foreign debt as a hedging instrument of exchange rate risk: a new perspective

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Foreign debt as a hedging instrument ofexchange rate risk: a new perspectiveLuis Otero González a , Milagros Vivel Búa a , Sara Fernández López a &Pablo Durán Santomil aa Finance and Accounting Department, Faculty of Sciences Economics ,University of Santiago de Compostela , 15.782, Santiago de Compostela,SpainPublished online: 28 Jun 2010.

To cite this article: Luis Otero González , Milagros Vivel Búa , Sara Fernández López & Pablo Durán Santomil(2010) Foreign debt as a hedging instrument of exchange rate risk: a new perspective, The European Journalof Finance, 16:7, 677-710, DOI: 10.1080/1351847X.2010.481455

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The European Journal of FinanceVol. 16, No. 7, October 2010, 677–710

Foreign debt as a hedging instrument of exchange rate risk: a new perspective

Luis Otero González∗, Milagros Vivel Búa, Sara Fernández López and Pablo DuránSantomil

Finance and Accounting Department, Faculty of Sciences Economics, University of Santiago de Compostela,15.782-Santiago de Compostela, Spain

This paper analyzes the factors that determine the use of foreign currency debt to hedge currency exposurefor a sample of 96 Spanish non-financial companies listed in 2004. Unlike previous empirical studies,which have attempted to explain the use of foreign currency debt using arguments stemming exclusivelyfrom hedging theory, we have complemented the analysis with hypotheses from capital structure theory.In particular, we analyze the variables that determine the decision to hedge with foreign currency debtand hedging volume. On the one hand, we found that the decision to hedge with foreign debt is positivelyrelated to the level of foreign currency exposure, size, tax loss carry-forwards, managerial risk aversionand the building, R&D and other services sector; and on the other hand, the extent of hedging is relatedpositively to the foreign currency exposure, size, managerial risk aversion and negatively to the costs offinancial distress. We also analyze the interaction between foreign currency debt and derivatives in thehedging decision. Moreover, after controlling for the existence and type of currency swaps, we found thatthis consideration did not have an effect on the determinants of hedging with foreign currency debt.

Keywords: foreign currency debt; exchange rate risk; hedging theories; capital theories

1. Introduction

The study of hedging for exchange rate risk has usually focussed on the use of derivatives andto a lesser extent on the use of other types of financial and operational hedging. This may bedue to the difficulty of obtaining this type of information. However, Kedia and Mozumdar (2003)indicate that to better understand a company’s exposure and management of risk, it is necessaryto also analyze other forms of hedging. Among these, debt denominated in foreign currency actsas a natural hedge to the firm’s exposure in that currency, since companies with income in foreigncurrency can borrow in that currency to perform cash flow matching and, therefore, eliminate orreduce exchange rate risk.

Up to now, the empirical studies analyzing the use of foreign debt as a currency hedginginstrument employ arguments based on optimal hedging theory and are an extension of the the-oretical and empirical analysis used to explain the use of short-term derivatives. Consideringthat foreign debt also constitutes a currency hedging instrument, it seems logical that similarapproaches can be applied. Nonetheless, this practice may mean omitting relevant variables orproposing dubious hypotheses. Foreign debt also affects a company’s level of leverage, whichmay depend on other company characteristics. Therefore, the analysis of the factors leading com-panies to use foreign debt should also consider arguments from capital structure theory. In fact,

∗Corresponding author. Email: [email protected]

ISSN 1351-847X print/ISSN 1466-4364 online© 2010 Taylor & FrancisDOI: 10.1080/1351847X.2010.481455http://www.informaworld.com

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678 L.O. González et al.

Allayannis, Brown, and Klaper (2003) examine the choice between local, foreign, and syntheticlocal/currency debt by East Asian non-financial firms and indicate that since local and foreigndebt are types of debt, theories of optimal capital structure (trade-off, pecking order, and agencycost) should also be applicable when explaining the decision to use foreign and local debt (Boothet al. 2001; Harris and Raviv 1991; Titman and Wessels 1988). This consideration involves theincorporation of new hypotheses, which in some cases are in line with the approach in hedg-ing theory, but in others modify the explanation of a variable’s effect or predict an oppositebehavior.

Although foreign debt appears to be an alternative to derivatives, certain differences exist. Forexample, although foreign debt can contribute to reducing exchange rate risk, it also impliesan increase in financial risk. Thus, firms will seek a trade-off between these effects. Given thisrelation, at a certain level, obtaining debt could become more difficult and expensive, and the useof derivatives more attractive. As Judge (2003) says, foreign debt is not the preferred hedgingtool for highly geared firms, instead these firms use foreign currency swaps to create syntheticforeign currency liabilities. This might be because these firms have no unused debt capacity, whichimpedes them from borrowing further funds.

Moreover, debt is usually issued for long periods of time, in contrast to derivatives (excludingswaps) that are usually short term. For this reason, it is necessary to identify the term for whichthe company is exposed (Aabo 2006). As Clark and Judge (2008) indicate, currency forwards,futures, and options have a finite time horizon, which makes them inappropriate for hedging long-term exposures. A more appropriate hedge in these circumstances would be a long-term foreigncurrency swap or foreign debt. This means that companies that also use currency swaps (syntheticforeign or domestic debt) need to be included in the study.

Finally, although foreign debt is generally used as a hedging product, companies seekingexclusively to lower the cost of their debt assume exchange rate risk and therefore, may, try tohedge their exposure with derivatives (Allayannis, Brown, and Klaper 2003).

This study aims to analyze the reasons Spanish firms make the decision to hedge their foreigncurrency exposure through foreign debt and to identify the variables that determine hedgingvolume in the context of optimal hedging theory and capital structure theory.

This study contributes to the existing literature by focussing explicitly on foreign debt formanaging exchange rate exposure in non-financial firms. Moreover, this paper makes three impor-tant contributions. First, our research focusses on the Spanish market and contributes importantevidence on the practices of currency hedging with foreign debt. Thus, it provides a greater under-standing of European markets for which, unlike the American market, few studies are available(Keloharju and Niskanen 2001; Otero et al. 2008).

Moreover, due to its high degree of international involvement/dependence, Spain is an interest-ing country for analyzing exchange rate exposure hedging strategies. Spain’s economic growthhas been accelerating since 2004, from 3.3% to 3.7% in 2007. The share of foreign trade in Spain’sgross domestic product is nearly 55%.

Spain’s top three export partners are: France, Germany, and Portugal. Spanish exports withinEurope but outside the eurozone rose by 4.3% in 2007. In addition, UK is the fifth largest exportpartner with a growth rate of exports from 2% in 2007. Of the remaining non-EU Europeandestinations, which grew overall by 6.1% in that year, it is important the progress of sales toRussia with a growth rate from 38.2% in 2007.

Outside of Europe, exports reached a market share of 29.9% of the total exported in 2007.Exports to the USA, which is the largest customer in America with a share of 4.2% of the total,rose 0.9%. In addition, exports to Asia reached a share of 6.2% of the total with a growth rate

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of 16.1% in 2007. Finally, Africa increased its weight in Spanish exports over the previous year,reaching 4.5% of the total in 2007.

Moreover, Spain has maintained a special identification with Latin America, maintaining eco-nomic and technical cooperation programs. It is important because the total EU trade with LatinAmerica reached 141.1 billion euro (approximately USD177.2 billion) in 2007, an 18% increasefrom 2005. Among the top 10 EU partners of Latin America, Spain posted one of the strongestincreases in total trade, with a rise of 19.7%. Thus, we believe that the generality of our findingscan be extended to other countries with open economies, such as England, Germany, Australia,and others.

Spain’s top three import partners are: Germany, France, and Italy. As in the export activity, theeurozone is the main source of imports. The EU was the origin of 59.1% of Spanish imports in2007. Germany was the first Spanish supplier in 2007, with a share of 15.2% and imports fromthis country increased by 15.1%. Purchases from France (12.2% of total) increased by 3.2%. Ofthe other community providers the progress of 14.6% on purchases from Italy can be highlighted.More modest increases were imports from the Netherlands (4.5%), Portugal (3.9%), UK (3.7%),and Belgium (3.1%).

However, a 40.9% of imports came from non-EU countries in 2007, and there are countriesthat pose a significant turnover as are China, USA, and UK. China is the major source of Spanishimports outside the EU and the fourth Spanish supplier with a market share of 6.7% in 2007.Purchases from China grew by 30.4% in 2007. Purchases from the USA rose 17.1% in 2007, andthis country accounted for 91.6% of total imports from North America. Finally, imports from theUK rose by 3.75 in 2007.

Thus, we believe that the generality of our findings can be extended to other countries withopen economies, such as UK, Germany, Australia, and others.

Secondly, previous studies adopt a theoretical framework that focusses on optimal hedgingtheory, thus extrapolating the theoretical approaches used for the analysis of derivatives as currencyhedging instruments. However, the present study also incorporates arguments arising from capitalstructure theory. The result is a theoretical framework unused in previous studies. OnlyAllayannis,Brown, and Klaper (2003) used this approach but they focussed on explaining the preferencebetween different types of debt (included foreign debt) and not the determinants of exchange raterisk hedging.

Thirdly, we have studied not only the decision to hedge but also the volume of hedging withforeign debt. This aspect had only previously been addressed by Allayannis and Ofek (2001) andAllayannis, Brown, and Klaper (2003) for the American and Asian markets. Furthermore, wehave taken the study by Clark and Judge (2008) as a reference to analyze the hedging strategycombining foreign debt and derivatives.

The paper proceeds as follows. The second section presents the main empirical researchregarding the issue of foreign debt as a hedging instrument. The third section presents the maindeterminants of foreign debt usage and poses the working hypotheses. The fourth section describesthe models applied and our working hypotheses as well as the empirical results obtained. Finally,the main conclusions as well as limitations and future lines of research are presented.

