The Journal of Risk Finance Corporate derivatives and foreign exchange risk management: A case study of nonfinancial

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1 The Journal of Risk Finance Corporate derivatives and foreign exchange risk management: A case study of nonfinancial firms of Pakistan Talat Afza Atia Alam Article information: To cite this document: Talat Afza Atia Alam, (2011),"Corporate derivatives and foreign exchange risk management", The Journal of Risk Finance, Vol. 12 Iss 5 pp Permanent link to this document: Downloaded on: 09 January 2015, At: 13:35 (PT) References: this document contains references to 30 other documents. To copy this document: permissions@emeraldinsight.com The fulltext of this document has been downloaded 1982 times since 2011* Users who downloaded this article also downloaded: Lee-Lee Chong, Xiao-Jun Chang, Siow-Hooi Tan, (2014),"Determinants of corporate foreign exchange risk hedging", Managerial Finance, Vol. 40 Iss 2 pp Tom Aabo, Marianna Andryeyeva Hansen, Christos Pantzalis, (2012),"Corporate foreign exchange speculation and integrated risk management", Managerial Finance, Vol. 38 Iss 8 pp dx.doi.org/ / Joshua Abor, (2005),"Managing foreign exchange risk among Ghanaian firms", The Journal of Risk Finance, Vol. 6 Iss 4 pp Access to this document was granted through an Emerald subscription provided by [] For Authors If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service information about how to choose which publication to write for and submission guidelines are available for all. Please visit for more information. About Emerald Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online products and additional customer resources and services. Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation. *Related content and download information correct at time of download.

2 The current issue and full text archive of this journal is available at Downloaded by New York University At 13:36 09 January 2015 (PT) Corporate derivatives and foreign exchange risk management A case study of non-financial firms of Pakistan Talat Afza Faculty of Business Administration, COMSATS Institute of Information Technology, Lahore, Pakistan, and Atia Alam Department of Management Sciences, COMSATS Institute of Information Technology, Lahore, Pakistan Abstract Purpose The purpose of this paper is to identify the factors affecting firms decision to use foreign exchange (FX) derivative instruments by using the data of 86 non-financial firms listed on Karachi Stock Exchange for the period Design/methodology/approach Required data were collected from annual reports of listed firms of Karachi Stock Exchange. Non-parametric test was used to examine the mean difference between users and non-users operating characteristics. Logit model was applied to analyze the impact of firm s financial distress costs, underinvestment problem, tax convexity, profitability, managerial ownership and foreign exchange exposure on firms decision to use FX derivative instruments for hedging. Findings Results explain that firms having higher foreign sales are more likely to use FX derivative instruments to reduce exchange rate exposure. Moreover, financially distressed large-size firms with financial constraints and fewer managerial holdings are more likely to use FX derivatives. Research limitations/implications Incomplete financial instrument disclosure requirements restricted researchers to using binary variable as a dependent variable instead of notional value or fair value of derivative usage. Practical implications The study shows that in the presence of amateur derivative market, Pakistani corporations possessing higher agency costs of debt, agency costs of equity, and financial constraints will benefit more by defining hedging policies coherent with the firm s investment and financing policies in order to enhance firm value. Originality/value Until now, no earlier empirical study focused on the determinants of a firm s hedging policies in Pakistan, in the presence of volatile exchange rates,. The current study, therefore, attempts to identify the factors which affect the firm s decision to use derivative instruments for hedging FX exposure of non-financial firms in Pakistan. Keywords Pakistan, Foreign exchange, Risk management, Foreign exchange derivatives, Hedging, Foreign exchange exposure, Non-financial firms Paper type Research paper Corporate derivatives and FX risk Introduction Growing globalization has encouraged many corporations to extend their businesses beyond the geographical boundaries in order to benefit from competitive advantage and economies of scale. Penetration into new markets has increased the firm s profitability, on one hand, and on the other it has also increased the variability in net income The Journal of Risk Finance Vol. 12 No. 5, 2011 pp q Emerald Group Publishing Limited DOI /

