The Use of Foreign Currency Derivatives and Firm Value In U.S.

The Use of Foreign Currency Derivatives and Firm Value In U.S. Master thesis Rui Zhang ANR: 484834 23 Aug 2012 International Management Faculty of Economics and Business Administration Supervisor: Dr. J.C. Rodriguez

Management Summary According to the International Financial Report Standards (I.F.R.S.) firms must disclosure their financial position about the financial derivatives position in their annual report, which makes it possible to do the empirical research about the derivative usage effect on the firm risk and firm value. In the last two decades, the financial market becomes more and more mature, and increasing number of firms choose to use the derivative instrument to hedge the risk, for instance, the interest rate risk, foreign exchange rate risk and commodity price risk. Following the study Allayannis and Weston (2001), this paper tests the relationship between the foreign currency derivative usage and firm value in U.S. A sample of 94 firms of Fortune 200 firms is selected based on their business activities and available information. This sample is studied during a research period from 2009 to 2011, which contributes to 282 observations. The information on the foreign currency derivatives of the sample is collected and extracted manually from their 10-k form annual reports. Followed by the research of Allayannis (2011), Tobin s Q which is defined as the ratio of market value of the firm to the total asset is used as a proxy for firm value. The hedging dummy variable equals to 1 if firm reports the derivative activity in annual report, otherwise, it equals to 0. In order to control some factors which may also have influence on firm value, several control variables consisting of size, profitability, investment growth, access to financial market, industry diversification, geographic diversification and advertisement expenditure are employed in my empirical analysis. In the univariate analysis the differences of firm characteristics between hedging and nonhedging observations are examined. It seems that hedgers have a higher firm value compared with non-hedgers, but the result is not statistically significant. Concerning the firm characteristics, firms having the derivatives activities are more likely to be industry diversified and geographic diversified, and have high advertisement expenditure. The univariate analysis just gives us a surface understanding about the relationship between the use of foreign currency derivative and firm value. However, the multivariate analysis can control the factors which may also impact firm value and isolate the effect of foreign currency derivative on firm value. In the multivariate analysis, I did the pooled OLS regression and fixed effect regression to investigate the relationship between hedging and firm value. The results from the both regressions show that foreign currency derivative usage does not significantly influence firm value. While, the control variable size has a negative effect on firm value and the result is statistically significant in both regressions. The coefficient of investment growth is positive and statistically significant in the fixed effect regression. 1

Preface This thesis presents and describes the main result of my theoretical and empirical research about the effect of foreign currency derivative on firm value. Since my major is International Management instead of Finance, The process of writing this thesis is much more challenging as I thought before. However, this experience will be very useful in my future career and life. During these several months, writhing this thesis increased my knowledge about the risk management, the statistically knowledge and the Stata software. First of all, I would like to thank Dr. J.C. Rodriguez for his role as supervisor. His advice and feedback were very helpful and enlightening during my writing process. Furthermore, I would like to thank Dr. F. Feriozzi for his time and role in the exam committee. With this master thesis, I successful finish my study of International Management at Tilburg University. When I look back this one year, although it is tough, I have developed myself both on academic and personal level. This one year abroad studying experience will be very useful in my future life and career. I would like to thank my parents who supported me during this one year. Furthermore, I would like to thank my friends who make my time in Tilburg unforgettable. Rui Zhang 23 Aug 2012 2

Content Management Summary... 1 Preface... 2 Chapter 1 Introduction... 4 Chapter 2 Background of hedging... 7 2.1 The financial distress costs... 7 2.2 Taxes... 8 2.3 Underinvestment... 9 2.4 Management incentives... 10 Chapter 3 Previous literature review... 11 Chapter4: research method... 15 4.1 The sample collection and data collection... 15 4.2 Firm value... 17 4.3 Control variable... 17 Chapter 5 Empirical research... 21 5.1 Summary statistics of derivative use... 21 5.2 Sample description... 22 5.3 Univariate analysis... 24 5.4 Multivariate analysis... 26 5.5 Alternative control variable... 31 Chapter 6 Determinants of hedging... 34 Chapter 7 Discussion of the result... 37 Chapter 8 Conclusion... 39 Reference:... 41 3