2. Related literature

Modigliani and Miller (1958) demonstrated that in absence of market imperfections, firm valueand financial decisions were not related. When these conditions are not met, a number of studieshave shown that hedging can increase company value (Bessembinder 1991; Froot, Scharfstein,

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and Stein 1993; Shapiro 2003; Shapiro and Titman 1986; Smith and Stulz 1985). Thus, authorssuch as Stulz (1984), Smith and Stulz (1985), Bessembinder (1991), Froot, Scharfstein, and Stein(1993), DeMarzo and Duffie (1995) and Leland (1998) developed theories on optimal hedgingthat aim to explain the reasons why companies may be interested in hedging their risks. Most ofthese arguments are based on value creation and refer to factors like information asymmetries,underinvestment problems, costs of financial distress, managerial risk aversion, and the existenceof a convex tax system.

In the 1990s, numerous empirical studies focussed on the determinants of derivatives usagebased on the postulates of optimal hedging theory. This research ranged from generic studies,focussing on one sector,1 to studies whose analysis was limited to specific types of risk. The lattergroup includes studies that analyze exchange rate risk (Wysocki 1995; Mian 1996; Geczy, Minton,and Schrand 1997; Howton and Perfect 1998; Graham and Rogers 2000; Allayannis and Ofek2001; Hagelin 2003; Otero et al. 2008; among others), interest rate risk (Mian 1996; Howton andPerfect 1998; Graham and Rogers 2000), and/or commodity price risk (Tufano 1996; Haushalter2000). Their results showed that the factors explaining the decision to hedge with derivativesdiffered based on the type of risk and market under analysis.

With respect to exchange rate risk, derivatives are not the only hedging option. The issue offoreign debt can act as a natural hedging instrument for companies with foreign income. In thiscase, the flow of liabilities destined to repaying the principal and interest of the foreign debt wouldbe compensated by income in that currency generated by foreign operations.

Only more recently have studies focussed on the analysis of using foreign debt itself to hedgeexchange rate risk. These studies assume that the determinants are the same as for derivativesusage, that is to say, those based on the optimal hedging theory. In fact, some of these studiesanalyze only the determinants of hedging exchange rate risk with foreign debt, while othersanalyze its use together with derivatives (Table 1).

Among the first group of studies is the work by Allayannis and Ofek (2001) for the Americanmarket. These authors analyzed 500 non-financial companies of the S&P 500 index in 1993 to findthe determinants of hedging decision and the extent of hedging with foreign debt. Their resultsshowed that companies with greater size and greater foreign currency exposure were more likelyto use foreign debt, while only the level of exposure experienced was an important determinantfor the volume issued. In addition, within the group of larger companies, the smallest of thesewere the ones that resorted most to hedging with foreign debt, which according to the authorscould be explained by the high costs of issuance.

Among the studies involving Europe, the one by Keloharju and Niskanen (2001) stands out.Using a sample of the long-term borrowing of 44 listed Finnish firms between 1985 and 1991,these authors found that firms raise foreign debt in order to hedge their foreign currency exposures

Table 1. Studies analyzing foreign debt as currency hedging instrument.

Foreign debt andexchange rate risk

Analysis of exclusivelyforeign debt

Allayannis and Ofek (2001),Keloharju and Niskanen (2001),Nandy (2002), Kedia andMozumdar (2003), Otero et al.(2008)

Analysis of foreigndebt and derivativesjointly

Judge (2006a, 2006b), Aabo (2006),Clark and Judge (2005, 2008)

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and to speculate (borrow when foreign interest rates are low). Likewise, they detected that thelargest companies had better access to international financial markets and, therefore, were morelikely to use foreign debt.

A multi-country study by Nandy (2002) analyzed US dollar denominated bank debt by asample of British and Canadian firms, as well as the interdependencies between different loancharacteristics such as maturity, secured status, and the currency of denomination. This authorfound that a firm’s decision to raise US dollar denominated debt is significantly related to itsexposure to the US market and with the existence of tax loss carry-forwards. He also found thatthe choice of currency denomination is significantly related to the maturity and the secured statusof the loan. Moreover, he modeled the loan contract terms simultaneously and found that ignoringthis simultaneity issue may result in biased estimates.

For a sample of 523 American companies, Kedia and Mozumdar (2003) examined the factorsdetermining the emission of debt in the 10 most widely used currencies. The results showed thatforeign debt issue, both at the individual and the aggregate levels, is positively related to foreignactivity and company size. In addition, they found that those companies that reduce their problemsof information asymmetry, by providing more and better information to their foreign investors,are more likely to issue foreign debt.

Finally, Otero et al. (2008) conducted a study involving the Spanish market that analyzed thedeterminants of exchange rate hedging with foreign debt for 49 non-financial companies listedin 2003. Their results showed that debt was issued in order to hedge exchange rate risk, and thatthe only variable that directly influenced the decision and volume of debt was the level of foreigncurrency exposure.

Within the group of studies that jointly analyze foreign debt and derivatives as instruments forexchange rate hedging, the work by Judge2 stands out (Table 1).

Judge (2006a) analyzed the determinants of hedging for non-financial companies included inthe FT500 (Financial Times Top 500) of the UK in 1995, including only those that faced exchangerate and/or interest rate exposure. In the first part of the empirical analysis, this author’s resultsshowed that the hedging decision is related to the existence of scale economies, the costs offinancial distress, and the level of foreign currency exposure and liquidity. In addition, the authorevaluated how hedging was used so he found that companies with greater liquidity and size as wellas those with tax loss carry-forwards were more likely to hedge with derivatives. With respect tothe type of exposure, the likelihood of using derivatives had a significant negative relation with theexistence of foreign assets, while this relation was positive for firms that use foreign debt or both.When exposure stemmed from export and/or import activity, hedging only with derivatives wasmore likely. Likewise, companies with greater exposure to interest rates or with greater likelihoodof financial distress were more likely to hedge only with derivatives, or with a combination ofthese and other hedging instruments.

In other study, Judge (2006b) analyzed the decision to hedge exchange rate risk for the samesample, selecting 366 companies, and found that the currency hedging decision was related tocompany size, the level of foreign currency exposure, the costs of financial distress, tax convexity,and liquidity.

Also in the European context, using a sample made up of 47 non-financial Danish companieslisted in 2001, Aabo (2006) analyzed the determinants of the relative importance of foreign debtcompared with derivatives for hedging exchange rate risk. This author found that the impor-tance of foreign debt in currency hedging was positively related to foreign currency exposure,company size, and the costs of financial distress, while it was negatively related to informationasymmetries.

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Table 2. Estimation models used in the evaluation of hedging with foreign debt.

Analysis of currency hedgingwith foreign debt

Issuing of Extent of issuingforeign debt foreign debt

Costs of Managerial Foreign Other InterestInformation financial risk currency hedging rate

Market Author(s) asymmetries distress Taxes Size aversion exposure instruments Sector differential

America Allayannis andOfek (2001)

Probit binomial Truncatedregression a

NOT NOT * + * + NOT * *

Kedia andModumdar(2003)

Probit binomial * − NOT NOT + * + NOT * *

Europe Keloharju andNiskanen(2001)

Probit binomial * NOT NOT * + * + NOT * +

Aabo (2006) Ordered probit * − + * + * + * NOT *Clark and Judge

(2005)Logit multi-

nomial andordered logit

* + + NOT + * + * * *

Judge (2006a,2006b)

Logit bino-mial andmultinomial

* NOT + + + * + * * *

Otero et al.(2008)

Tobit * NOT NOT * NOT NOT + * * *

Clark and Judge(2008)

Logitmultinomial

* * + NOT + * * * * *

Multicountry Nandy (2002) Probit binomial * NOT NOT + NOT * + * * NOT

Notes: +, Positive relationship; NOT, there is no relationship; −, negative relationship; *, donot contrast this hypothesis.Note: Allayannis and Ofek (2001) found that the only relevant variable to determine the level of exchange rate hedging with foreign debt was the level of exposure approximatedby the percentage of foreign sales.

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Finally, Clark and Judge (2005, 2008) delve deeper into the analysis of currency hedgingpractices in the British market using the same study sample as Judge (2006a, 2006b) that wasreduced to 174 companies which responded to their survey and for which they had annual reports.Thus, Clark and Judge (2005) obtained that the hedging decision was significantly and positivelyrelated to underinvestment problems, the costs of financial distress, the level of exposure andeconomies of scale, and that it was negatively related to liquidity. A second study by Clark andJudge (2008) analyzed the joint use of derivatives and foreign debt to delve deeper into thehypothesis that hedging aims to avoid costs of financial distress. They presented two possiblereasons for the inconclusive results obtained in previous studies regarding the influence of thisfactor: a classification problem resulting from identifying hedging companies as only those thatuse derivatives, as Judge (2006a, 2006b) had already pointed out, and the fact that debt level isnot a good proxy for costs of financial distress.3 They propose the simultaneous use of severalindicators as proxies for costs of financial distress (the interest coverage ratio, if the company hasnet positive financial income, company credit rating, and tax losses carried forward). Moreover,they identify hedging companies as those that solely hedge foreign currency exposure. Theirresults show that the leverage variable is a significant determinant only when hedging companiesare considered to be those that use debt in foreign currency or both instruments simultaneously.All the other proxies for costs of financial distress are significant independently of whether thecompany hedges with foreign debt and/or derivatives, with the exception of interest coverage ratiowhich is not significant for companies that use only derivatives. Furthermore, credit rating is thefactor that most determined hedging with derivatives only.

In short, all the above-mentioned studies have attempted to explain the use of foreign debtthrough arguments stemming exclusively from hedging theory. In contrast, we have complementedour analysis with hypotheses from capital structure theory. While not often addressing the choiceof local versus foreign currency debt directly, financial theory does provide guidance on the choiceof debt type. As Allayannis, Brown, and Klaper (2003) explain, since local and foreign debt aretypes of debt, theories of optimal capital structure (trade-off, pecking order, and agency cost)should also be applicable in explaining the decision to use them (Booth et al. 2001; Harris andRaviv 1991; Titman and Wessels 1988). For this reason, the study by Allayannis, Brown, andKlaper (2003) tried to explain the reasons behind the decision to use domestic versus foreigndebt based on arguments from optimal capital structure theories. For a sample of companies fromSoutheast Asia in the period 1996–1998, they found that variables related to risk management(foreign EBIT and cash holdings), agency costs (asset tangibility), large external capital needs(capital expenditures), and to pecking order theory (foreign equity listing) were important inexplaining the levels of foreign currency but not natural local currency debt. The results supportthe use of optimal capital structure theories in explaining the decision to use foreign debt, as wepropose in the present paper.