3 JRF 12,5 410 because of various financial risks. Therefore, the managers of the multinational firms are focusing on the importance of risk management techniques to reduce variability of their cash flows from foreign operations due to the fluctuations in foreign exchange (FX) rates. It is generally believed that the higher exchange rate movements and the unpredictability of foreign sales affect the firms level of profitability. Therefore, managers dealing in international operations are of the view that different trade agreements and removal of restrictions on capital flows have increased firms exchange rate exposure. Additionally, majority of the countries are following floating exchange rate or variations of floating exchange rate system, due to which estimated cash flows from their international operations are exposed to higher exchange rate risk and thus highlights the importance of employing different risk management techniques for hedging firms uncovered positions. Asian crises in 1998 had increased the FX exposure of the countries having large number of multinational firms, in general, and Asian countries in particular. Depreciating currency and unstable economic and political environment in Asian countries have increased the countries risk level, although lower cost of the factors of production and untapped markets have provided many new opportunities for multinational companies. During the past five years, Pakistani stock markets have shown higher stock price volatility and can be characterized as among the top unstable markets. Like many other emerging economies, in order to hedge the firm s future cash flows, Pakistan has developed an exchange traded derivative market for future contracts in 2006 but due to lower trading and liquidity, corporations are reluctant to invest in derivative instruments. (SECP, 2006). A significant increase in export and import volume of 36 and 61 percent, respectively, has been reported by the State Bank of Pakistan, during the last five years (SBP, 2009). This increase in foreign trade volume has shown an increasing exposure faced by corporations due to exchange rate fluctuations. Corporations also realize that it is difficult to manage exchange rate risk at the early stages of economic development. Thus, a growing need for employment of different risk management techniques exists in Pakistani firms to reduce the FX exposure. Till now, no exchange traded derivative market exists in Pakistan, therefore, corporations are using over the counter market derivative instruments to hedge their risk exposure. In this context, derivatives, defined as off-balance sheet financial instruments whose values are hypothetically derived from other financial assets, are widely used by the firms to hedge their FX risk. Existing empirical evidence has focused on examining the factors, both internal and external, which affect the firms decision to hedge FX exposure (Mian, 1996; Jalivand, 1999; Haushalter, 2000; Guay and Kothari, 2003; Foo and Yu, 2005; Schiozer and Saito, 2009). However, this issue is not well explored yet in developing and third world countries, especially, in Pakistan. Therefore, the current study focuses on the Pakistani market to extend the existing literature by identifying the factors affecting FX derivative usage of firms to reduce exchange rate exposure by using sample data of 86 listed non-financial firms, for the period of The remaining paper is organized as follows: next section discusses empirical literature, whereas the data and methodology are presented in the third section. Empirical findings are discussed in fourth section while the last section concludes the discussion.

4 2. Literature review It is generally believed that shareholders are able to reduce risk by constructing a well diversified portfolio. However, existing literature on risk management shows that corporations are using derivative instruments to minimize firms risk exposure. According to Modigliani and Miller (1958) under perfect capital market conditions, it is useless for a firm to reduce risk by using derivatives. Whereas, theoretical evidence provided by Stulz (1984) and Smith and Stulz (1985) had shown that, under certain market frictions, corporations having specific operating characteristics like, higher financial distress costs, tax convexity, growth opportunities, managerial holdings and liquidity constraints, have an opportunity to enhance firm value by optimally utilizing hedging techniques. By considering investment and financing decisions in accordance with firms hedging policies, Froot et al. (1993) had proved