Chapter 1 Introduction Derivatives are financial weapons of mass destruction. -----Warren E. Buffett, 2003 Berkshire Hathaway Annual report The financial crisis of 2008-2009 has brought new scrutiny to the use of financial derivatives. Recent proposals in major countries, including the United States, call for greater regulations of over-the-counter (OTC) derivatives, including conditions for making positions to market prices, trade registrations, trade clearing, exchange trading, and higher capital and margin requirement 1. The use of financial derivative instrument by non-financial firms has grown rapidly in last two decades, and the markets of derivative financial instruments on interest rates, foreign exchange rates and commodity prices also have displayed an rapidly development. Regulations about these financial derivatives have been improved in many countries as well, which require the companies to disclose the information on the derivative position in the fiscal annual report. In particular, firms in the United States, United Kingdom, Australia, Canada, and New Zealand as well as firms fulfilling with International Accounting Standards (IAS) are required to disclose the information about the financial derivative position 2. The available data makes the empirical research about the financial derivatives by non-financial firms become possible and effective. Before the disclosure of financial information in the annual report, the financial derivative as part of risk management was considered as the important strategy for firms. During that time, most of the researches about the financial derivative were theoretical. Others researchers conducted the empirical analysis by collecting the data through the survey. The big disadvantage of survey or questionnaire is that it is difficult for the researcher to get the accurate information or data about the firms derivatives position, because managers of some firms do not want to disclose their motivation or determinants of derivative usage or they do not want to leak the information to their competitors. In fact, although the data of derivative instrument become more and more available, the detailed empirical research about the effect of derivatives usage on firms risk and value is unclear and mixed. For instance, Mian(1996) studies a large sample with 2799 non-financial firms in U.S. after the introduction of information disclosure requirement about the derivatives position. They find that the derivative usage exhibits the economies of scale, but 1 2 Bartram 2011 Bartram 2011 4

the evidence is weak with supporting the convex tax function. Geczy(1997) testes a sample consisting of 372 Fortune 500 non-financial firms in U.S. The result shows that firms with tighter financial distress, greater growth options, extensive foreign exchange rate exposure, and economies of scale in hedging activities are more likely to use the currency derivatives. Guay(1999) finds that the total risk, idiosyncratic risk exposure to interest risk declined for firms with derivative usage, but the author finds no significant change in the market risk of these firms. In contrast, Hentschel and Kothari (2001) find that the difference about risk for firms which use the derivatives is economically small compared to firms that do not use them. Allayannis and Weston (2001) present the evidence to support that derivatives activity contribute to an approximately 4%increases in market value. Graham and Rogers (2002) find that the hedging activity allows the firms to increase the debt capacity, which is associated with a1.1% increase to firms market value. However, Guay and Kothari (2003) point out that the magnitude of the cash flow generated by hedging activities is modest and is unlikely to account for such big difference on firms market value. Consistent with result of Guay and Kothari (2003), Jin and Jorion (2006) also find an insignificant effect of hedging activity on firm value by employing a sample of oil and gas producers in the U.S. The reason why I choose to collect the sample from the U.S. is that compared with other countries, the financial markets in the U.S. is more mature and steady. Another major reason is the data availability. The improvement of disclosure requirement in U.S. allows the researchers to obtain the information about firm s derivatives position and to investigate whether the use of derivative for hedging purpose is a value creative strategy for firms. In this paper, I chose to focus on the effect of foreign currency derivative usage on firm value for the following reasons: (1) I am interested in isolating a common risk factor (the foreign exchange rate risk) and investigate whether the use of foreign currency derivatives increases the market value of the firms or not which are exposure to the exchange rate risk. (2) In the U.S., foreign currency derivatives are the most commonly used derivatives. Geczy (1995) documents that among the Fortune 200, 52.1% firms use currency derivatives. Bartram (2003) reports 63.2% of 2841 firms in U.S utilize the foreign currency derivatives. Bartram (2011) employs the sample of 2076 firms in U.S. and finds that 65.1% of firms have the usage of foreign currency derivatives. (3) Most companies in the U.S. have the foreign exchange rate exposure by having foreign sale, foreign asset or foreign liability. (4) The previous literatures demonstrate that the factors affecting firm s motivation of using the interest rate, foreign currency and commodity price derivatives are different, which can also have effect on firm value. In my research, I used the data set that includes 94 firms in Fortune 200 firms in the U.S. from 2009 to 2011. I collected the annual reports of Fortune 200 firms from the U.S. Securities and Exchange Commission (SEC), and checked them one by one. Among these 200 5