Table 2 summarizes the findings of the main empirical studies analyzing the determinants ofusing foreign currency to hedge exchange rate risk.

3. Reasons explaining the foreign debt issue

In this section, we introduce the study hypotheses, which incorporate arguments from both hedgingtheory and capital structure theory. In addition, we specify the variables used at the empiricalanalyses and the expected relation with the use of foreign debt. All the information is summarizedin Tables 3 and 4.

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Table 3. List of the hypotheses included in the empirical analysis.

Determinants Hedging theory Capital structure theory

H1. Exchange rate risk + +H2. Growth opportunities + −H3. Information asymmetries − −H4. Costs of financial distress + −H5. Resources generated internally + −H6. Tax aspects + −H7. Size ± +H8. Managerial risk aversion + −H9. Economic sector + +

3.1 Foreign currency exposure

The level of exposure to exchange rate risk is one of the main motivations when it comes toexplaining the use of hedging instruments. In this sense, most of the studies on foreign debt haveused the percentage of company sales abroad as a proxy for the level of exposure4 (Keloharju andNiskanen 2001; Nandy 2002; Kedia and Mozumdar 2003; Aabo 2006; Clark and Judge 2008;Otero et al. 2008), expecting to find a positive relation with foreign debt issuance.

However, Aabo (2006) clarifies the interpretation of this proxy by indicating that the timehorizon of the exposure affects the preference for hedging with derivatives or with foreign debt.Thus, when the exposure is more direct and short term, which is usually associated with higherlevels of exports,5 companies tend to opt for derivatives instead of foreign debt. In fact, Allayannisand Ofek (2001) found evidence that American exporters preferred derivatives for hedging theirexposure.

Nevertheless, here we consider the volume of short-term commitments to be a proxy for thevolume of a company’s long-term commitments. Therefore, we propose a positive relation betweenforeign sales and foreign debt.

The existence of subsidiaries in foreign countries can also be considered a greater commitmentto international activity. For this reason, like Aabo (2006), foreign subsidiaries should also beconsidered as a proxy for level of foreign currency exposure. In particular, we have consideredthe number of foreign countries in which the firm has subsidiaries as a proxy for foreign currencyexposure. From the perspective of agency theory, the presence abroad through subsidiaries and/orsales may facilitate access to foreign debt in the domestic market to the extent that this presencereduces the cost of monitoring and information asymmetries for the providers of funds. In thissense, for a sample of English companies, Bradley and Moles (2002) found that 84% of firms withsubsidiaries abroad used foreign debt compared with 20% of those that did not have subsidiariesabroad.

In summary, this study uses both variables, the percentage of foreign sales outside the Eurozone over total sales and the number of countries in which the company has subsidiaries outsidethe Euro zone, as proxies for foreign currency exposure.

3.2 Growth opportunities

Companies with more growth opportunities are more likely to adopt a hedging program in orderto reduce variability in expected cash flow, thus avoiding potential underinvestment problems

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Table 4. Definition variables and empirical predictions.

Prediction

CapitalHedging structure

Theoretical rationales Variable theory theory Definition Data source

Exchange rate risk Percentage of foreign sales + + (Foreign sales/total sales)*100 Annual dataCountry subsidiaries + + Number of countries with foreign

subsidiaries (excluded Spain)Annual data

Growth opportunities Market to book ± − Market value/book value SABI databasePercentage of intangible assets ± − (Intangible assets/total assets)*100 SABI database

Information asymmetries Percentage of institutionalownership

+ + Percentage of capital held by institutionalinvestors

SABI database

Percentage of intangible assets − − (Intangible assets/total assets)*100 SABI databaseCosts of financial distress Debt ratio + − Total debt/total assets SABI database

Sector-adjusted debt ratio + − Total debt/average debt in the sector SABI database andannual data

Payback capacity + − (Long-term debt+current liabili-ties)/(sales+depreciation+variationin operating provisions+variation in theprovisions financial investment)

SABI database

Interest coverage ratio − + EBITDA/interests SABI databaseLiquidity − + Current assets/current liabilities SABI databaseImmediate liquidity − + Cash and cash equivalent/current liabilities SABI database

Resources generatedinternally

Profitability + − EBIT/total assets SABI database

Tax aspects Tax loss carry-forwards + − Dummy equal to 1 if firm has tax losscarry-forwards in 2004

Annual data

Size Size ± + Logarithm of total assets SABI databaseManagerial risk aversion Percentage of shares held by

managers+ − Percentage of shares held by managers SABI database

Economic sector Sector + + Dummies equal to 1 if firm is some of thesesectors: industrial, energy or building,R&D and other services

SABI database

Note: Only the direct managerial property has been considered and not the total property (direct plus indirect property). For this reason, the impact of the managerial risk aversionvariable may be underestimated because the difference between both percentages of property may occasionally be substantial.

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(Keloharju and Niskanen 2001). Growth opportunities can be approximated by the market-to-bookratio, or by the intangible assets to total assets ratio.

From the perspective of capital structure theory, companies with greater growth opportunitieswill have more difficulty finding external financing and, therefore, they will have a lower degreeof leverage, which, in turn, will lead to using less foreign debt. Thus, the pecking order theory(Myers and Majluf 1984) predicts that companies with greater growth opportunities will givepriority to resources generated internally over debt. This is because their future performance issubject to greater uncertainty and will suffer to a greater degree from problems deriving fromasymmetric information, with the resulting increase in finance cost and difficulty in obtainingexternal financing. Moreover, according to agency theory (Myers 1977) underinvestment prob-lems increase for companies with greater growth opportunities, consequently, creditors reducetheir supply of funds, which implies a negative relation between the firm’s level of debt andgrowth opportunities. Furthermore, Allayannis, Brown, and Klaper (2003) explain that the poten-tial agency costs are higher for firms with greater growth opportunities, so these firms will getrelatively worse terms and borrow less in foreign currency from foreign lenders.

The market-to-book ratio and the percentage of intangible assets are used as proxies for growthopportunities.

3.3 Information asymmetries

Hedging theories justify currency hedging with derivatives when companies are subject to con-siderable information asymmetries that make obtaining external financing more difficult andexpensive. These theories propose a positive relation between the level of information asymme-try and the decision to hedge exchange rate risk with derivatives (Froot, Scharfstein, and Stein1993). On the other hand, the existence of information asymmetries will make it more difficultand/or expensive to use foreign debt as a hedging instrument. Thus, we propose a negative relationbetween the existence of information asymmetries and the use of foreign debt.

The agency theory perspective would also suggest a negative relation, since, as we have alreadymentioned, information asymmetries make it more difficult to obtain external resources, includingforeign debt. According to Allayannis, Brown, and Klaper (2003), the presence of tangible assetscould facilitate the access to foreign debt because of the reduced cost of monitoring borrowers.

The following companies present greater information asymmetries: start-ups, smaller compa-nies, those with a greater proportion of intangible assets, and those that invest more heavily inR&D. Likewise, we use the percentage of shares held by institutional investors because it is themost popular measure of information asymmetry (Geczy, Minton, and Schrand 1997; Graham andRogers 2000). This variable is included in regressions on the grounds that institutions have privi-leged information and the resources to monitor the firm’s management.Also, institutions are them-selves subject to strict disclosure requirements that oblige them to periodically report informationabout their investments. Accordingly, institutional shareholding should facilitate processing ofinformation concerning the firm’s operations and financial performance on the market.

Thus, an elevated ownership by institutions implies less likelihood of hedging because there isless information asymmetry as a result of the greater control that the management of the firm issubject to.

As proxies for information asymmetries, we will use the logarithm of total assets andthepercentage of institutional ownership, for which we expect a positive relation with foreigndebt, and the ratio of intangible assets to total assets, for which we expect a negative relation.The variable percentage of institutional ownership has not been used in previous studies.

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3.4 The costs of financial distress

Companies may hedge against exchange rate risk to avoid bankruptcy. Smith and Stulz (1985)indicated that hedging reduces the likelihood of financial distress and the related costs, and so, thevalue of the company may increase. Currency hedging creates more value to companies with ahigh level of debt because it reduces the likelihood of bankruptcy. Keloharju and Niskanen (2001)established a positive relation between debt level and the volume of foreign debt used by thecompany. Similarly, Aabo (2006) indicated that if the company has a predisposition to use debt,it can be assumed that they will also have a predisposition to use foreign debt.

Nevertheless, Clark and Judge (2008) questioned the use of leverage as a proxy for the likelihoodof financial distress when companies use foreign debt, indicating that leverage is not as importantas the ability to repay the debt. For this reason, they proposed the joint use of other variables suchas credit rating, the interest coverage ratio, the payback capacity, and the tax loss carry-forwards.

From a capital structure theory perspective, particularly according to trade-off theory, compa-nies with less debt have a lower likelihood of bankruptcy; therefore, they will be more prone toraise debt, including foreign debt. This process continues while the tax benefit of paying interestsis greater than the costs of financial distress produced by the debt. At high levels of debt, thepossibility of financial distress becomes significant, thus, the positive tax effect of the debt willprobably be neutralized.

As in most previous studies, debt ratio, both adjusted for sector and unadjusted, liquidity, andimmediate liquidity are used as proxies for bankruptcy probability. In addition, unlike any previousstudy focussing exclusively on the determinants of foreign debt, we have also includedpaybackcapacity and theinterest coverage ratio as proxies.

3.5 Resources generated internally

Two contrasting situations can be distinguished regarding the influence that profitability has onthe decision to hedge exchange rate risk with foreign debt. The reputation of highly profitablecompanies gives them better access to external financing and, therefore, they may be interested inraising foreign debt to hedge exchange rate risk. In these cases, debt emission does not representa high financial risk and, nevertheless, means a reduction in exchange rate risk. According to thishypothesis, the sign of the profitability variable would be positive with respect to the foreign debtissue.