mathematically that derivatives will be beneficial for firms in two different situations: first, when external financing cost exceeds opportunity cost of internal financing and second, when correlation between investment expenditures and firms cash flows were negative. These results were further tested by Gay and Nam (2002) on 486 non-financial firms of USA over the period of and empirical findings were consistent with Froot et al. (1993). A different justification for corporate risk management had been provided by Bessembinder (1991) that hedging provides an incentive for the firm to decrease financial distress costs by reducing the opportunistic behavior of equity holders. Purnanandam (2008) had empirically tested the relationship between financial distressed firms and corporate risk management activities on 2000 non-financial US firms and found that firms decision to use derivatives was positively influenced by leverage whereas highly leveraged firms had lower tendency towards derivative usage. In order to test the relationship between firms endogenous policies, Lin et al. (2008) had simultaneously examined the relationship between firms endogenous polices-leverage, growth opportunities and hedging policies, along with other control variables, with a sample data of 495 S&P firms. They observed that highly leveraged firms were more likely to use derivatives and highly growth oriented firms, with low debt ratio, were also more inclined towards the derivative usage. Graham and Rogers (2002) by taking sample data of 442 US non-financial firms had calculated two tax-based incentives for hedging by using derivative instruments and found that debt tax benefit from hedging is four times more than advantage acquired from tax convexity. In addition, study had analyzed the simultaneous effect of debt and leverage on each other and reported a significantly positive effect on each other. Similarly, with another sample data, Borokhovich et al. (2004) also documented a positive and significant effect of debt and derivative usage on each other. Borokhovich et al. (2004) had attempted to test the relationship between board composition and derivative usage on 284 US non-financial firms. By considering other control variables, they suggested that firms having larger outsiders holdings were more likely to use derivatives. Coefficient of size and financial constraints were consistent with the theory whereas results depicted no relationship with underinvestment problem. Researchers had also explored the determinants of firms derivative usage. By using different sample size of US non-financial firms, Mian (1996), Horng and Wei (1999) and Haushalter (2000) had found positive effect of leverage on firms derivative usage for hedging purpose whereas many studies exhibited negative relationship of debt Corporate derivatives and FX risk 411

5 JRF 12,5 412 (Nance et al., 1993; Fok et al., 1997; Geczy et al., 1997). Nance et al. (1993) and Haushalter (2000) depicted positive coefficient for size, growth opportunities and tax convexity. Whereas, Mian (1996) and Horng and Wei (1999) observed mixed evidence for size and growth variables and tax convexity. Mixed results for hedging substitutes and managerial ownership were reported by the empirically studies of Nance et al. (1993), Fok et al. (1997), Horng and Wei (1999) and Haushalter (2000). Based on the same sample data of Australian non-financial firms, Nguyen and Faff (2002, 2003) found that derivative usage was an increasing function of leverage and size, while managerial ownership is negatively related to firms decision to use derivatives. Mixed evidence was reported for growth options and hedging substitutes. By analyzing 77 non-financial Canadian firms, Jalilvand (1999) depicted a positive relationship between financial distress hypothesis, dividend payout, convertible debt and firm s decision to use derivative. Existing empirical evidence is mainly based on developed countries whereas a few empirical investigations had been undertaken in Asian countries to identify the factors effecting the firms hedging polices like Muller and Verschoor (2007) and Faziullah et al. (2008). Former examined the relationship of firms operating characteristics with the FX exposure on 3,436 Asian firms and estimated a positive influence of size and dividend payout on FX risk while leverage and liquidity showed a negative impact. Whereas, the later one empirically tested 101 Malaysian firms using derivatives and found a positive relationship between debt, tax convexity, size and firms decision to use derivative techniques, whereas market to book value and dividend yield depicted a negative impact on derivative usage. In case of Pakistan, although researchers have tried to determine factors affecting exchange rate of Pakistani rupee, yet no study had explored the factors, both endogenous and exogenous, affecting the firms decision to use FX derivative instruments for hedging firms FX rate risk in Pakistan. Current paper aims to fill this gap by investigating the factors influencing firm s decision to use FX derivatives by using the data of 86 listed non-financial firms of Pakistan for the period Moreover, it is also expected that present study may help in providing additional guidelines to decision makers in managing the firm s FX risk exposure by simultaneously planning firm s investment and financing policies with firm s hedging policies. 