firms, 15 firms did not mention any foreign sale, foreign asset or foreign liability; 41 firms are financial firms; 4 Firms had big merger or acquisition activities in the research year from 2009 to 2011. 46 firms did not disclose the annual report at the December fiscal year-end. Finally, I got 94 firms which contribute to 282 observations in my sample. In my empirical research, I use Tobin s Q followed by Allayannis (2011) as a proxy to firm value. Set the hedge dummy variable equal to 1 if firm reports the foreign currency derivatives usage in the annual report. While, some factors including size, access to financial market, profitability, investment growth, industry diversification, geographic diversification leverage and advertisement expenditure also have impact on firm value. My empirical research includes the univariate analysis and multivariate analysis. In the univariate analysis, the firm characteristic and firm value differences between foreign currency hedging and non-hedging observations are examined. Compared with non-hedging firms, hedging firms have higher firm value, but the result is not statistically significant. Concerning the control variables, the statistically significant differences with respect to the effect of hedging on firm value are industry diversification, geographic diversification and advertisement expenditure. The univariate analysis just presents surface difference between the hedgers and non-hedgers, however, the multivariate analysis enable the usage of detailed quantitative information about the hedging position in the regression. Furthermore, the multivariate analysis permits the inclusion of a set of control variables which may be associated with firm value. Thus, the multivariate analysis can isolate the impact of foreign currency derivatives on firm value from others factors. In my research, I use the Pooled OLS and Fixed-effect regression in the multivariate analysis. The results from these regressions show that foreign exchange rate hedging does not significantly influence firm value. The control variable firm size has a negative coefficient and the coefficient is statistically significant in both regressions. Furthermore, the control variable investment growth has a positive coefficient, but the coefficient is just significant in the fixed-effect regression. The geographic diversification shows a statistically significant and positive coefficient in the Pooled OLS regression. The remainder of the paper is organized as follows: The background of hedging is presented in chapter 2. The previous literature review is showed in chapter 3. The research method is described in chapter 4. The detailed empirical results are presented in chapter 5 while chapter 6 investigates the determinants of hedging activities. Chapter 7 is about the discussion and limitation of empirical results. Section 7 concludes. 6

Chapter 2 Background of hedging According to Modigliani and Miller (1985), a firm, managed by the value-maximizing agent, in a world of perfect capital markets, with investors who have equal access to these markets, would not engage in hedging activities, since these activities add no value to firm. Anything the firm could accomplish through hedging could equally well be accomplished by the investor acting on his or her own account 3. However, in the real world, it is impossible to get access to this perfect capital market. Financial theory suggests that corporate risk management is a value creative activity in the presence of imperfection of capital market such as bankruptcy costs, a convex tax schedule(smith and Stulz,1985), or underinvestment problems(smith and Stulz, 1985; Bessembinder1991). Recently, some empirical studies provide some evidences in support of these theories. Some findings suggest that risk management may come from the conflicts between managers and shareholders or earning management and speculation (Core and Guay2002). Some researches try to investigate the effect of derivative instrument on firm value with the presence of imperfect financial market. The paragraph below will describe these imperfections in Modigliani and Miller model and discuss the effect of hedging these imperfections on firm value. 2.1 The financial distress costs In the real financial market, the financial distress, for instance, the payment to lawyers and court costs, is costly, and shareholder are concerned whether the cash flow variability raise the probability of financial distress 4.Cash flow volatility will contribute to a situation in which a firm s liquidity is insufficient to fully meet the fixed payment obligations, for instance wages and interest payments, on time. Financial risk management can reduce the profitability of encountering such situation and thus decrease the expected costs associated with financial distress (Bratram 2003). Stulz(1996) demonstrates that hedging is assumed to reduce the variability of cash flow and to reduce the probability of default, as shown in figure1. At the same time, if the gains of positive net present value project accrue primarily to the fixed claimholders, then financial distress provides equityholders with incentive to abandon this profitable project. Thus, the financial hedging reduces the probability of financial distress and decreases the likelihood of equityholders passing up the valuable project. Dolde (1995) and Haushalter(2000) confirm that companies which have a higher possibility of financial distress with high debt ratio or leverage ratio,, will hedge more than the ones with lower debt ratio. 3 Bartram (2011) 4 Stulz(1996) 7

Figure 1: Cash Flow distribution and Probability of Default Risk management can reduce the probability and cost of financial distress, where X is the level of Cash Flow where costs of financial distress begin to appear. *Source: Valuation and Risk management (David A. DUbofsky and Thomas W.Miller) 2.2 Taxes In U.S., as in the most countries, companies effective tax rates rises along with increase in pre-tax income. Because of the convexity of the tax code, there are benefits to managing taxable income so that as much of it as possible falls within an optimal range-that is, neither too high nor too low 5. For firms without using the hedging activities, their pre-tax income will go through a boom and bust cycle. Under the convex tax schedule, a tax schedule that high levels of taxable income should pay more tax than low levels, this boom and bust cycle of pre-tax income will lead to a higher overall tax bill. A simple example in the table 1 below can help illustrate this issue. Suppose the convex tax schedule is that tax rate of earning equal or below 100,000 is 20% and the rate of earning above 100,000 is 30%. Firm A with hedging activities has a smooth cash follow, while firm B without hedging activities has the cash flow of higher volatility. With the same total earnings (200,000), firm A with hedging has a lower overall taxes payment than firm B without hedging (Firm A pay 40,000 taxes overall while firm B pay 50,000 taxes overall). 5 Stulz (1996) 8

