms partially hedge on the expectation of benefiting from FX trading (see Hakkarainen et al., 1998), it is possible that the percentage of exposure that is hedged as well as the degree of utilisation of certain techniques will vary. Firms that frequently use FX forwards to hedge transaction exposure tend to exhibit much lower variability on CASHMV compared to occasional users. This result is expected since the mis-match of the cash flows from the instrument and the underlying exposure would not occur, in the absence of default. The degree of utilisation of FX forwards is also positively related to NCOUNT. Furthermore, the degree of utilisation of FX options is positively related to dividend yield, TAXMV and NCOUNT as well as the length of time since the firms had established their formal corporate hedging policies. Thus it appears that greater experience in exposure management (see also Dolde, 1993) increases the firms confidence in using more complex techniques. Firms that are occasional and frequent users of factoring tend to hedge a larger percentage of PERSALE. They are also larger in terms of NSUBS. All those considerations apply to transaction exposure. The long-term nature of economic exposure presents special problems for firms such that those hedging techniques which reduce the amount of foreign investments are likely to be preferred. Furthermore, the economic exposure arising from the long leads of growth options is likely to re-enforce the incentive to partially hedge. In general, the results indicate that both occasional and frequent users of foreign currency borrowing/lending exhibit lower variability on certain growth option measures, i.e. BOOKMV and SALESMV. The degree of variability on those measures is lowest for frequent users. Further, the degree of utilisation is positively related to PERSALE. It should be noted that firms that hedge more than 81% of their global exposure exhibit greater variability on SALESMV, BOOKMV and dividend yield while firms that hedge less than 40% of global exposure exhibit the least variability on those measures. But the statistical results are not significant (P-values 0.060). However, there is the potential for the degree of utilisation to impact on the percentage of exposure that is hedged. Frequent users of FX options tend to exhibit less variability on the growth option measures as well as GCASHMV, DIRECMV, EMPMV, while occasional users exhibit the highest level of variability on those measures. Extending Smith s (1993) argument, it had been suggested that the terms of managerial compensation would provide an incentive for using FX options, forwards and futures particularly when hedging economic and translation exposures. The results suggest that the incentive to increase the firms volatility is greater only for occasional users of FX options.

15 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000) Finally, the results indicate that firms that use foreign currency borrowing/lending to hedge translation exposure exhibit less variability on OPM, IGEAR, and LTBORMV. The lower variability of the leverage measures is unexpected. However, firms that hedge less than 40% of their global exposure exhibit less variability on both CGEAR and IGEAR while those that hedge between 41 and 80% of their global exposure exhibit more variability on those measures (P-value 0.025). Thus it appears that the extent to which exposure is hedged impacts on the hypothesised relationship. The use of foreign currency borrowing/lending when hedging translation exposure is also positively related with NSUBS and PERSALE. While occasional users of foreign currency swaps exhibit greater variability on both OPM and TAXMV, frequent users exhibit less variability on OPM. These contrasting results may be due to the inflexibility inherent in the use of foreign currency swap agreements Multi ariate test of hedging techniques and firms characteristics Bivariate tests tend to be weak since they do not allow for interactions among the explanatory variables. To further assess the choice of hedging techniques, a logistic regression was applied. The dependent variable of the logistic regression is determined by using the ratings that represent the degree of usage. Here, the score of 1 (not used) is coded as 0 and, the scores of 2 and 3 (occasionally and frequently used) are coded as 1. The existence of missing explanatory variables and the anonymous responses result in an overall sample size of 54 firms. To minimise the potential problems of small sample size, we present the results for the models where: (i) at least 20% of the firms can be allocated to either group 0 or 1, a priori; (ii) each empirical model outperforms a naive proportional chance model (see Joy and Tollefson, 1975); and (iii) each model s n2 statistic is significant at the 0.05 level. No evidence was found that suspiciously large regression residuals had an adverse effect on the estimated coefficients Internal hedging techniques Panel A of Table 3 shows that the explanatory variables exhibit some discriminatory power for the degree of utilisation of internal hedging techniques. Only the coefficients associated with transaction exposure are significant. As expected, the use of internal techniques is positively related with measures of internationalisation. The use of leads and lags is positively related with the coefficients of both SALESMV and NCOUNT but those coefficients are marginally significant. The coefficient value of for SALESMV means that as its variability increases, all else held constant, the likelihood that the firm will use leads and lags to hedging transaction exposure increases. In this case, each unit increase in the variability of SALESMV increases the log odds by a factor of 1.148; that is, e EMPMV makes the greatest contribution to the explanatory power of the model and the coefficient of PERHEDGE is always positive. Both EMPMV and DIRECMV have negative coefficients for leads and lags, and transfer pricing, respectively (Pvalue 0.05).