3. Data and methodology Following Nguyen and Faff (2002), the study aims to identify the impact of financial distress costs, underinvestment costs, tax convexity, managerial incentives and other control variables on firm s decision to use FX derivative to reduce FX rate risk. It is assumed that firms use derivatives to hedge FX exposure, hence, in order to test whether firms use FX derivatives to hedge risk exposure or not, logit model is used with a value one for users and zero for non-users. In order to test empirically the factors affecting the firm s decision to use FX derivatives instruments, a sample data of 86 non-financial firms are taken for the period of Data are collected from annual reports of non-financial firms listed on Karachi Stock Exchange and prices data are gathered from official web site of Karachi Stock Exchange. According to International Accounting Standards 32 and 39, it is mandatory for firms to disclose their usage of hedging instruments and their respective fair value in the notes of annual reports in a uniform manner. Almost 60 percent

6 of the sample firms declared their usage of foreign currency derivatives. Financial sector has been excluded from the sample data since their business activities require derivatives to be used for trading purpose or speculative motive. For detailed comparison between operating characteristics of firms that consider hedging as a value enhancing activities to those firms whose operating distinctiveness does not consider derivative usage as a feasible activity, sample data has been divided into two sub-groups. One group is classified as users and other as non-users. Non-parametric univariate test is used to test the mean difference between the operating characteristics of users and non-users. In order to identify the determinants of firm s hedging policies, logit model is used. Model 1 depicts that derivative usage is a function of financial distress costs, tax convexity, asset growth cash flow, profitability, managerial ownership and foreign sales: Corporate derivatives and FX risk 413 Downloaded by New York University At 13:36 09 January 2015 (PT) DERIV it ¼ a þ b 1 FDC it þ b 2 INC it þ b 3 SIZE it þ b 4 AGCF it þ b 5 ROA it þ b 6 MNGRL it þ b 7 TAX it þ b 8 LFS it þ e it ð1þ where: DERIV ¼ dummy one if firm is a FX derivative user and zero otherwise. FDC ¼ ratio of tangible assets over total assets, representing financial distress costs. INCOV ¼ ratio of earning before interest and taxes by interest expense, representing interest coverage ratio. SIZE ¼ log of total assets, representing size. AGCF ¼ ratio of addition of change in tangible assets plus depreciation to net income plus depreciation, representing firm s ability to convert growth options into assets in place. ROA ¼ ratio of earning after interest and taxes by total assets, representing profitability. MNGRL ¼ log of managerial holdings, representing managers ownership in firm. TAX ¼ binary value 1 for unused tax losses and 0 otherwise, representing tax convexity. LFS ¼ log of foreign sales, representing FX exposure. Whereas, model 2 observed the interaction between firm s FX derivative usage and its investment and financing policies following Mian (1996), Lin et al. (2008) and Bartam et al. (2009): where: LEV MTB DERIV it ¼ a þ b 1 LEV it þ b 2 MTB it þ b 3 DP it þ b 4 QR it þ e it ¼ ratio of total debt to total assets, representing leverage. ¼ ratio of market value of firm to book value of firm, representing growth options. ð2þ