Highly profitable companies have generally less leverage.According to the pecking order theory(Myers and Majluf 1984), companies prefer to finance their business with internally generatedresources. If these become exhausted, they use debt and, in last instance, externally raised equity.Less profitable companies must raise more debt to externally fund their investment projectsbecause they do not have sufficient internal resources and because issuing stock would be harmfulin terms of market value. Allayannis, Brown, and Klaper (2003) explain that foreign debt seemsto be a complement of local debt but firms will use foreign debt only after exhausting local debtmarket. Consequently, in the same line, highly profitable companies use less debt, meaning acorrespondingly lower volume of foreign debt as well.

Economic profitability is used as a proxy for the profitability variable.

3.6 Tax aspects

According to optimal hedging theory, hedging can lead to a reduction in the quantity of the taxesto be paid when the company is subject to a convex tax system (Smith and Stulz 1985), that

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is, a tax system which is progressive and/or subject to possible tax deductions or compensationfor losses in future accounting periods. This is because hedging generates greater performancestability and entails a reduction in the quantity of taxes to be paid. Therefore, greater convexityin the tax function should lead to a greater likelihood of hedging.

From a capital structure theory perspective, the trade-off theory predicts that leverage shouldincrease with tax benefits. As explained above (see the costs of financial distress), companies withless debt will be more prone to raise debt, including foreign debt, while the tax benefit of payinginterests is greater than the costs of financial distress produced by the debt.

Moreover, according to DeAngelo and Masulis (1980), if companies already have at theirdisposal other mechanisms that can be used to obtain tax deductions, such as tax loss carry-forwards, they would be less prone to use debt for this purpose.

In Spain, the current tax legislation does not demand a progressive tax system for companies,although tax deductions and tax loss carry-forwards exist which can benefit companies. Thedifficulty involved in obtaining the information necessary to analyze this aspect has led us toconsider only tax loss carry-forwards, like Judge (2006a, 2006b). In fact, it should be noted thatthe majority of the studies analyzing foreign debt (Table 2) have not been able to consider taxationas a possible hedging determinant due to the lack or aggregation of relevant information (Aabo2006; Keloharju and Niskanen 2001).

3.7 Size

The foreign debt issue can be an inflexible and expensive hedging option for smaller companies(Aabo 2006). Larger companies have greater resources, and their financial reputation and expe-rience can give them easier and cheaper access to foreign debt markets. Indeed, the size variableconstitutes a key factor in the analysis, which according to these arguments can be expected tohave a positive relation.

However, Nandy (2002) indicates that the size effect could be ambiguous. According to thisauthor, smaller companies tend to find themselves in progressive tax brackets and are more affectedby the costs of financial distress; therefore, they will be more prone to hedge with foreign debt.Furthermore, larger companies tend to be more diversified which acts as an operational hedgingsystem, and means that they may not use foreign debt as a hedging instrument. In light of this,the relation between size and debt usage would be negative.

In the scope of capital structure theory, the agency and trade-off theories show a positive rela-tionship between foreign debt and size with different arguments. Thus, the agency theory indicatesthat greater size leads to greater conflict of interest between managers and shareholders, due tothe separation of property and control. Under these circumstances, an increase in debt volumecould reduce conflict, leading to a positive relation between foreign debt and size. According totrade-off theory, firm size may be an inverse proxy for the probability of financial distress and,therefore, positively related to leverage.

The logarithm of total assets is used as a proxy for the size variable.

3.8 Managerial risk aversion

Under the theories of optimal hedging, the greater the commitment of manager’s personal wealthto the company, the greater their interest in using hedging instruments to protect performanceas well as their own wealth by obtaining profits or mitigating losses (Stulz 1984). Thus, foreigndebt may constitute a good accounting tool for reducing the impact of foreign operations on the

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consolidated annual accounts (Smith and Stulz 1985; DeMarzo and Duffie 1995). However, theagency theory indicates that managers may not be interested in increasing the company’s debt tooptimal levels because a greater volume of debt implies, first, a greater likelihood of bankruptcythat threatens managers’ wealth as well as their job, and secondly, the repayment of those debtsreduces free cash flow limiting the perquisites of their job (Jensen 1986).

Unlike any previous study analyzing foreign debt as a currency hedging instrument, we use thepercentage of capital held by managers as a proxy for managerial risk aversion.

3.9 Economic sector

The company’s economic sector also constitutes a key variable in the choice of foreign debt as ahedging mechanism, although it has only been included in the study by Aabo (2006). Economicsectors characterized by long-term investments and projects should be more likely to have a timehorizon that corresponds to the uses of foreign debt than firms in sectors characterized by short-term investments. To the extent that this effect is not captured by the other factors, the influenceof the economic sector must be introduced through a specific variable.

The theory of trade-off successfully explains sectorial differences in the definition of capitalstructure. Thus, companies with a greater percentage of tangible assets and a greater amount oftaxable income tend to have a higher objective debt ratio in order to take advantage of tax savingsderived from paying interest, compared with those companies that are less profitable and have ahigh amount of intangible assets.

As a proxy for the economic sector, three dummy variables are used with a value of one ifthe company belongs to the industrial sector (sector02), energy sector (sector04), or building,R&D, and other services sector (sector 07), and with a value of zero otherwise. We consider thesesectors because they are the only sectors with homogeneous firms in our sample when we use theclassification of NACE (European Classification of Economic Activities).

For all firms belonging to these sectors, we expect a positive relation with foreign debt becausethese sectors are engaged in long-term projects associated with research, development, and/orproduction.

Table 3 summarizes the study hypotheses proposed in this section. In addition, Table 4 liststhe variables with their definition and expected sign in order to compare and contrast each of theworking hypotheses.

4. Empirical analysis

This paper analyzes the factors determining exchange rate hedging with foreign debt in the Spanishmarket based on the arguments from hedging and capital structure theories. The study sample con-sists of Spanish non-financial listed companies with foreign currency exposure in 2004 (Appendix1). We excluded credit institutions, insurance companies, real-estate firms, and portfolio and hold-ing companies because the nature of their activity impedes the homogenous measurement andcomparison with the other companies under analysis. Secondly, we excluded those companiesthat were not exposed to exchange rate risk at the end of 2004. As an indicator of this exposure,we considered firms with sales outside the euro zone as well as those with subsidiaries in foreignmarkets. The final sample consisted of 96 companies.

The sources of information were the 2004 annual accounts for data regarding the currencyhedging practices of these companies, and the SABI database (Sistema de Análisis de BalancesIbéricos) for other economic and financial variables. This database provides individual data at

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the firm level for Spain and Portugal. The SABI database compiles data from sources such asbalance sheets, financial rates, and administrative information for about 95% of the active firmsin an industry.

In addition, a questionnaire was sent to those companies whose annual accounts did not containinformation regarding the amount of business done in foreign markets outside the euro zone, thenotional volume of derivatives in foreign currency, and/or the amount of foreign debt (Appendix2). Thus, questionnaires were sent to 78 Spanish, non-financial firms listed on the BMEx (Bolsasy Mercados Españoles). In November 2005, the target persons were identified through telephoneconversations (42 firms) and electronic mail (36 firms) and consisted mainly of finance managers.In March 2006, the firms that had not responded were contacted again by telephone. By the end of2006, only 56 firms had sent in completed questionnaires, resulting in a response rate of 71.79%.When we contacted the rest of the population (22 firms) again by telephone throughout the year2007, we obtained a response rate of 100% (78 firms).

Based on this information, we first tried to explain the reasons influencing the decision tohedge exchange rate risk with foreign debt using a binomial probit model. Secondly, the hedgingdecision was evaluated by jointly considering foreign debt and derivatives using a multinomiallogistic regression model. Finally, we evaluated the determinants of the level of hedging volumewith foreign debt using a Tobit regression.

4.1 Univariate analysis

Table 5 shows the main descriptive statistics for the variables used in the empirical analysis. Theaverage company in the sample had a percentage of foreign sales of 24.12% (outside the eurozone) and had subsidiaries in an average of seven countries (excluding Spain). In addition, itsaverage market-to-book ratio was 4.42, approximately 14% of its assets were intangible and 7.8%of its share capital was held by institutional investors.

The variables related to the costs of financial distress indicate that the average company pre-sented a healthy financial situation. Thus, debt represented 56.2% of assets and the average valuesfor payback capacity (3.01) and interest coverage (1.15) revealed a certain financial security.Likewise, both general liquidity (1.37) and immediate liquidity (1.32) were at acceptable levels.Furthermore, the average company had a considerable ability to generate internal resources sinceit had an average profitability of 4.13%, and 60.4% of the companies had tax loss carry-forwardsat the close of 2004.

Average assets reached 3.3 million euros and, with respect to managerial risk aversion, theparticipation of managers in the capital of the company was a rather high average of 35.44%.

Finally, 20% of the companies operated in the industrial sector (sector02), 17% in the energysector (sector04), and 23% in the building, R&D, and other services sector (sector07), where thenature of the business activity entails longer-term time commitments and greater investment intangible assets.

Moreover, 39% of the companies used neither derivatives nor foreign debt to hedge againstexchange rate risk. Among those that did hedge (61% of the total sample), only 10% of companiesused foreign debt exclusively. The majority used a combination of foreign debt and derivatives(32%). A relatively high number of companies, 19% of the total, only use derivatives for currencyhedging.

Table 6 shows the differences of means for the companies that did or did not hedge with foreigndebt. Significant differences were found in a group of the variables selected in the theoreticalframework. In particular, the companies that use foreign debt had, on average, a greater number

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Table 5. Descriptive statistics.