16 176 Table 3 Logistic regression for the use of internal and external hedging techniques and the characteristics of the firms a Transaction exposure Leads and lags Coeff R Transfer pricing Coeff R Domestic cur- Coeff R rency invoicing Panel A: Internal hedging techniques EMPMV 0.148** CASHMV 0.038* SALESMV 0.065** (0.070) (0.020) (0.027) SALESMV 0.138* LTBORMV 0.042*** TAXMV 0.106*** (0.018) (0.014) (0.040) NCOUNT 0.027* DIRECMV 0.055** PERHEDGE 0.024* (0.015) (0.025) (0.014) Constant NCOUNT 0.071*** Constant (0.754) (0.023) (1.182) PERHEDGE Constant 0.050*** (0.019) 4.179*** (1.516) Diagnostics Statistics Diagnostics Statistics Diagnostics Statistics 2 Model s ** 2 Model s *** % classified *** % classified *** S. Residuals S. Residuals N 1,N 2 30, 24 N 1,N 2 32, 22 2 Model s *** % classified *** S. Residuals *** N 1,N N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000)

17 Table 3 (Continued) Transaction exposure ***Currency borrowing/ lending Coeff R Foreign Coeff R Factoring Coeff R Cross-currency Coeff R exchange interest rate options swaps Panel B: External hedging techniques TPM 0.480*** GCASHMV 0.187** DIRECMV 0.120** TLBOR 0.039** (0.163) (0.076) (0.053) (0.017) OPM 0.210*** TAXMV 0.181*** EMPMV 0.127*** IGEAR 0.049** (0.051) (0.062) (0.048) (0.024) CASHMV 0.096*** CASHMV 0.047** NSUBS 0.013*** NCOUNT 0.035* (0.016) (0.022) (0.005) (0.020) CASH 0.084*** BOOKMV 0.095** PERSALE 0.036** (0.042) (0.055) (0.016) SALES 0.187*** (0.071) PERHEDGE 0.068** Constant 3.389*** (0.029) (1.038) Constant Constant (1.245) Constant (0.934) (1.106) Diagnostic Statistics Diagnostic Statistics Diagnostic Statistics Diagnostic Statistics 2 Model s *** 2 Model s *** 2 Model s *** 2 Model s ** % classified *** % classified 79.63*** % classified *** % classified ** S. Residuals S. Residuals S. Residuals S. Residuals N 1,N 2 18, 36 N 1,N 2 18, 36 N 1,N 2 43, 11 N 1,N 2 41, 13 N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000)

18 178 Table 3 (Continued) Economic exposure Translation exposure Currency borrowing/lending Coeff R Foreign ex- Coeff R Currency bor- Coeff R Foreign cur- Coeff R change options rowing/lending rency swaps GCASHMV 0.118** OPM 0.046** OPM 0.092** TPM 0.338*** (0.047) 0.023) (0.035) (0.125) Dividend yield SALESMV 0.049** CGEAR 0.041** OPM 0.340*** (0.038) (0.021) (0.018) (0.117) EMPMV 0.065** IGEAR 0.053** TAXMV 0.059** TAXRATIO 0.179** (0.038) (0.023) (0.027) (0.072) Constant Constant 1.601** PERSALE 0.026* NSUBS 0.151** (0.862) (0.714) (0.015) (0.007) PERHEDGE 0.038** Constant (0.019) (0.619) Diagnostics Statistics Diagnostics Statistics Constant (1.357) Diagnostics Statistics Diagnostics Statistics 2 Model s b 2 Model s *** 2 Model s *** 2 Model s *** % classified a % classified *** % classified *** % classified *** S. Residuals S. Residuals S. Residuals S. Residuals N 1,N 2 23, 31 N 1,N 2 37, 17 N 1,N 2 13, 41 N 1,N 2 28, 26 a The explanatory variables are entered into/removed from the logistic regression using a stepwise procedure. The likelihood-ratio test is used for both entering (cut-off P-value 0.05) and removing (cut-off P-value 0.10) the explanatory variables into/from the model. For this reason some coefficients are significant at the 10% level, which is considered to be marginal. The Wald statistic is used to test the null hypothesis that each coefficient of the model is zero. The standard errors of the coefficients are in parentheses. R is the partial correlation between the dependent and independent variables. S. Residuals is the average of the standardised residuals of the logistic regression model. For the ith case its residual is divided by p i (1 p i ) where p i is the predicted value. The chi-square n 2 statistic tests the null hypothesis that all coefficients in the model (except the constant) are simultaneously zero against the alternative that at least one coefficient is non-zero. The percentage correctly classified is a measure of the classificatory efficiency of the model. The level of significance indicates that the classificatory efficiency of the empirical model is superior to that of a naive proportional chance model (see, Joy and Tollefson, 1975). N 1 indicates the number of firms in the sample that do not use the hedging techniques while N 2 indicates the total number of occasional and frequent users. The results are presented where: (i) it was possible to allocate at least 20% of the firms to group 0 or 1 a priori; (ii) the percentage correctly classified by the empirical model outperforms a proportional chance naive model (P-value 0.05; one tailed); and (iii) each model s n 2 statistic is significant at the 5% level or less. * The test statistic is significant at 5% but 10% level. ** The test statistic is significant at 1% but 5%. *** The test statistic is significant at 1% level. N.L. Joseph / J. of Multi. Fin. Manag. 10 (2000)