Table 1: Tax reduction effect of risk management Firm A Firm B Earnings Taxes Earnings Taxes 1st year 100,000 20,000 0 0 2nd year 100,000 20,000 200,000 50,000 Total 200,000 40,000 200,000 50,000 Thus, to some extent, risk management can lead to a lower tax payment over a complete business cycle. Smith and Stulz (1985) also demonstrate that a firm can reduce expected tax liabilities by using financial hedging instruments to smooth taxable income, which contributes to an increase of firm value. Because of the fact that hedging can reduce the financial distress, hedging activities will lead to an increase of optimal debt-equity ratio. This ability of financial hedging activity therefore increases the associated tax shield and finally increases firm value. Stulz (1996) and Leland (1998) argue further that a reduction in cash-flow volatility through hedging can increase debt capacity and generate greater tax benefits, and Graham and Rogers (2002) provide the empirical support for this hypothesis. 2.3 Underinvestment Risk management can increase shareholder s value by harmonizing financing and investment policies 6. Because of high transaction cost, raising external capital is costly for firms, thus it is possible that firm may underinvestment. The conflict between shareholders and debt holders can also contributes to the problem of underinvestment. Under the situation that firms leverage is high and shareholders only have a small residual claim on firm s asset, the problem of underinvestment is more likely to happen and the benefit of safe but profitable investment projects accrue primarily to bondholders and may be rejected by the managers 7. A suitable and credible risk management program can help mitigate the underinvestment problem through reducing the volatility of cash flows and firm value. Furthermore, if financing an investment project by using the internal funds is cheaper than financing it from the external funds, hedging is a value creative activity, the reason is due to the fact that risk management allows the firm to support more positive net present value projects. Mayers and Smith (1990) argue that the volatility of cash flows is positively related to the costs of financial distress and the underinvestment problem. Thus, hedging is predicted to have a positive effect on firm value. As the underinvestment is likely to be more prominent in firms with higher leverage, significant growth and investment opportunities, 6 Froot, Scharfstein, and Stein (1993) 7 Bessenbinder (1991) 9

various measures such as the market-to-book ratio, research and development expenditure to sales ratio, or capital expenditure to sales ratio are used for test the hypothesis with respect to the underinvestment problem. 2.4 Management incentives Because the conflicting interest in the agency relationship between managers and shareholders, sometimes, managers have the incentive to use the derivatives for purposes rather than hedging the risk. Most senior managers have a highly undiversified financial position because they derive substantial (monetary and non-monetary) income from their employment by the firm 8. Consequently, risk aversion may cause managers to deviate from acting purely in the best interest of shareholders (Stulz 1984; Mayer and Smith, 1982) by investing lots of resource to hedge firm risk. Han (1996) and Stulz (1984) point out that corporate risk management can mitigate this problem by linking manager s payoff to firms stock price. Additionally, managers can use the derivatives to speculate the movements of interest rate, foreign currency exchange rate and commodity prices, which are supported by the previous derivative survey. For instance, 90% of the derivatives users surveyed by Dolde (1993), and over 40% of the firms surveyed by the Wharton Study of derivative usage (Bodnar 1995) admit that they sometimes take a view about the movement of financial market when they determine their derivative portfolios (Bartram 2003). Because speculative activity is on average not expected to be related with firms underlying business exposure, derivative activities used for this purpose are anticipated to increase, not reduce, firm risk 9, which will impact firms stock volatility and firm value. 8 Bartram (2003) 9 Bartram (2003) 10

Chapter 3 Previous literature review Overall, the previous literatures on the derivative use in the non-financial firms focus on the two parts. Firstly, many studies try to analyze the determinants and the theoretical motivation behind the using of the derivatives. Some papers support that firms use the derivatives instrument in order to reduce the risk exposure. While, others researches conclude that firms use the derivatives for speculation or for solving the conflicts between managers and shareholders instead of risk management. Secondly, many researchers try to test the relationship between the financial derivative activities and firm value. However, the relationship between firm value and general derivatives use is still mixed, both for U.S. and non U.S. firms. There are several significant results, but they are not all consistent with the valuation hypothesis. While so far most studies test what determines the firms decision to use the derivatives instrument, very little researches test the fundamental issue that whether these hedging activities increase firm value or not. Before the 1990s, a firm s derivative position is not disclosed and is considered as an important component of firm s strategy. Given this fact, little data can be used to test the effect of derivative usage on firm value. Most research at that time are focus on the theoretical parts, and most of these researches are derived from the friction to the classic Modigliani and Miller model which states that in a world of perfect capital markets, in the absence of taxes, bankruptcy costs, agency costs and asymmetric information, the value of a firm is unaffected by how that firm is operated. Others researches which do the empirical research collected the data by using the survey. For example, Nance, smith and Smithson (1993) makes a research about the derivative usage by using a sample of 159 large U.S. non-financial firms based on the response to the questionnaire. They find that firms which employ the derivative to hedge the risk have more growth options and more convex tax function. Geczy and Schrand (1997) studies a sample of 372 firms which are Fortune 500 firms in the United States, and their study result shows that firms with greater growth options, extensive foreign exchange rate exposure, tighter financial constraints, and economies of scale in hedging activities are more likely to use the foreign currency derivatives. Since 1990s, the companies were required to report their notional amount of derivative usage and derivative usage situation in the footnotes of the annual report. 1997 GAAP pertaining to disclosure about financial derivatives is contained in the statement of Financial Accounting Standard No.199 (SPSA 119). Disclosure about derivative financial instrument and fair value of financial instruments was released in 1994. As accounting disclosure requirement was regulated in the early 1990s, more academic and empirical researches have examined the derivative usage by the nonfinancial firms. Most of these researches used the U.S. nonfinancial firms as a sample, because information becomes more available and more 11