7 JRF 12,5 DP QR ¼ ratio of dividend per share to earning per share, representing dividend payout ratio. ¼ ratio of subtraction of current assets minus inventory to current liabilities, representing liquidity. Downloaded by New York University At 13:36 09 January 2015 (PT) 414 Table I. Univariate analysis 4. Findings and analysis (i) Univariate analysis: Table I shows descriptive statistics of users and non-users of FX derivatives; standard deviation is in parenthesis. Univarite analysis explains that users have significantly higher financial distress costs with mean value of as compared to non-users. Leverage, calculated by taking ratio of total debt over total assets, is lower for the users though mean difference is not statistically significant. Users, on average have leverage ratio, whereas non-users demonstrate mean value of Inconsistent with the theory of financial distress costs, derivative users are characterized as low debited firms, though they are able to pay their finance costs but still the additional debt will lead a firm to higher financial distress costs and it may be costly for a firm to adopt risk management techniques in such situations. Another measure of firms financial distress cost is its interest coverage ratio, ability of a firm to pay its finance costs, parallel with the theory, users are less competent to pay its interest costs due to financial constraints and hence employ derivatives as hedging instruments. Aligned with the Pakistan s derivative market situation and economies of scale hypothesis, users are identified as large size firms with a value of in comparison with non-users that document an average size of Mann-Whitney U test shows that users and non-users are statistically different from each other in terms of size. Firm s growth opportunities are observed by taking ratio of market value of firm to book value of firm. Contradictory to theory, users show on average less growth opportunities, having a mean value of , which is lower than average value of non-users; According to pecking order theory, if firms encounter positive NPV projects then they are more likely to finance their tasks through internally Mean Variables Non-user (140) User (204) Mann-Whitney U test FDC (0.4317) (0.2137) (0.001) ** LEV (0.5139) (0.2125) (0.384) INC (3.7856) (3.2221) (0.394) SIZE (0.6690) (0.9391) (0.019) ** MTB (0.7931) (0.5812) (0.048) ** AGCF (0.7169) (1.3995) (0.000) *** ROA (0.1213) ( ) (0.824) DP (2.4462) (1.2714) (0.478) QR (3.3618) (2.3274) (0.000) *** MNGRL (0.2991) (0.2174) (0.167) TAX (0.4992) (0.4904) (0.329) LFS (2.3763) (2.7339) (0.000) *** Note: Significant at: * 10, ** 5 and *** 1 percent, respectively

8 generated funds. Therefore, corporations having growth opportunities are more probable to issue debt and thus tend less towards using FX derivative instruments due to of high transactions costs. Moreover, less growth oriented firms have little FX exposure thus less likely to use foreign currency hedging instruments. Theory predicts that firms ability to finance its growth opportunities provides them an incentive to use hedging instruments. Consistent with theory, by taking ratio of change in net tangible assets plus depreciation to net income plus depreciation, reveals that users are less able to finance its growth opportunities with a mean value of in comparison with non-users which are on average only incapable in financing their growth opportunities. Mean difference test of asset growth over cash flow shows that users and non-users are significantly different from each other. Similarly, coherent with the expected coefficients for liquidity and profitability, it is found that users have lower level of profitability and liquidity. Users are identified on average 5.13 percent profitable, whereas non-users are more profitable firms with the mean value of 6.93 percent. Nevertheless, mean difference of users and non-users are not statistically significant. Moreover, users are identified as liquidity constrained firms with the mean value of in comparison with non-users, having an average value of In this case, Mann-Whitney U test shows that users and non-users are significantly different in terms of liquidity. Contradictory to the theory of substitutes of hedging, firms with lower dividend payout ratio are characterized as user of hedging instruments. Supporting financial distress hypothesis, users report that non-users have higher dividend payout ratio of percent, whereas users have percent dividend payout ratio, as lower dividend payout firms perceive themselves riskier because of highly invariable cash flows, hence, they use hedging instruments to reduce financial distress costs by minimizing cash flow unpredictability. However, mean difference test demonstrate statistically insignificant difference between dividend payout ratio of both the groups. According to agency cost of equity, managers having higher equity stake are more probable to use derivative in best interest of firm as it will ultimately affect firm value. Hence, consistent with the theory, users have higher managerial ownership with the mean value of while non-users document an average value of , nevertheless, the mean difference for both groups is not statistically significant. A dummy variable is used to measure tax convexity. Contradictory to expectations, non-users