the use of foreign currency derivatives and firm value in u.s

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

Master thesis

Rui Zhang

ANR: 484834

23 Aug 2012

International Management

Faculty of Economics and Business Administration

Supervisor: Dr. J.C. Rodriguez

The Use of Foreign Currency Derivatives and Firm value In U.S. Tilburg University

1

Management Summary

According to the International Financial Report Standards (I.F.R.S.) firms must disclosure their

financial position about the financial derivatives position in their annual report, which makes

it possible to do the empirical research about the derivative usage effect on the firm risk and

firm value. In the last two decades, the financial market becomes more and more mature,

and increasing number of firms choose to use the derivative instrument to hedge the risk, for

instance, the interest rate risk, foreign exchange rate risk and commodity price risk.

Following the study Allayannis and Weston (2001), this paper tests the relationship between

the foreign currency derivative usage and firm value in U.S. A sample of 94 firms of Fortune

200 firms is selected based on their business activities and available information. This sample

is studied during a research period from 2009 to 2011, which contributes to 282

observations.

The information on the foreign currency derivatives of the sample is collected and extracted

manually from their 10-k form annual reports. Followed by the research of Allayannis (2011),

Tobin’s Q which is defined as the ratio of market value of the firm to the total asset is used as

a proxy for firm value. The hedging dummy variable equals to 1 if firm reports the derivative

activity in annual report, otherwise, it equals to 0. In order to control some factors which

may also have influence on firm value, several control variables consisting of size, profitability,

investment growth, access to financial market, industry diversification, geographic

diversification and advertisement expenditure are employed in my empirical analysis.

In the univariate analysis the differences of firm characteristics between hedging and non-

hedging observations are examined. It seems that hedgers have a higher firm value

compared with non-hedgers, but the result is not statistically significant. Concerning the firm

characteristics, firms having the derivatives activities are more likely to be industry

diversified and geographic diversified, and have high advertisement expenditure.

The univariate analysis just gives us a surface understanding about the relationship between

the use of foreign currency derivative and firm value. However, the multivariate analysis can

control the factors which may also impact firm value and isolate the effect of foreign

currency derivative on firm value. In the multivariate analysis, I did the pooled OLS

regression and fixed effect regression to investigate the relationship between hedging and

firm value. The results from the both regressions show that foreign currency derivative usage

does not significantly influence firm value. While, the control variable size has a negative

effect on firm value and the result is statistically significant in both regressions. The

coefficient of investment growth is positive and statistically significant in the fixed effect

regression.


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Preface

This thesis presents and describes the main result of my theoretical and empirical research

about the effect of foreign currency derivative on firm value. Since my major is International

Management instead of Finance, The process of writing this thesis is much more challenging

as I thought before. However, this experience will be very useful in my future career and life.

During these several months, writhing this thesis increased my knowledge about the risk

management, the statistically knowledge and the Stata software.

First of all, I would like to thank Dr. J.C. Rodriguez for his role as supervisor. His advice and

feedback were very helpful and enlightening during my writing process. Furthermore, I

would like to thank Dr. F. Feriozzi for his time and role in the exam committee.

With this master thesis, I successful finish my study of International Management at Tilburg

University. When I look back this one year, although it is tough, I have developed myself both

on academic and personal level. This one year abroad studying experience will be very useful

in my future life and career. I would like to thank my parents who supported me during this

one year. Furthermore, I would like to thank my friends who make my time in Tilburg

unforgettable.

Rui Zhang

23 Aug 2012


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Content

Management Summary ............................................................................................................. 1

Preface ....................................................................................................................................... 2

Chapter 1 Introduction .............................................................................................................. 4

Chapter 2 Background of hedging ............................................................................................. 7

2.1 The financial distress costs .............................................................................................. 7

2.2 Taxes ................................................................................................................................ 8

2.3 Underinvestment ............................................................................................................. 9

2.4 Management incentives ................................................................................................ 10

Chapter 3 Previous literature review ....................................................................................... 11

Chapter4: research method ................................................................................................. 15

4.1 The sample collection and data collection .................................................................... 15

4.2 Firm value ...................................................................................................................... 17

4.3 Control variable ............................................................................................................. 17

Chapter 5 Empirical research................................................................................................... 21

5.1 Summary statistics of derivative use ............................................................................. 21

5.2 Sample description ........................................................................................................ 22

5.3 Univariate analysis ......................................................................................................... 24

5.4 Multivariate analysis ...................................................................................................... 26

5.5 Alternative control variable ........................................................................................... 31

Chapter 6 Determinants of hedging ........................................................................................ 34

Chapter 7 Discussion of the result ........................................................................................... 37

Chapter 8 Conclusion............................................................................................................... 39

Reference: ................................................................................................................................ 41


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Chapter 1 Introduction

Derivatives are financial weapons of mass destruction.