firms use the derivative in the U.S. Bartram, Brown and Fehle (2003) makes a very large scale research on the derivative usage in 50 countries by using a sample of 7,319 non-financial firms which together comprise about 80% of the global market capitalization, and provides evidence that hedging is a value creative corporate activity. At a basic level, this study finds strong evidence supporting the hypothesis that interest rate risk management is closely related with higher firm value for both the U.S. and international firms. But the result does not indicate whether the use of foreign currency derivatives usage is also closely associated with firm value or not. Concerning the determinants of firms risk management by using derivative activity, this research finds evidence that the use of foreign derivative is, in fact, risk management rather than simply speculation (Bartram 2003). For instance, firms that use foreign currency derivatives have higher proportions of foreign asset, sales, and income and firms that use interest rate derivatives have higher leverage 10. Bratram, Brown and Conrad (2011) also use a very large scale sample of non-financial firms from 47 countries to test the effect of derivative use on firm risk and fire value. This research uses a new method to reduce the effect of omitted variables bias and to improve the quality of the result and finds a strong evidence to support the hypothesis that using the financial derivative reduces both the total and systematic risk. However, this research still does not make a clear conclusion that the derivatives activity would lead to higher firm value compared with the firms without using the risk management activity. It mentions that the effect of derivative use on firm value is positive but more sensitive to endogeneity and omitted variable, however the usage of derivatives is related with firm value, abnormal returns and larger profits during the economic downturn in 2001-2002, suggesting that firms are hedging downside risk 11. Allayannis and Weston (2001) directly tests the potential impact of foreign currency derivatives on firm value by using a big sample of 720 larger non-financial firms from 1990 to 1995 in U.S. Using Tobin s Q defined as the ratio market value to replacement cost of assets, this research concludes that the use of foreign currency derivative is positively related with firms value. Specially, it finds strong evidence to support the hypothesis that firms which are facing the foreign currency exposure and choose to use the foreign currency derivative, on average, have a higher value as much as 4.87% than firms which do not use the foreign currency derivatives. It also demonstrates that firms that begin a hedging policy experience an increase in firm value above these firms that choose to remain un-hedged and that firms that quit hedging activities experience a decrease in value relative to those firms that choose 10 Bratram (2003) 11 Bratram (2011) 12

to remain hedged 12. Graham and Roger (2002) by using a broad sample also has a similar conclusion that the derivatives use has a positive effect on the debt capacity and this debt capacity leads to 1.1% firm value premium on average. While, Guay(2002) identifying an initial sample of the 1000 largest non-financial firms as of the end of 1995 also tries to estimate the relationship between the usage of derivatives and firm value. Contrary to Allayannis(2001), this research indicates that even if firms with derivative usage have much more information about the directional movements in interest rates, exchange rates and commodity prices, most of the derivative positions appear too small to increase the firm value by 4.87% as Allayannis(2001) demonstrates. Consistent with this conclusion, Jin and Jorion(2006) also finds an insignificant effects of hedging on market value by using a sample of oil and gas producers. After Allayannis and Weston (2001), some researchers have focused on the estimation the effect of the financial instruments on firm value. Some researchers exactly implement the initial model used by Allayannis and Weston (2001), while others adjust it to the special economic environment or industry situation. For instance, Carter, Rogers and Simkins (2004) examine the relationship between the derivatives use and firm value in the U.S. airline industry. Since the fuel cost accounts for on average 13% of firms operational cost, using the derivative instrument to hedge the volatility of fuel price is a justifiable strategy for these firms in the airline industry. The authors following the model of Allayannis(2001) with a little adjustment find that hedging activity in the airline industry contributes to a premium of 14.94%-16.08% increase on firm value and the result is statistically significant at the level of 10% and 1%. The size of the hedging premium is much bigger than the one of Allayannis and Weston (2001), which may be due to the fact that the firms in the airline industry spent a larger income on fuel and this fact heavily influences the firm value. At the same time, Weston (2001) and Carter (2004) also repeat the previous analysis in order to identify the major source of hedging premium. They find that capital expenditures are valued higher for the firms with fuel price hedging activity, and the positive ability of hedging to stabilize and protect capital expenditure and to avoid underinvestment contribute to the 52%-100% of the firm value premium on average. Another empirical researchs also following the Allayannis and Weston (2001), but focus on the U.S oil and gas producer industry are Jin and Jorion (2006) and Carter, Rogers and Simkins (2004). The main contribution of Jin and Jorion (2006) is a new and simple estimation of Tobin s Q which is also proxy for firms value. Contrary to Allayannis and Weston (2001), Carter, Rogers and Simkins (2004) shows that the derivative usage does not have a significant impact on firm value. But it discloses that the usage of derivative reduce the price sensitivity with respect to oil and gas prices. The authors attribute the establishment of hedging to the personal benefit of the management team. Concerning the 12 Allayannis and Weston (2001) 13