show higher tax losses with the mean value of 0.45 in contrast with users which have 39.7 percent tax losses. This might be due to the infant status of Pakistani derivative market. Mian (1996) considering sample data of 3,022 firms observed hedgers as having lower tax losses. It is expected that firms need to hedge risk exposure is directly proportional to its FX exposure which is supported by our findings. Users of hedging instruments are found to be having more foreign currency exposure with the mean value of , whereas, non-users report an average value of of foreign sales. Mean difference results show that users are significantly different from non-users in terms of FX exposure. Generally, users are identified as a financially distressed large size firms with the lower debt ratio and growth opportunities. In addition, financially constrained firms having high FX exposure and larger managerial ownership are characterized as the user of derivative instruments for hedging purpose. Corporate derivatives and FX risk 415

9 JRF 12,5 416 Table II. Correlation matrix Correlations coefficients are presented in Table II. Firms operating characteristics are divided into two groups. Correlation results of Group A, excluding all investment and financing variables, explain that profitable firms are large in size, have higher interest coverage ratio, more ability to convert its growth options into assets in place and lower managerial ownership; which is consistent with the theory. In addition, firms having higher financial distress costs have lower interest coverage ratio as it is difficult for them to fulfill their obligations. Group B reports correlation coefficients for firms endogenous polices which supports the theory that financially constrained firms are more likely to take debt for their investments. (ii) Empirical results Logit model is used to identify the determinants of the firms decision to use FX derivatives. Estimated results of models 1 and 2 are presented in Table III. The results of model 1 report that financial distress costs, interest coverage ratio, size, asset growth over cash flow, profitability and foreign sales have signs consistent with the theory, whereas managerial ownership and tax convexity have estimated signs contrary to risk management theory. According to financial distress theory, corporations having higher financial distress costs and less ability to pay its interest costs are more likely to employ foreign currency derivative instruments for hedging firm risk exposure and to avoid opportunistic behavior of debt holders. Outside directors emphasize value creation activities thus firms with smaller managerial holdings have fewer chances to make hedging decisions via derivative instruments in their own interest. Haushalter (2000) and Bartram et al. (2009) had also found a negative relationship between managerial holdings and derivative usage. In line with Howten and Perfect (1998), results show inverse relationship between tax losses and decision to use FX derivatives. Since tax losses reduce firms income gains, thus tax-benefits acquired from unused tax losses are smaller than reduction in income gain, so it is not feasible for firm having unused tax losses to use FX derivatives. Empirical results of model 2 support our earlier results of univariate analysis. Similar to Nance et al. (1993), Fok et al. (1997) and Geczy et al. (1997), leverage depicts a significant negative effect on firms likelihood of derivative usage. Hence, Group A FDC INC SIZE AGCF ROA MNGRL TAX LFS FDC 1.00 INC SIZE AGCF ROA MNGRL TAX LFS Group B LEV MKBK DP QR LEV 1.00 MTB DP QR

10 Model 1 Model 2 Variables Predicted signs Coeff. p-value Coeff. p-value FDC *** LEV þ ** INC ** SIZE 2 /þ MTB þ AGCF þ ** ROA * DP 2 /þ QR *** MNGRL þ * TAX þ * LFS þ *** Constant *** Note: Significant at: * 10, ** 5 and *** 1 percent, respectively proving that high debt leads firm to more financial distress and increases its cost of hedging, therefore making it difficult for a leveraged firm to bear higher risk management costs. Dividend payout ratio shows a negative effect on firms derivative usage, supporting signaling theory. Firms having volatility in cash flows are more likely to cut dividend amounts in advance so that at the end of fiscal year lower dividend payout ratio signals a weak financial position of firm; consistent with Haushalter (2000). Generally, large size financially distressed firms, having lower leverage, dividend payout ratio, liquidity, managerial ownership, profitability and tax convexity are more likely to use derivative instruments for hedging purpose. 