StandardObservations Media Maximum Minimum deviation

Dependent variable Use of foreign debt 96 0.42 1 0 0.49Percentage of foreign

debt96 0.05 33.53 0 0.15

Exchange rate risk Percentage of foreignsales

96 24.12 97.72 0 0.22

Country subsidiaries 96 7.70 32 0 8.62Growth oppor-

tunitiesMarket to book 96 4.42 56.26 −3.56 7.66

Percentage ofintangible assets

96 14.06 99.89 0 0.19

Informationasymmetries

Percentage ofinstitutionalownership

96 7.80 44 0 108.05

Costs of financialdistress

Debt ratio 96 0.56 10.82 0.01 0.20

Sector-adjusted debtratio

96 1.01 1.99 0.03 0.37

Payback capacity 96 3.01 485.08 0.12 851.89Interest coverage ratio 96 1.15 253.91 −10.61 2.89Liquidity 96 1.37 7.01 0 0.95Immediate liquidity 96 1.32 58.65 0 6.08

Resourcesgeneratedinternally

Profitability 96 4.13 40.16 −106.19 180.92

Tax aspect Tax loss carry-forwards 96 0.60 1 0 0.49Size Size 96 3.36 63.46 4.55 2.06Managerial risk

aversionPercentage of shares

held by managers96 35.440 66.88 0 0.11

Economic sector Sector02 (industrial) 96 0.20 1 0 0.40Sector04 (energy) 96 0.17 1 0 0.38Sector07 (building,

R&D, otherservices)

96 0.23 1 0 0.42

Note: The table shows the descriptive statistics for the independent variables included in the empirical analysis.

of countries in which it has subsidiaries, a greater percentage of institutional investors and capitalheld by managers, a greater debt ratio and sector-adjusted debt ratio, a greater tax loss carry-forwards, were larger in size, and operated in industrial sector and building, R&D, and otherservices sectors.

Table 7 shows the correlations matrix of the dependent variable percentage of debt in foreigncurrency as well as the continuous independent variables included in the empirical analysis. Thepercentage of debt in foreign currency had a significant positive correlation with the percentageof foreign sales. This would support the hypotheses that companies use foreign debt as a hedginginstrument and not to speculate in financial markets. Furthermore, there was a significant positivecorrelation between variables size and country subsidiaries, which indicates that the number of

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Table 6. Comparison of the variables between users and non-users of foreign debt..

Using of foreign debt N Media T

Exchange rate risk Percentage of foreignsales

0 55 21.58 −1.281 41 27.53 (0.20)

Country subsidiaries 0 55 5.56 −2.93***1 41 10.58 (0.00)

Growthopportunities

Market to book 0 55 5.17 1.111 41 3.41 (0.26)


0 55 0.11 −1.261 41 0.16 (0.26)



0 55 5.46 −2.53**1 41 10.94 (0.01)


Debt ratio 0 55 0.51 −2.81***1 41 0.62 (0.00)


0 55 0.95 −1.77*1 41 1.08 (0.07)

Payback capacity 0 55 20.25 −1.321 41 43.41 (0.18)

Interest coverage ratio 0 55 15.43 1.541 41 6.25 (0.12)

Liquidity 0 55 1.45 0.891 41 1.27 (0.37)

Immediate liquidity 0 55 1.86 1.001 41 0.60 (0.31)


Profitability 0 55 2.60 −0.961 41 6.19 (0.33)

Tax aspect Tax loss carry-forwards 0 55 0.52 −1.79*1 41 0.70 (0.07)

Size Size 0 55 12.19 −6.98***1 41 14.62 (0.00)

Managerial riskaversion

Percentage of capitalheld by managers

0 55 0.00 −2.65***1 41 0.06 (0.00)

Economic sector Sector02 – industrial 0 55 0.27 1.81*1 41 0.12 (0.07)

Sector04 – energy 0 55 0.12 −1.481 41 0.24 (0.14)

Sector07 – building,R&D, other services

0 55 0.16 −2.04**

1 41 0.34 (0.04)

Note: This table shows the difference of means for the independent variables used in the empirical analysis betweencompanies that hedge with foreign debt (1) and those that do not (0). The t-statistic is used to test the equality of means.*The Levene test for equality of variances with a level of significance of 10%.**The Levene test for equality of variances with a level of significance of 5%.***The Levene test for equality of variances with a level of significance of 1%.

countries with subsidiaries is proportionally higher in larger companies. In representative variablesfor costs of financial distress, there is a significant positive correlation between the variables sizeand debt ratio, both adjusted for sector and unadjusted, and payback capacity. The size variablealso had a positive relation with the variables institutional ownership and profitability.

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Table 7. Correlation matrix.

% Foreign % Foreign Country Marker % Intangible % Institutional Debt Sector-adjusted Payback Interest Immediate % Capital held

debt sales subsidiaries to book assets ownership ratio debt ratio capacity coverage ratio Liquidity liquidity Profitability Size by managers

% Foreign debt 1

% Foreign sales 0.1850* 1

Country subsidiaries 0.0371 0.0138 1

Market to book −0.0896 0.1449 −0.1104 1

% Intangible assets −0.0186 0.1838* 0.0115 0.0535 1

% Institutional

ownership

−0.0206 0.0135 0.0937 −0.0972 0.0186 1

Debt ratio −0.0814 0.1476 0.2141* 0.0061 0.0585 0.1387 1

Sector-adjusted debt

ratio

−0.0373 0.0490 0.1381 −0.0709 −0.0045 0.1096 0.8652** 1

Payback capacity −0.0190 −0.0003 0.0442 −0.0250 0.0998 −0.0154 0.0846 0.0055 1

Interest coverage

ratio

−0.0821 −0.1805* −0.0666 0.0751 0.0617 −0.0794 −0.2370** −0.1731* −0.0350 1

Liquidity 0.0787 0.0119 −0.1397 0.0223 0.0406 −0.1343 −0.3977** −0.3533* 0.0052 0.2118** 1

Immediate liquidity −0.0478 0.0827 −0.0852 −0.0027 −0.0860 −0.0621 −0.1932* −0.2144 −0.0281 −0.0251 0.1466 1

Profitability 0.0091 0.0489 0.0914 0.2088** 0.1349 0.0866 −0.0014 −0.0405* 0.0721 0.3319** 0.2137**−0.0072 1

Size 0.1333 0.0600 0.4980**−0.0575 0.0727 0.2151** 0.3440** 0.1693* 0.3063** −0.0001 −0.0808 −0.0546 0.3654** 1

% Capital held by

managers

0.1584 −0.0171 0.1336 −0.0255 0.0164 0.0883 −0.0054 0.1310 0.0060 0.0429 −0.0154 −0.0457 0.0717 0.0460 1

Notes: The table shows the Pearson’s correlation coefficients for the dependent variable percentage of debt in foreign currency as well as the continuous independent variables included in the empirical analysis.*Significance level of 10%.**Significance level of 5%.***Significance level of 1%.

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4.2 Analysis of the decision to hedge with foreign debt

Most empirical studies test the hypotheses established in the theoretical framework with condi-tional likelihood models. Therefore, we have chosen to apply a binomial probit model to analyzethe hedging decision (Appendix 3).

Table 8 shows the models that result from combining the various independent variables. Thereare a group of variables that are significant in all the models estimated. Thus, the decision to hedgewith foreign debt was related positively to the level of foreign currency exposure, size, tax losscarry-forwards, managerial risk aversion, and the building, R&D, and others services sector.

Specifically, the variable percentage of foreign sales, used as a proxy for the company’s exposureto exchange rate risk, was significant and positive, as found by Judge (2006a), Allayannis andOfek (2001), Keloharju and Niskanen (2001), Nandy (2002), and Otero et al. (2008). Furthermore,the marginal effect value of this variable indicates that it was the variable with greatest impacton the decision to hedge exchange rate risk with foreign debt. This finding supports H1 (Table 3)indicating that companies with greater level of exposure are more likely to use foreign debt bothfrom the perspective of hedging theory and capital structure theory.

Like previous studies, we found a positive relation between the use of foreign debt and companysize (Allayannis and Ofek 2001; Allayannis, Brown, and Klaper 2001; Keloharju and Niskanen2001; Kedia and Mozumdar 2003; Aabo 2006; Judge 2006a, 2006b; Clark and Judge 2008). Thisfinding is consistent with H7 (Table 3) from the perspective of hedging theory and capital structuretheories (trade-off and agency theories). As proposed by hedging theory, larger companies havegreater resources, and their financial reputation and experience can give them easier and cheaperaccess to foreign debt markets. According to capital structure theories, debt usage could reducethe conflict between shareholders and managers of larger companies, and firm size leads to easieraccess to foreign debt.

The percentage of capital held by managers, used as aproxy for managerial risk aversion, wasalso found to be significant and positive. Like the hypothesis stemming from hedging theory, thisfinding confirms H8 (Table 3), which explains that if managers assume high risk in a businessthey may be interested in hedging more (Smith and Stulz 1985).

Moreover, we also found a positive relation between the use of foreign debt and the tax losscarry-forwards variable that supports H5 (Table 3) under the hedging theory perspective. There-fore, this result confirms that greater convexity in the tax function should lead to greater likelihoodof hedging.

Finally, only the sector07 variable, which includes companies from building, R&D, and othersservices, is significant as opposed to the findings by Aabo (2006). Our finding supports H9(Table 3), which postulates that companies operating in this sector, with a longer-term orientation,are more likely to use foreign debt.

The remaining variables were not found to be significant. However, the negative sign of market-to-book and debt ratio variables supports that the usage of capital structure theories can lead to abetter understanding of the determinants of hedging with foreign debt.

4.2.1 Controlling for the effect of currency swapsIn the literature, there is support for the notion that the type or source of exposure (short versus longterm) might influence the choice of hedging strategy (Allayannis and Ofek 2001). Thus, accordingto Clark and Judge (2008), long-term foreign debt and currency swaps might be more effectiveat hedging foreign currency exposure over long time horizons, such as that due to operationsin foreign locations, whereas forwards, futures, and options might be more effective at hedging

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short-term foreign exchange exposure, such as that due to exporting/importing or the receipt offoreign dividends, interest, profit, or other income.

With respect to currency swaps, if firms use them to translate domestic debt into foreign debtor foreign debt of one currency into foreign debt of another currency for asset liability matching,then issuing foreign debt in the currency of firm’s assets is a substitute strategy. On the otherhand, if firms use currency swaps to convert foreign debt into domestic debt in order to currencymatch domestic assets with domestic liabilities then issuing foreign debt without the concomitantcurrency swap would not be a substitute strategy. It follows, therefore, that foreign debt does notnecessarily substitute for the use of swaps in reducing foreign currency exposure.