hedging premium, the authors attribute it to the factors such as the information asymmetry or the operational hedging which could be positively associated with the derivative usage. From the perspective of managerial motives, Hagelin, Knopf and Prambory (2004) find the evidence to prove that the firm value will decrease when the hedging activity is based on the motivations from manager s stock options. The authors make a conclusion that if the hedging activities are used to reduce the stock price sensitivity of managerial stock options, hedging will lead to a value discount. From the perspective of agency costs and monitoring problems, the Fauver(2010) uses the derivative usage sample about over 1745 firms in the U.S. during the period from 1991 to 2000, and finds that firms having greater agency and monitoring problems (i.e., less transparent, greater agency costs, weaker corporate governance, lager information asymmetry problem, poorer monitoring) are likely to have the negative association between Tobin s Q and derivative usage. Except doing the research in the United States, some empirical researches also employ the sample from other countries to test the effect of derivatives use on firm value. Berrospide, Amiyatosh and Uday (2008) test the relationship between the foreign currency derivative usage and firm value on Brazilian firm and find that firms using the derivative instruments have a 6.7% to 7.8% higher value than firms without using the foreign currency derivatives. They also make a conclusion that hedging with foreign currency derivatives permits the firm to sustain larger capital investment and to reduce the sensitivity of investment to internally generated funds, which has a positive influence on the mitigation of underinvestment problems 13. Ameer and Rashid (2009) examine the statement of derivative usage in Malaysian and try to evaluate the value-relevance of the notional amount of foreign exchange and interest rate derivatives over the period between 2003 and 2007, however, since few firms in Malaysian employed the derivatives, this research dose not find an significant relationship between the derivative usage and firm value. 13 Amiyatosh and Uday (2008) 14

Chapter4: research method 4.1 The sample collection and data collection I examined the Fortune 200 firms in the U.S. from 2009 to 2011. I focused on these large firms because previous literature showed that they larger firms are more likely to be derivatives users (Nance 1993; Graham and Rogers 2002). From the initial sample, I selected every firm by some criterions which I will describe below and reduced the sample to 94 firms. This sample reduction permits my following hand collection with a significant quantity of information about each firm s derivatives position from the form 10-K annual report which I downloaded from the database of the SEC (U.S. Security Exchange Commission). Note, even though I gathered the derivative data from 2009 to 2011, I selected the sample from the Fortune 200 firms as of 2011. In order to determine a desired sample for this research, it is required to identify firms which have the foreign exchange rate exposure. In my research, a firm is considered to have the foreign currency exposure if it reports foreign sales or income, foreign asset or foreign debt in the three-year research period. The criterions used in my research to collect the suitable firms are as followed. (a) Financial firms should be excluded from the sample, since these firms are also derivative makers and have different purpose for derivative using compared with the non-financial firms. Among the initial 200 firms, 41 firms are financial firms. (b) 4 Firms having big merger or acquisition activity between 2009 and 2011 are also dropped from my study. (c) Restricting the sample to December year-end firms improve the analysis result with high quality, since it allows the consistent assumptions about the financial market, and by this criterion I omited 24 firms from the sample. (d) This criterion requires that firms have published a 10-K annual report which can be retrieved from the database of the U.S. Securities and Exchange commission (SEC) during my research period. These 10-K annual reports provide useful and accurate information about the foreign currency derivative position at fiscal-year end. Without this information from the 10-K report, it would be very difficult and practically impossible to determine firms financial derivative instrument and to do the empirical analysis. Among the 200 firms, 22 firms do not meet this criterion. (e) Finally, 15 firms which do not mention any foreign sale, foreign asset or foreign liability are also expected from my sample, since these firms can be considered having little exposure to foreign exchange rate risk. At last, I got 94 firms and these firms have non-missing data about size (nature logarithmic of total asset) and market value. To sum up, the number of firms that fulfill these above criterions is 94 from 2009 to 2011, which contributes to the balanced panel data of 282 firm-year observations (both time-series and cross-sectional data). The main advantages of a balanced panel data approach is that it allows for the control of individual heterogeneity, it gives more informative data, more degree of freedom and more efficiency, at the same time, it can 15