5. Conclusion Current study extends the existing literature by identifying factors influencing firms decision to use FX derivative as an instrument for hedging exchange rate exposure of 86 non-financial firms listed on Karachi Stock Exchange for the period The estimated results support the hedging theory by Smith and Stulz (1985) that FX derivatives are used to enhance shareholder s wealth by reducing firm s FX exposure. In case of Pakistani non-financial firms, coefficient of financial distress, size, interest coverage ratio, profitability and foreign sales are consistent, in terms of direction and magnitude, with the risk management theory. Contrary to financial distress theory, negative relationship between leverage and firm s derivative usage depicts that high leverage increases corporation s financial distress costs and decreases firms ability to bear high risk management costs. Firms having larger outsiders holdings are more likely to make hedging decision in the best interest of shareholders as company s financial health signals their performance in the market. Tax convexity, measured by tax losses carry forward has negative impact on firm s decision to use FX derivatives inconsistent with the risk management theory. This might be due to the inappropriate measure for tax convexity and the fact that cost of risk management exceeds the tax deductible benefit of unused tax losses. Unexpected coefficient of dividend payout though inconsistent with the hedging theory but still supports the signaling theory. Growth options though shows positive effect on firm s hedging policies, have Corporate derivatives and FX risk 417 Table III. Logit regression

11 JRF 12,5 418 insignificant effect on firm s derivative usage to hedge exchange rate risk. Study also attempts to examine the relationship between corporate FX derivative usage and firm s FX exposure, and a significant positive relationship between firm s foreign sales and their decision to use FX derivatives to hedge FX exposure is reported, despite of illiquid and amateur Pakistani derivative market. The estimated results provide the policy guidelines to the Pakistani firms having FX transactions, that the optimal usage of FX derivative instruments may enable them to smooth their future cash flows by reducing opportunistic behavior of shareholders and managers, hence, minimizing the agency costs of debt and equity. The findings of current empirical investigation also suggest that the policy makers should develop a well-organized exchange traded derivative market in Pakistan for the benefit of financially constrained firms with highly variable cash flows and foreign sales. The study also highlights that effective usage of derivative instruments may enable corporations to define their hedging policies that are compatible with firm s internal investment and financing policies. Therefore, properly planned and implemented investment, financing and hedging policies, will not only facilitate firms in achieving their primary goal of shareholders wealth maximization, but may also enhance economic stability. The current study has identified the factors affecting the firm s decision to use FX derivative instruments; however, future research could be focused on determining the factors influencing the usage of interest rate derivative instruments and extent of such derivative usage. References Bartram, S.M., Brown, G.W. and Fehle, F.R. (2009), International evidence on financial derivative usage, Financial Management, pp Bessembinder, H. (1991), Forward contracts and firm value: investment incentive and contracting effects, The Journal of Financial and Quantitative Analysis, Vol. 26 No. 4, pp Borokhovich, K.A., Brunarski, K.R., Crutchley, C.E. and Simkins, B.J. (2004), Board composition and corporate use of interest rate derivatives, The Journal of Financial Research, Vol. XXVII No. 2, pp Faziullah, M., Azizan, N.A. and Hui, T.S. (2008), The relationship between hedging through forwards, futures & swaps and corporate capital structure in Malaysia, paper presented at Second Singapore International Conference on Finance (SSIF), Organized by Saw Center for Financial Studies and Department of Finance NUS, Singapore, July. Fok, R.C.-W., Carroll, C. and Chiou, m.c. (1997), Determinants of corporate hedging and derivatives: a revisit, Journal of Economics and Business, Vol. 49, pp Froot, K.A., Scharfstein, D.S. and Stein, J.C. (1993), Risk management: coordinating corporate investment and financing policies, The Journal of Finance, Vol. 4 No. 5, pp Gay, G.D. and Nam, J. (1998), The underinvestment problem and corporate derivatives use, Financial Management, Vol. 27 No. 4, pp Geczy, C., Minton, B.A. and Schrand, C. (1997), Why firms use currency derivatives, The Journal of Finance, Vol. 52 No. 4, pp Graham, J.R. and Rogers, D.A. (2002), Do firms hedge in response to tax incentives?, The Journal of Finance, Vol. 57 No. 2, pp