-----Warren E. Buffett, 2003 Berkshire Hathaway Annual report

The financial crisis of 2008-2009 has brought new scrutiny to the use of financial derivatives.

Recent proposals in major countries, including the United States, call for greater regulations

of over-the-counter (OTC) derivatives, including conditions for making positions to market

prices, trade registrations, trade clearing, exchange trading, and higher capital and margin

requirement1.

The use of financial derivative instrument by non-financial firms has grown rapidly in last two

decades, and the markets of derivative financial instruments on interest rates, foreign

exchange rates and commodity prices also have displayed an rapidly development.

Regulations about these financial derivatives have been improved in many countries as well,

which require the companies to disclose the information on the derivative position in the

fiscal annual report. In particular, firms in the United States, United Kingdom, Australia,

Canada, and New Zealand as well as firms fulfilling with International Accounting Standards

(IAS) are required to disclose the information about the financial derivative position2. The

available data makes the empirical research about the financial derivatives by non-financial

firms become possible and effective.

Before the disclosure of financial information in the annual report, the financial derivative as

part of risk management was considered as the important strategy for firms. During that

time, most of the researches about the financial derivative were theoretical. Others

researchers conducted the empirical analysis by collecting the data through the survey. The

big disadvantage of survey or questionnaire is that it is difficult for the researcher to get the

accurate information or data about the firms’ derivatives position, because managers of

some firms do not want to disclose their motivation or determinants of derivative usage or

they do not want to leak the information to their competitors.

In fact, although the data of derivative instrument become more and more available, the

detailed empirical research about the effect of derivatives usage on firms’ risk and value is

unclear and mixed. For instance, Mian(1996) studies a large sample with 2799 non-financial

firms in U.S. after the introduction of information disclosure requirement about the

derivatives position. They find that the derivative usage exhibits the economies of scale, but

1 Bartram 2011

2 Bartram 2011


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the evidence is weak with supporting the convex tax function. Geczy(1997) testes a sample

consisting of 372 Fortune 500 non-financial firms in U.S. The result shows that firms with

tighter financial distress, greater growth options, extensive foreign exchange rate exposure,

and economies of scale in hedging activities are more likely to use the currency derivatives.

Guay(1999) finds that the total risk, idiosyncratic risk exposure to interest risk declined for

firms with derivative usage, but the author finds no significant change in the market risk of

these firms. In contrast, Hentschel and Kothari (2001) find that the difference about risk for

firms which use the derivatives is economically small compared to firms that do not use

them. Allayannis and Weston (2001) present the evidence to support that derivatives activity

contribute to an approximately 4%increases in market value. Graham and Rogers (2002) find

that the hedging activity allows the firms to increase the debt capacity, which is associated

with a1.1% increase to firms’ market value. However, Guay and Kothari (2003) point out that

the magnitude of the cash flow generated by hedging activities is modest and is unlikely to

account for such big difference on firms’ market value. Consistent with result of Guay and

Kothari (2003), Jin and Jorion (2006) also find an insignificant effect of hedging activity on

firm value by employing a sample of oil and gas producers in the U.S.

The reason why I choose to collect the sample from the U.S. is that compared with other

countries, the financial markets in the U.S. is more mature and steady. Another major reason

is the data availability. The improvement of disclosure requirement in U.S. allows the

researchers to obtain the information about firm’s derivatives position and to investigate

whether the use of derivative for hedging purpose is a value creative strategy for firms.

In this paper, I chose to focus on the effect of foreign currency derivative usage on firm value

for the following reasons: (1) I am interested in isolating a common risk factor (the foreign

exchange rate risk) and investigate whether the use of foreign currency derivatives increases

the market value of the firms or not which are exposure to the exchange rate risk. (2) In the

U.S., foreign currency derivatives are the most commonly used derivatives. Geczy (1995)

documents that among the Fortune 200, 52.1% firms use currency derivatives. Bartram

(2003) reports 63.2% of 2841 firms in U.S utilize the foreign currency derivatives. Bartram

(2011) employs the sample of 2076 firms in U.S. and finds that 65.1% of firms have the usage

of foreign currency derivatives. (3) Most companies in the U.S. have the foreign exchange

rate exposure by having foreign sale, foreign asset or foreign liability. (4) The previous

literatures demonstrate that the factors affecting firm’s motivation of using the interest rate,

foreign currency and commodity price derivatives are different, which can also have effect on

firm value.