eliminates some potential bias due to the aggregation over firms or individual 14. The new accounting standards are one of the reasons why I choose to pick up the sample in U.S. The available data due to the regulation of the accounting standards make it possible to make the empirical research to investigate the effect of foreign currency derivatives on firm value. According to the International Financial Reports Standards (I.F.R.S.), firms must disclose in their annual report whether they use derivative or not and their purpose is for hedging or trading. At the same time, they have to report the information about the whole specters of the risk they face in their business operations and the activity they take to handle these risks. Statement of Financial Accounting Standards (SFAS) 105 requires all firms to report information about financial instruments with off-balance sheet risk. For example, futures, forwards, options and swaps. Before the implementation of these disclosure regulations the sole method to get the derivative information is by the survey activity. SEC requires firms to report seven specific parts of information about financial derivative in their footnotes of annual report. The section Quantitative market risk disclosures requires firms to provide detailed and prospective information on the market risks that can be related with the firm s active position in financial instruments. The quantitative information about the firms risk and the financial instruments make it possible for readers of the financial statements to interpret the market risk which firms face in their business activity. In this part, I will describe the process of data collection. I obtained the 10-K fillings annual report of these 94 firms from the database of U.S. Securities and Exchange Commission (ESC). Extracting the information about the foreign currency derivatives position from the 10-K reports was done manually. In most of the 10-K form reports, the section 7a called Quantitative and Qualitative disclosure about the market risk provides much more detailed information about the market risk that the firm faces and the derivative usage position for each market risk. Furthermore, footnotes of the financial statements present valuable and detailed information about the active hedging position of the firm as well. For each firm I collected the detailed and useful data by searching information in the annual reports about the financial derivative position. In order to capture all relevant hedging information in the 10-K reports of all observations, a manual search is carried out to investigate all related words about the foreign currency derivatives. I search the following important keywords on hedging: hedge, hedging risk, derivative, foreign currency, interest rate, commodity price, forward, swap, option, future, collar, market risk, risk management, call etc. Firms are classified as foreign currency derivative users, if their annual reports mention the use of foreign currency derivatives exactly. The others are classified as non-foreign currency derivative. To improve the quality of data collection in my research, I also try to collect the data about notional amount of these 14 Baltagi (1995). 16

derivatives. Unfortunately, few firm disclosures this information. Thus, a hedging dummy is used in my following analysis, and it indicates to 1 when the company has the derivatives instrument and to 0 when the company was not active in hedging position in that fiscal year. Besides the hedging data, the data used to calculate the dependent variable which is Firm value (Tobin s Q) and other control variables, like firm size, leverage, profitability, investment growth, access to financial market, industry diversification, geographic diversification and advertisement expenditure, are also extracted from annual report.the calculation about the firm value (Tobin s Q) and other control variables will be described in the following part. 4.2 Firm value In order to determine whether foreign currency derivatives add firm value or not, it is necessary to measure this value. Followed by Allayannis (2001), I use Tobin s Q as a proxy for a firm s market value. Tobin s Q is defined as the ratio of market value of the firm to the replacement cost of asset, which is evaluated at the end of the fiscal year for each firm. If Tobin s Q has the value higher than one unit, the market appreciates the value of the firm to be higher than the next best use of firm s assets which is the replacement cost (Kapitsinas 2008).The methodology for constructing the replacement cost employed by Allayannis(2001), and Lewellen and Badrinath(1997) is the sum of the replacement cost of fixed asset plus inventories. However, due to the lack of data, the replacement cost of the firm s asset is hard to determine. Thus, in my research, I estimate Tobin s Q in an algorithm undertaken by most of the previous researchers in similar studies which use the book value of total assets as an approximation of the replacement value of the assets. Ultimately, the formula used to determine the firm value (Tobin s Q) in my research is: Q = Book value of total asset Book value of equity + market value of common euqity Book value of total asset 4.3 Control variable To effectively explain the effect of foreign currency derivative usage on firm value, it needs to exclude the noise resulting from other variables which also have effect on firm value. Based on the literature review, several control variables which are assumed to have a relationship with the dependent variable are selected. As followed, I will describe these control variables, the theoretical reasons why I choose these factors as control variables in my research and the expected relationships between these control variables and firm value. 4.3.1 Size According to the previous literature, there are lots of empirical researches on the effect of 17