12 Guay, W. and Kothari, S.P. (2003), How much do firms hedge with derivatives?, Journal of Financial Economics, Vol. 70, pp Haushalter, G.D. (2000), Financing policy, basis risk, and corporate hedging: evidence from oil and gas producers, The Journal of Finance, Vol. 55 No. 1, pp Horng, Y.-S. and Wei, P. (1999), An empirical study of the derivative use in the REITs industry, Real Estate Economics, Vol. 27 No. 3, pp Howten, S. and Perfect, S. (1998), Currency and interest rate derivatives use in US firms, Financial Management, Vol. 27 No. 4, pp Jalilvand, A. (1999), Why firms use derivatives: evidence from Canada, Canadian Journal of Administrative Science, Vol. 16 No. 3, pp Lin, C.M., Richard, D.P. and Stephen, D.S. (2008), Hedging, financing, and investment decisions: theory and empirical tests, Journal of Banking & Finance, Vol. 32, pp Mian, S.L. (1996), Evidence on corporate hedging policy, Journal of Financial and Quantitative Analysis, Vol. 31 No. 3, pp Modigliani, F. and Miller, M.H. (1958), The cost of capital, corporation finance and the theory of investment, American Economic Review, Vol. XLVIII No. 3, pp Muller, A. and Verschoor, W.F.C. (2007), Asian foreign exchange risk exposure., J. Japanese Int. Economies, Vol. 21, pp Nance, D.R., Smith, C.W. and Smithson, C.W. (1993), On the determinants of corporate hedging, The Journal of Finance, Vol. XLVIII No. 1, pp Nguyen, H. and Faff, R. (2002), On the determinants of derivative usage by Australian companies, Australian Journal of Management, Vol. 27 No. 1, pp ( June). Nguyen, H. and Faff, R. (2003), Further evidence on the corporate use of derivatives in Australia: the case of foreign currency and interest rate instruments, Australian Journal of Management, Vol. 28 No. 3, pp Purnanandam, A. (2008), Financial distress and corporate risk management: theory and evidence, Journal of Financial Economics, Vol. 87, pp SBP (2009), Balance of Payment Imports, available at: GoodsImport.pdf (accessed 25 September 2009). Schiozer, R.F. and Saito, R. (2009), The determinants of currency risk management in Latin American non-financial firms, Emerging Markets Finance & Trade, Vol. 45 No. 1, pp SECP (2006), Report on the Feasibility of Exchange Traded Derivatives Market in Pakistan, available at: (accessed 25 September 2009). Smith, C.W. and Stulz, R.M. (1985), The determinants of firms hedging policies, Journal of Financial and Quantitative Analysis, Vol. 20 No. 4, pp Stulz, R.M. (1984), Optimal hedging policies, Journal of Financial and Quantitative Policies, Vol. 19 No. 2, pp Corporate derivatives and FX risk 419 Further reading Berkman, H. and Bradbury, M.E. (1996), Empirical evidence on the corporate use of derivatives, Financial Management, Vol. 25 No. 2, pp SBP (2009), Balance of Payment Exports, available at: goodsexport.pdf (accessed 25 September 2009). Warner, J. (1977), Bankruptcy costs: some evidence, Journal of Finance, Vol. 32, pp

13 JRF 12,5 420 About the authors Dr Talat Afza (Professor of Finance) holds a PhD in International Trade and Finance and an MA Economics degree from Wayne State University, Detroit, USA. She also earned an MBA Finance degree from B.Z. University, Multan, Pakistan. She has taught at various prestigious universities including University of Michigan Dearborn (USA), Wayne State University, Detroit (USA), B.Z. University, Multan (Pakistan), University of Lahore (Pakistan) and Virtual University of Pakistan. Currently, she is working as Dean, Faculty of Business Administration at COMSATS Institute of Information Technology, Islamabad, Pakistan. Her areas of research interests include international trade and finance, money and banking, women entrepreneurship and financial management. She has published more than 30 research papers in reputed national and international journals and a similar number of research papers were presented in national and international conferences. She has successfully completed a 16 months research project on Women Entrepreneurship funded by the Higher Education Commission of Pakistan and also supervised a number of research theses of MS and PhD students. Dr Afza is also a member of editorial boards and an active reviewer for a number of national and international research journals. Talat Afza is the corresponding author and can be contacted at: talatafza@ciitlahore.edu.pk Atia Alam is an MS Research Scholar at COMSATS Institute of Information Technology, Lahore. Her areas of research include hedging policies, derivatives, financial restructuring and the bond market of Pakistan. To purchase reprints of this article please reprints@emeraldinsight.com Or visit our web site for further details:

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