The importance of controlling for the existence of currency swaps and their type which areused by hedging firms is shown by Judge (2003) who found, using a sample that excluded foreigncurrency swap users, significant evidence that British firms preferred to use foreign debt rather thanderivatives to hedge foreign currency exposure arising from assets located in foreign locations.This author also found that issuing foreign debt is not a substitute strategy for firms that swapforeign debt into domestic debt; however, it is for firms that swap into foreign debt.

For these reasons, we have controlled for the existence and type of currency swaps. Thus, inthis section, we also analyzed the effect of currency swaps in the group of foreign debt userswhich could affect the results. As shown in Table 8, not considering currency swaps has no effecton the determinants of foreign currency debt usage.

4.3 Analysis of the hedging decision: joint consideration of derivatives and foreign debt

The use of foreign debt to hedge exchange rate risk may be affected by the use that companies makeof other hedging instruments. In this sense, companies with a more direct and short-term foreigncurrency exposure may find it advisable to use derivatives. Also, companies with informationasymmetries find it more difficult to raise debt and, therefore, have to choose to hedge withderivatives. Moreover, although costs play a critical role in the decision to use derivatives andin the choice of strategies (Geczy, Minton, and Schrand 1997), empirical research indicates thatstarting up and managing a derivatives hedging program involves considerable economies ofscale (Nance, Smith, and Smithson 1993; Sinkey and Carter 1997; Cummins, Phillips, and Smith1997b). Finally, the use of derivatives for other hedging purposes may lead companies to also usethem to hedge exchange rate risk, as a result of their experience and the lower transaction costsinvolved.

In accordance with Clark and Judge (2008), the consideration of only one hedging method canlead to biased results. Therefore, this section analyzes the decision to hedge exchange rate riskwith foreign debt by considering the possibility that it is used in combination with derivatives.Thus, we can improve the analysis of currency hedging practices in Spanish companies and ofthe factors that affect the choice of hedging instruments.

In particular, the following groups of companies have been distinguished:

• Companies that use neither derivatives nor foreign debt (Group 0).• Companies that exclusively use derivatives (Group 1).• Companies that use both derivatives and foreign debt (Group 2).

The analysis of the factors that influence the likelihood of choosing one option over another wasdone with a multinomial logit model (Appendix 3).

The results of the estimations are shown inTable 9.As a reference we use group 2, which includesthe companies that use both currency debt and derivatives for currency hedging. Thus, size and

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696L

.O.G

onzálezetal.Table 8. Binomial probit estimations of the likelihood of using foreign debt.

Dependent variable: Using of foreign debt = 1; not using of foreign debt = 0

Model 3, Model 4,excluding synthetic excluding synthetic

Model 2, foreign debt users - domestic debt usersModel 1, excluding currency swap into foreign - swap into domesticall firms swaps users debt debt

(96 firms) (10 firms) (6 firms) (4 firms)

Coefficient M.E. Coefficient M.E. Coefficient M.E. Coefficient M.E.

Exchange rate risk Percentage foreignsales

1.82* (0.33) 0.61 2.01** (0.30) 0.60 1.94* (0.30) 0.60 1.90* (0.33) 0.63

Country subsidiaries −0.66 (0.08) −0.05 −0.37 (0.08) −0.03 −0.24 (0.08) −0.01 −0.91 (0.08) −0.07Growth opportunities Market to book −1.16 (0.02) −0.03 −1.00 (0.02) −0.02 −1.08 (0.02) −0.02 −1.14 (0.02) −0.03




1.20 (0.01) 0.01 0.33 (0.01) 0.01 1.25 (0.01) 0.01 0.40 (0.01) 0.01


Debt ratio −0.22 (0.43) −0.09 −0.44 (0.40) −0.17 −0.45 (0.42) −0.18 −0.23 (0.41) −0.09


Payback capacityInterest coverage ratioLiquidity

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Resources generatedinternally

Profitability 0.33 (0.01) 0.01 0.28 (0.01) 0.01 0.44 (0.01) 0.01 0.12 (0.01) 0.01

Tax aspects Tax loss carry-forwards 1.98** (0.13) 0.29 2.01** (0.12) 0.27 2.13** (0.12) 0.29 1.90* (0.13) 0.27Size Size 3.99*** (0.07) 0.29 3.26*** (0.07) 0.22 3.54*** (0.07) 0.24 3.95*** (0.08) 0.28Managerial risk

aversionPercentage of shares

held by managers1.78* (1.98) 3.26 1.88* (2.10) 3.33 1.81* (1.92) 3.03 1.82* (0.22) 3.58

Economic sector Sector07 2.38** (0.15) 0.40 2.44** (0.15) 0.40 2.50** (0.15) 0.42 2.28** (0.15) 0.38Pseudo-R2 0.51 0.44 0.48 0.51

Log likelihood −31.99 −31.07 −30.79 −30.31P 0.00 0.00 0.00 0.00

Obs Dep=0 55 55 55 55Obs Dep=1 41 31 35 37

Notes: The table shows the binomial probit estimations of the relation between the likelihood of using foreign debt and the independent variables mentioned. The standard errorsare shown in parenthesis. M.E. represents the marginal effects of independent variable changes on the value of the dependent variable, calculated for the average values of theindependent variables. We have analyzed possible problems of heteroscedasticity, absence of normality and multicollinearity. In addition, a sample adjustment has been madethat consisted of defining companies that use foreign debt as a hedging instrument to be those that have a proportion of foreign debt of at least 1 per 1000 (seven cases).*Significance level of 10%.**Significance level of 5%.***Significance level of 1%.

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percentage of foreign sales were again found to be significant. In particular, size is a relevantexplanatory variable for groups 0 and 1. The positive sign of the marginal effects indicates thatan increase in size increases the likelihood that a company will use foreign debt. This finding isconsistent with H7 (Table 3) from the perspective of hedging theory and capital structure theories.In addition, the differentiation between the three groups reveals that the increase in likelihoodwould be greater for group 2, which indicates that an increase in size brings along a preferencefor using derivatives and debt together with respect to the other alternatives.

The impact of the percentage of foreign sales is also significant on the use of hedging prod-uct. This finding indicates that companies with a greater level of foreign currency exposurehave a greater likelihood of using only derivatives, and at a low extent of hedging by usingdebt in foreign currency and derivatives together. This finding is again in the line with theresults obtained with the binomial probit analysis of foreign debt and supports H1 (Table 3)that proposes that exchange rate risk leads companies to use foreign debt, although companiesare more likely to use derivatives. This is also consistent with the results of Allayannis and Ofek(2001) and Aabo (2006) who found evidence that exporters preferred derivatives for hedging theirexposure.

Managerial risk aversion was also found to have a significant positive impact, as in the binomialanalysis, such that the greater the percentage of capital held by managers, the greater the likelihoodof being in group 2. Thus, H8 (Table 3) is supported from the perspective of hedging theory, whichproposes that if managers assume high risk in a business they may be interested in hedging more.

Moreover, we also found a positive relation between the use of foreign debt and the tax losscarry-forwards variable that supports H5 (Table 3) under the hedging theory perspective. There-fore, this result confirms that greater convexity in the tax function leads to a greater likelihood ofhedging.

Finally, distinguishing between groups of companies made it possible to identify new factorswith a significant influence on the decision to hedge exchange rate risk.

For one, the market-to-book variable was significant in the relation between the groups 0and 1 and had negative marginal effects. This finding is consistent with H2 (Table 3), from theperspective of capital structure theory, which indicates that those companies with more growthopportunities have greater difficulty obtaining foreign debt. On the other hand, the institutionalownership variable was also significant and presented a positive marginal effect in the group 2.This result is consistent with H2 (Table 3), from the perspective of capital structure theory, andmeans that the presence of institutional investors in the firm reduces information asymmetriesand makes it easier to obtain foreign debt.

The models 2–4 contain the effect of excluding swaps on the multinomial regression. AsTable 9 shows, the consideration of currency swaps had no effect on the determinants of foreigndebt usage.

4.4 Analysis of the volume of foreign debt raised

After analyzing the decision to hedge exchange rate risk with foreign debt, we have studiedthe factors that determine the level of currency hedging with this instrument. We used a Tobitregression model to analyze the relation, which makes it possible to evaluate the effect of theindependent variables on the level of hedging in the sample of companies that decided to hedgewith foreign debt (Appendix 3).

The results of the different estimations appear in Table 10. As can be seen, the determinantsof the extent of exchange rate hedging with foreign debt are very similar to those of the decision

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Table 9. Multinomial logit estimations regarding the likelihood of using various currency hedging methods.

Model 2: Excluding currency Model 3: Excluding synthetic foreign debt users Model 4: Excluding synthetic domestic debt

Model 1: All firms (96 firms) swaps users (10 firms) - swap into foreign debt (6 firms) users - swap into domestic debt (4 firms)

Group 0: Not using Group 0: Not using Group 0: Not using Group 0: Not using

foreign debt and Group1: Using foreign debt and Group 1: Using foreign debt and Group 1: Using foreign debt and Group 1: Using

derivatives only derivatives derivatives only derivatives derivatives only derivatives derivatives only derivatives

Selection of hedging instruments Coefficient E.M. Coefficient E.M. Coefficient E.M. Coefficient E.M. Coefficient E.M. Coefficient E.M. Coefficient E.M. Coefficient E.M.