the size on the determinant of derivative instruments. For example, Bartram, Brown and Stulz(2011) find that firm size is an important determinant of both total risk and systematic risk. Booth, Smith and Stolz(1984) State that because setting up an effective hedging program is related to the economies of scale, larger firms are more likely to use the derivative instrument compared with the smaller companies. The evidence about the effect of firm size on firm value is ambiguous. Larger firms have more capital and human resource which contribute to economies of scale and high profitability, thus a positive relationship is expected. However, some previous literature point out that the relationship between firm value and firm size is negative. Warner (1977) find that the direct cost of financial distress is not positively associated with firm size. Therefore, the benefits stemming from hedging activities are expected to be greater for smaller firms than for larger firms (Smith and Stulz, 1985). Allayannis (2001) also find evidence to support that the relationship between the firm size and firm value is negative. In my research, I use the nature log of total asset which is measured by the book value of total asset to control this variable. 4.3.2 Profitability It is expected that higher profitable firms have a higher firm value on average. Firms with higher profitability are expected to have lower financial distress costs and have more resource to invest in the positive net present value project, which lead to higher cash flow to equity holders. The high returns of profitable firms will be reflected in the stock price, which will consequently have a positive impact on the market value of the firm. All these benefits will lead to a higher firm value and higher Tobin s Q for the higher profitable firms. In order to adjust the effect of profitability on firm value, the return of asset which is defined as the ratio of net income to total asset is used as a control variable and the coefficient between the profitability and Tobin s Q is expected to be positive. 4.3.3 Investment growth Myers(1977), Smith and Watts(1992) have found that firm value depends on the future opportunities. If there are lots of investment opportunities available to the firms, it seems that this firm has the capability to generate more cash flow to the firm and to the shareholders. Consequently, this will be reflected in the stock price. So, the firm value of a firm having much more investment opportunities will be higher compared with the one of a firm with limited set of investment opportunities, which is supported by the result form Allayannis(2001). As an indicator of investment opportunities for the company, the ratio of capital expenditure to total sale is employed. Companies with high percentage of capital expenditure are expected to have higher Tobin s Q. At the same time, the Allayannis(2001) also point out that intangible asset, for instance, consumer goodwill, also affect firm value for the same reason as capital expenditure. Similar to Morck and Yeung (1991) and Allayannis 18

(2001), I use the percentage of advertising cost to total sales as a proxy for the consumer goodwill. 4.3.4 Leverage A firm capital structure also has effect on firm value. Graham and Rogers (2002) demonstrated that the increase in debt capacity and leverage associated with hedging contribute to an increase in firm value by an average of about 1.1% increase. However, too much debt will means high risk of bankruptcy and the expected bankruptcy costs, which leads to low premium of firm value and low expectation from shareholders. All the advantages and disadvantages resulting from leverage will be incorporated by investors and be reflected in the share price of the firms. Thus, it is necessary to include one control variable to filter out the effect of leverage on firm value. In my research, I use the control variable defined as the ratio of long-term debt to book equity as a proxy for leverage. 4.3.5 Access to financial market The position of accessing to financial market is closed related with the probability of underinvestment problems for non-financial firms. Thus firm value may be also associated with firm s access to financial market. If firms internal capital resource is limited and the ability of getting access to the financial market is also restricted, the firm will only be able to invest the project with the highest net present value or forgo this project which can contribute cash flows to shareholders. This capital restriction will yield to a lower total return for the firm. Consequently, this will lead to a lower share price and to a lower firm value. As most literatures do, the payment of dividend can be interpreted as the ability to get access to the financial market, since these firms which have the capital to pay the dividend are less likely to be financially constrained. In my research, I use dummy variable to control whether firm get access to financial market or not. If firm pays the dividend in that year, the dividend dummy variable is equal to 1. If it does not pay the dividend, then the dummy variable equals to 0. 4.3.6 Industry diversification There are several researches about the effect of corporate diversification on firm value or firm performance. Larry and Stulz (1993) demonstrate that through the late 1970s and the 1980s, single diversified firms are valued more highly by the capital markets than diversified firms, and highly diversified firms (defined as those firms that report sales for five segments or more) have both a mean and a median Tobin s q below the sample average for each firm. Additionally, other arguments also suggest that the outgrowth of agency problems between managers and shareholders is negatively associated with firm value. However, other researches, for example Willianson(1970) and Lewellen(1986), supported that industry diversification increase firm value. I use dummy variable to control the effect of industry diversification. If firm report that it operates in more than one segment in the 10-K annual 19

report, the dummy variable of industry diversification equals to 1. Otherwise, it equals to 0. 4.3.7 Geographic diversification In previous literature, some authors indicated that geographic diversification or multinationality has positive effect on firm value. Coase(1937) and Dunning(1973) find several reasons to explain why multinationality does in fact add share value. Firstly, some intangible asset, such as increasing production skill or superb consumer goodwill, will promote the firm to make some foreign direct investment, which will contribute to the increase of firm value. Secondly, because of the imperfect world capital market, the institutional constraints on international capital flows, information asymmetries and other reasons make it difficult for investors to optimally diversify their portfolio internationally in a direct manner. However, multinational firms can offer shareholders this opportunities by their direct investment abroad. These benefits will be reflected in share prices and thus lead to a relatively high stock price for these multinational firms. However, some researchers also pointed out that, like industry diversification, the geographic diversification also cause the outgrowth of agency problem, which is negatively associated with firm value. In my research, firms which have business operation outside the USA are considered as multinational firms. To control for the effect of geographic diversification, I use the ratio of foreign sale to total sales as a continuous measure of multinationality. 20