Exchange rate risk % Foreign sales −1.62* (2.42) −1.06 0.26 (2.20) 0.66 −1.72* (2.58) −0.99 −0.02 (2.40) 0.75 −1.74* (2.43) −1.04 0.10 (2.21) 0.71 −1.62* (2.58) −1.04 0.17 (2.39) 0.74

Countrysubsidiaries

1.42 (0.48) 0.05 1.56 (0.50) 0.05 1.49 (0.56) 0.02 1.60 (0.59) 0.03 1.04 (0.49) 0.02 1.19 (0.50) 0.03 1.91* (0.56) 0.06 2.02** (0.58) 0.06

Growth oppor-tunities

Market to book 1.38 (0.14) 0.03 0.71 (0.15) −0.01 1.45 (0.19) 0.03 0.96 (0.19) −0.01 1.30 (0.14) 0.03 0.61 (0.14) −0.01 1.58 (0.20) 0.04 1.12 (0.20) −0.01

% Intangibleassets


% Institutionalownership

−1.70* (0.04) −0.01 −1.79* (0.05) −0.01 −1.50 (0.05) −0.01 −1.60 (0.05) −0.01 −1.76* (0.04) −0.01 −1.87* (0.05) −0.01 −1.48 (0.05) −0.01 −1.56 (0.05) −0.01


Debt ratio 0.17 (2.51) −0.07 0.49 (2.60) 0.18 0.50 (0.27) −0.07 0.80 (2.77) 0.19 0.36 (2.64) −0.05 0.65 (2.71) 0.18 0.35 (2.56) −0.07 0.67 (2.64) 0.20

Sector-adjusteddebt ratio

Payback capacity

Liquidity


Profitability −1.34 (0.07) −0.02 −0.30 (0.06) 0.01 −1.24 (0.08) −0.01 −0.36 (0.07) 0.01 −1.43 (0.07) −0.02 −0.47 (0.07) 0.01 −1.17 (0.07) −0.02 −0.23 (0.07) 0.01

Tax aspect Tax losscarry-forwards

−2.41** (1.06) −0.24 −2.32** (1.08) −0.10 −2.40** (1.30) −0.15 −2.33** (1.32) −0.04 −2.48** (1.18) −0.19 −2.41** (1.10) −0.07 −2.39** (1.15) −0.20 −2.28** (1.18) −0.07

Size Size −4.07*** (0.46) −0.26 −3.38*** (0.44) −0.02 −3.54*** (0.53) −0.17 −2.88*** (0.52) 0.03 −3.73*** (0.47) −0.20 −2.97*** (0.45) 0.02 −3.96*** (0.53) −0.22 −3.35*** (0.51) 0.01

Managerial riskaversion

% Shares held bymanagers

−1.68* (7.64) −0.12 −1.40 (1.55) −2.38 −1.75* (7.80) 0.74 −1.42 (1.57) −1.98 −1.72* (7.23) 0.35 −1.35 (1.54) −2.02 −1.75* (8.32) 0.35 −1.49 (1.58) −2.35

Economic sector Sector

Normalized with Group 2 Group 2 Group 2 Group 2 Group 2 Group 2 Group 2 Group 2

Note: The table shows the results of the multinomial logit regressions of the relation between the likelihood that a company will select one of two hedging categories and the independent variables identified as proxies for the determinants of hedging, selected through

various test of individual and combined significance. The hedging strategy categories shown in the table (group 0 and group 1) are expressed in relation to the hedging method defined by the use of derivatives and foreign debt (group 2). Group 0 represents hedging neither

with derivatives nor with foreign debt, and group 1 represents hedging only with derivatives. The information shown is the odds logarithm (coefficient) and the marginal effect (M.E.). The marginal effect measures the marginal change in the likelihood of hedging neither

with derivatives nor with foreign debt, or of hedging only with derivatives resulting from a change in the independent variable. *Significance level of 10%. **Significance level of 5%. ***Significance level of 1%.

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Table 10. Tobit regression estimations of hedging volume with foreign debt.

Dependent variable: Foreign debt/total assets

Model 4: ExcludingModel 3: Excluding synthetic domestic

Model 2: Excluding synthetic foreign debt users - debt users - swapModel 1: All currency swaps swap into foreign debt into domestic debt

firms (96 firms) users (10 firms) (6 firms) (4 firms)

Coefficient Std. Err. Coefficient Std. Err. Coefficient Std. Err. Coefficient Std. Err.

Exchange rate risk Percentage foreign sales 0.25* 0.15 0.35* 0.18 0.30* 0.17 0.29* 0.16Country subsidiaries 0.02 0.03 0.02 0.04 0.03 0.04 0.01 0.04Foreign subsidiaries

Growth opportunities Market to book −0.01 0.01 −0.01 0.01 −0.01 0.01 −0.01 0.01Percentage of intangible assets

Information asymmetries Percentage of institutionalownership

−0.01 0.01 −0.01 0.01 −0.01 0.01 −0.01 0.01

Costs of financial distress Debt ratioSector-adjusted debt ratioPayback capacityInterest coverage ratio −0.01* 0.01 −0.01* 0.01 −0.01* 0.01 −0.01* 0.01Liquidity

Resources generated internally Profitability 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01Tax aspects Tax loss carry-forwards 0.04 0.07 0.05 0.09 0.04 0.08 0.05 0.07Size Size 0.05*** 0.02 0.06** 0.02 0.06** 0.02 0.06*** 0.02Managerial risk aversion Percentage of shares held by

managers0.67** 0.26 0.81** 0.31 0.73** 0.28 0.73*** 0.27

Economic sector Sector07 0.07 0.07 0.11 0.09 0.09 0.08 0.07 0.08C −1.00*** 0.28 −1.23*** 0.38 −1.15*** 0.35 −1.08*** 0.31

Pseudo-R2 0.49 0.42 0.44 0.46Log likelihood −17.85 −20.48 −19.99 −18.98

P 0.00 0.00 0.00 0.00Obs Dep=0 55 55 55 55Obs Dep=1 41 31 35 37

Note: The table shows Tobit regressions. These regressions estimate the relation between the percentage of debt in foreign currency and the independent variables mentioned. Only those companies that have decided tohedge with foreign debt have been considered. Std. Err. are the standard errors. *Significance level of 10%. **Significance level of 5%. ***Significance level of 1%.

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to hedge. In this sense, there is a significant positive relation with foreign currency exposure,managerial risk aversion, and size. In addition, a new factor which is the cost of financial distresswith the variable interest coverage ratio was found to be a negative relation.

In particular, the variables that turned out to be most significant were the level of foreigncurrency exposure, approximated by the percentage of foreign sales, and managerial risk aversion,represented by the percentage of shares held by managers. With respect to the first variable, theresult is similar to the findings by Allayannis and Ofek (2001) for the American market. Thispositive relation suggests that companies with a greater level of exchange rate exposure use agreater volume of foreign debt, which confirms H1 (Table 3) indicating that exchange rate riskimpels companies to hedge with foreign debt. Managerial risk aversion was also found to havea significant positive impact such that the greater the percentage of capital held by managers,the greater the volume of debt used by the company. Thus, H8 (Table 3) is supported from theperspective of hedging theory, which proposes that if managers assume high risk in a businessthey may be interested in hedging more.

The size variable was also found to have a significant positive impact. This supports the assertionin H7 (Table 3) that larger companies use a greater volume of foreign debt. According to hedgingtheory and, more specifically, Allayannis, Brown, and Klaper (2003), larger companies havegreater resources, and their financial reputation and experience can give them easier and cheaperaccess to foreign debt markets. According to capital structure theories, debt usage could reducethe conflict between shareholders and managers of larger companies, and firm size leads to aneasier access to foreign debt.

With respect to the costs of financial distress, a significant and negative relation was foundwith the variable interest coverage ratio on the volume of hedging and confirms H4 (Table 3)from the perspective of hedging theory. Thus, companies with more ability to repay debt willbe less prone to use foreign debt as a means of exchange rate hedging. This result supports thetraditional hedging theory view that assumes companies closer to an insolvency situation willhedge more. Moreover, this finding is consistent with Clark and Judge (2008), who indicate thatconsidering new proxies and not only leverage, makes it possible to identify variables that supportthe reduction of financial distress cost.

The models 2–4 contain the effect of excluding currency swaps on the Tobit regression. Asshown in Table 10, the consideration of these swaps has no effect on the determinants of foreigncurrency debt usage and the determinants of hedging volume are the same if we exclude thedifferent alternatives of synthetic debt.

5. Conclusions

This paper analyzes the factors determining the hedging of foreign currency exposure with foreigndebt in the Spanish market. In particular, we analyze the variables that determine the decisionto hedge with foreign debt as well as hedging volume for a sample of 96 Spanish non-financialcompanies listed in 2004. We also analyze the interaction between the foreign debt and derivativesin the hedging decision.

Unlike previous empirical studies, which have attempted to explain the use of foreign debtthrough arguments exclusively stemming from optimal hedging theory, we have complemented theanalysis with hypotheses from capital structure theory. This approach is based on the assumptionthat, although foreign debt may be used as an instrument for hedging exchange rate risk, its use alsoaffects financial structure, which, in turn, depends on company characteristics. The considerationof capital structure theory involves the incorporation of new hypotheses, which in some cases are

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in agreement with hedging theory, but in others, modify the explained effect of a certain variableor predict the opposite behavior.

The findings obtained with probit models show that the level of foreign currency exposureapproximated by the percentage of foreign sales is the main factor determining the decisionto hedge with foreign debt. This corroborates the fact that foreign debt is used as a hedgingmechanism and not for speculating in financial markets.

In addition, we found that the decision to hedge with currency debt also has a direct significantrelation with the size variable. As proposed by hedging theory, larger companies have greaterresources, and their financial reputation and experience can give them easier and cheaper access toforeign debt markets. According to capital structure theories, debt usage could reduce the conflictbetween shareholders and managers of larger companies, and firm size leads to easier accessto foreign debt. The percentage of capital held by managers, used as a proxy for managerialrisk aversion, was also found to be significant and positive, thus confirming that if managersassume higher risk in a business they may be interested in hedging more. Furthermore, we alsoobtained a positive relation between the use of foreign debt and the tax loss carry-forwards variablethat confirms that greater convexity in the tax function leads to a greater likelihood of hedging.Finally, only the sector variable that includes companies from building, R&D, and others servicessector was significant, indicating that companies operating in this sector, which has a longer-termorientation, are more likely to use foreign debt.

Based on the approach by Clark and Judge (2008), our study of the decision to hedge with foreigndebt was complemented by considering the use of foreign debt and derivatives jointly. Thus, byestimating a multinomial logit model, we found that an increase in size increased the likelihoodthat a company will use foreign debt and brings along a preference for using derivatives and debttogether with respect to the other alternatives. Moreover, companies with a greater level of foreigncurrency exposure are more likely to use only derivatives, and to a lesser extent foreign debt andderivatives together. The managerial risk aversion was also found to have a significant positiveimpact, such that the greater the percentage of capital held by managers, the greater the likelihoodof hedging with foreign debt and derivatives jointly. Moreover, we also found a positive relationbetween the use of foreign debt and tax loss carry-forwards which confirms that greater convexityin the tax function leads to a greater likelihood of hedging. Finally, distinguishing between groupsof companies made it possible to identify new factors with a significant influence on the decisionto hedge exchange rate risk: market-to-book and institutional ownership. This result indicates thatcompanies with more growth opportunities have greater difficulty obtaining foreign debt and alsomeans that the presence of institutional investors in the firm reduces information asymmetriesand makes it easier to obtain foreign debt.

In the third and last section of the empirical research, we analyzed the determining factorsof the quantity hedged with foreign debt and observed a set of variables having an impact onthe decision to hedge with this instrument. Thus, with Tobit regressions, we obtained that thedeterminants of the amount of exchange rate hedging with foreign debt were very similar to thoseaffecting the decision to hedge. In this sense, there is a significant positive relation with foreigncurrency exposure, size, andmanagerial risk aversion. Furthermore, a new factor which is theinterest coverage ratio was found with a negative relation, so companies with more ability torepay debt will be less prone to use foreign debt as a means of exchange rate hedging.

In addition, when we controlled for the existence and type of currency swaps in our empiricalanalysis (probit, multinomial, and Tobit models), this consideration did not have an effect on thedeterminants of foreign currency debt usage. Thus, the determinants of currency hedging withforeign debt are the same if we exclude the different alternatives of synthetic debt.

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Our study findings suggest that the incorporation of new hypothesis based on capital structuretheory provides a better explanation of foreign currency debt use by non-financial companies.Thus, in contrast to hedging theory arguments that focus exclusively on the reduction of exchangerate risk, we have found that the use of foreign currency debt may be affected by access to externalfinancing and the financial risk that it represents on a company’s balance sheet.

The limitations of this paper are mainly associated with the availability of information.Althougha considerable effort was made to obtain a larger sample of the Spanish market, our results werelimited by the availability of data from annual reports. Therefore, as a future line of research, wepropose the gathering of qualitative data on other internal hedging practices by companies, as wellas improving the quantitative data available in order to carry out an analysis over time and notonly with respect to a given year, which would make it possible to incorporate new independentvariables and new relations.

Notes

1. These studies analyze the non-financial business sector (Dolde 1993; Nance, Smith, and Smithson 1993) or onespecific industry (Colquitt and Hoyt 1997; Cummins, Phillips, and Smith 1997a, 1997b; De Ceuster et al. 2003;Gunther and Siems 1995; Hardwick and Adams 1999; Otero and Fernández 2005; Sinkey and Carter 1997).

2. According to this author, jointly considering these products avoids bias due to classifying companies as non-hedgingwhen they use only foreign debt for that purpose. Furthermore, the inclusion of companies in the study sample thathedge other types of exposure aside from exchange rate risk, such as interest rate and commodity price risk, can alsobias results.

3. The traditional interpretation maintains that a high debt level is an incentive to hedge in order to alleviate potentialsproblems and costs of financial distress. Nevertheless, Clark and Judge (2008) indicate that high debt level might bedue to the fact that the sample included a high number of companies that use foreign debt and not to the presence ofpotential financial distress.

4. It was Jorion (1990) who first proposed using this variable. This author found that the level of hedging was related tothe proportion of sales abroad.

5. Aabo (2006) clarifies that due to the fact that it is not possible to know the proportion of foreign sales made up ofdirect sales in foreign currency, which are clearly a source of exchange rate risk, and which are sales from foreignsubsidiaries quoted in the local currency, which are not a source of currency risk for the subsidiary but are for thebusiness group, there may be a weak relation between exchange rate exposure approximated by the percentage offoreign sales and the foreign debt issue.

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regulation and banking, ed. B. Schachter, 165–85. New York: Elsevier Science B. V.Smith, C.W. and R.M. Stulz. 1985. The determinants of firms’ hedging policies. Journal of Financial and Quantitative

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Appendix 1: Spanish non-financial listed companies with foreign currency exposure in2004 included in the study sample with the sectorial classification of BMEx (Bolsas yMercados Españoles)

Sector Company

Consumer goods Food and beverages Barón de LeyBodegas RiojanasCampofríoEbro PulevaCia Vinícola Norte EspañaFederico PaterninaNatraPescanovaSOS CuetaraViscofan

Paper and graphic arts Grupo EnceIberpapel GestiónMiquel y Costas & MiquelPapeles y Cartones de EuropaUnipapel

Other services AmperIndo InternacionalVidrala

Pharmaceutical products Faes FarmaGrifolsNatraceuticalPrimPuleva BiotechZeltia

Textiles, clothing, and footwear Adolfo DomínguezDogi International FabricsInditexLiwe españolaSniaceTavex Algodonera

Consumer services Freeways and parking lots AbertisItinereCintra

Communication and publicity Antena 3 TelevisiónGestevisión TelecincoJazz TelecomPromotora de InformacionesTelefonicaVocento

Consumer Services Other services Vueling AirlinesFunespañaCorporación DermoestéticaCodereClinica BavieraNh HotelesProsegurSol MeliáService Point Solutions

(continued)

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Appendix 1: Continued.

Sector Company

Electricity and gas EndesaGas NaturalIberdrolaRed Eléctrica CorporaciónCia Española de PetróleosRepsol YPFUnión Fenosa

Transportation and distribution Aguas de BarcelonaAguas de ValenciaIberia

Basic Mat./industry/build. Construction FerrovialObrascon Huarte LainSacyr VallehermosoAccionaACSFomento Constr. y Contratas

Chemical ErcrosLa seda de Barcelona

Engineering and others Duro FelgueraAvanzitBefesaEspañola del ZincFersa Energías RenovablesIberdrola RenovablesInypsa Informes y ProyectosFluidraTécnicas ReunidasUrbar IngenierosTecnocomAbengoa

Capital goods ElecnorExide TechnologiesMecaluxNicolás CorreaZardoya OtisGamesaAzkoyenConstrucciones y Aux.FF.CC. (CAF)

Mineral/metals/transf. CIE AutomotiveAcerinoxMinerales y Productos DerivadosTubacexLingotes EspecialesTubos Reunidos

Construction materials Cementos Portland ValderrivasUralitaIndraCementos Molins

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Appendix 2. Survey of exchange rate risk hedging activities

Confidential

Company:

1.-What was the value of foreign sales outside the euro zone in 2004?(please write the number in Euros or enter NA if you did not have them)

2.- Did you hedge your foreign currency exposure with currency derivatives (such as forward, futures, options and/or swaps) in 2004? (please check X the appropriate row)

3.- If yes, what was your notional volume of currency derivatives in 2004? (please write the number in Euros)

4.- Did you hedge your foreign currency exposure with foreign debt in 2004? (please check X the appropriate row)

5.- If yes, what was your amount of foreign debt in 2004? (please write the number in Euros)

I would like a copy of the final report (please check if yes)

Thank you for filling out this questionnaire

YesNot

YesNot

Appendix 3. Mathematical appendix

A.1 Binomial probit model

This model establishes a nonlinear relation between a dichotomic-dependent variable and a set of independent variables.The model specification is carried out with the following normal distribution equation:

Yi =∫ z

−∞1

(2π)1/2e−s2/2 ds + ui, where zi = Xiβ. (A1)

The dependent variable quantifies the probability of using foreign debt. Apart from their signs, the coefficients in thisbinary choice model are not easy to interpret directly. One way to interpret the parameters is through marginal effects,

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which in this case is equal to

∂�(xiβ)

∂xi

= βiϕ(Xiβ) (A2)

where φ(Xiβ) denotes the standard normal density function. Therefore, the impact that a variation in one variable has onlikelihood of using derivatives depends both on the estimator of parameter β and on the values of the density function atthe ith point. Since the binomial probit models are not linear, they should be estimated by maximum-likelihood methods.

Moreover, for the purpose of analyzing the relative importance of each variable, we also have calculated the marginaleffect each has on the hedging decision. Given that the effect is not linear and depends on the point chosen, the usualapproach is to show the value of this effect for the average values.

A.2 Multinomial probit model

With this model, the likelihood of choosing the alternative j is expressed with the following equation:

P(yi = j) = exp(x′ij β)

1 + exp(X′i2β) + · · · + exp(X′

ikβ), (A3)

where Y is the number of possible options.If the odds ratio is calculated, the model can be linearized with logarithms, making it much easier to obtain the

parameters. This ratio is interpreted as the odds between the likelihood of choosing one option over another. Thus, theodds ratio is denominated as follows:

P(y = J )

P (y = 0)= exp(X′β). (A4)

As the model calculates the parameters using the logarithm of the odds ratio as the dependent variable, it is difficultto interpret the parameters directly. For this reason, an alternative exists consisting of using the marginal effects on theaverage values of the variables. Thus, the marginal effects can be calculated as follows:

∂Yij

∂Xij

=(βjx −

∑Yij βjx

)· Yij , (A5)

where Bjx is the parameter value of variable x for alternative j . Once the parameters have been estimated by maximumlikelihood, it is easy to determine likelihood using the original functions, such that

P(y = 1) = eU1

1 + eU1 + eU2,

P (y = 2) = eU2

1 + eU1 + eU2,

P (y = 3) = 1 − P(y = 1) − P(y = 2),

(A6)

where U1 = b0 + b11X1 + b12X2 + . . . + b1kXk ,

U2 = b1 + b21X1 + b22X2 + . . . + b2kXk.

A.3 Tobit regression model

Our analysis of the hedging volume with foreign debt was carried out with a Tobit model. As in Allayannis et al. (2003),we used this specification because not all firms use foreign debt (i.e. we have a point mass at zero). The estimationsobtained with the Tobit model directly represent the marginal effect of each variable on the average value Y*. However,the interpretation of the coefficients is not as obvious if we wish to analyze the effect on the censored variable. In this

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case, the parameter estimations should be weighted by the likelihood that an observation is not censored:

∂E(yi/xi)

∂xi

= βϕ

(β ′xi

σ

).

The partial effects of xj on the expected value of y have the same sign as the coefficient, but the magnitude of the effectsdepends on the values of all the explanatory variables and parameters (Wooldridge 2006).

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foreign debt as a hedging instrument of exchange rate risk: a new perspective

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