In my research, I used the data set that includes 94 firms in Fortune 200 firms in the U.S.

from 2009 to 2011. I collected the annual reports of Fortune 200 firms from the U.S.

Securities and Exchange Commission (SEC), and checked them one by one. Among these 200


6

firms, 15 firms did not mention any foreign sale, foreign asset or foreign liability; 41 firms are

financial firms; 4 Firms had big merger or acquisition activities in the research year from

2009 to 2011. 46 firms did not disclose the annual report at the December fiscal year-end.

Finally, I got 94 firms which contribute to 282 observations in my sample.

In my empirical research, I use Tobin’s Q followed by Allayannis (2011) as a proxy to firm

value. Set the hedge dummy variable equal to 1 if firm reports the foreign currency

derivatives usage in the annual report. While, some factors including size, access to financial

market, profitability, investment growth, industry diversification, geographic diversification

leverage and advertisement expenditure also have impact on firm value. My empirical

research includes the univariate analysis and multivariate analysis.

In the univariate analysis, the firm characteristic and firm value differences between foreign

currency hedging and non-hedging observations are examined. Compared with non-hedging

firms, hedging firms have higher firm value, but the result is not statistically significant.

Concerning the control variables, the statistically significant differences with respect to the

effect of hedging on firm value are industry diversification, geographic diversification and

advertisement expenditure.

The univariate analysis just presents surface difference between the hedgers and

non-hedgers, however, the multivariate analysis enable the usage of detailed quantitative

information about the hedging position in the regression. Furthermore, the multivariate

analysis permits the inclusion of a set of control variables which may be associated with firm

value. Thus, the multivariate analysis can isolate the impact of foreign currency derivatives

on firm value from others factors. In my research, I use the Pooled OLS and Fixed-effect

regression in the multivariate analysis. The results from these regressions show that foreign

exchange rate hedging does not significantly influence firm value. The control variable firm

size has a negative coefficient and the coefficient is statistically significant in both regressions.

Furthermore, the control variable investment growth has a positive coefficient, but the

coefficient is just significant in the fixed-effect regression. The geographic diversification

shows a statistically significant and positive coefficient in the Pooled OLS regression.

The remainder of the paper is organized as follows: The background of hedging is presented

in chapter 2. The previous literature review is showed in chapter 3. The research method is

described in chapter 4. The detailed empirical results are presented in chapter 5 while

chapter 6 investigates the determinants of hedging activities. Chapter 7 is about the

discussion and limitation of empirical results. Section 7 concludes.


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Chapter 2 Background of hedging

According to Modigliani and Miller (1985), a firm, managed by the value-maximizing agent,

in a world of perfect capital markets, with investors who have equal access to these markets,

would not engage in hedging activities, since these activities add no value to firm. Anything

the firm could accomplish through hedging could equally well be accomplished by the

investor acting on his or her own account3. However, in the real world, it is impossible to get

access to this perfect capital market. Financial theory suggests that corporate risk

management is a value creative activity in the presence of imperfection of capital market

such as bankruptcy costs, a convex tax schedule(smith and Stulz,1985), or underinvestment

problems(Smith and Stulz, 1985; Bessembinder1991). Recently, some empirical studies

provide some evidences in support of these theories. Some findings suggest that risk

management may come from the conflicts between managers and shareholders or earning

management and speculation (Core and Guay2002). Some researches try to investigate the

effect of derivative instrument on firm value with the presence of imperfect financial market.

The paragraph below will describe these imperfections in Modigliani and Miller model and

discuss the effect of hedging these imperfections on firm value.

2.1 The financial distress costs

In the real financial market, the financial distress, for instance, the payment to lawyers and

court costs, is costly, and shareholder are concerned whether the cash flow variability raise

the probability of financial distress 4.Cash flow volatility will contribute to a situation in

which a firm’s liquidity is insufficient to fully meet the fixed payment obligations, for instance

wages and interest payments, on time. Financial risk management can reduce the

profitability of encountering such situation and thus decrease the expected costs associated

with financial distress (Bratram 2003). Stulz(1996) demonstrates that hedging is assumed to

reduce the variability of cash flow and to reduce the probability of default, as shown in

figure1.

At the same time, if the gains of positive net present value project accrue primarily to the

fixed claimholders, then financial distress provides equityholders with incentive to abandon

this profitable project. Thus, the financial hedging reduces the probability of financial

distress and decreases the likelihood of equityholders passing up the valuable project. Dolde

(1995) and Haushalter(2000) confirm that companies which have a higher possibility of

financial distress with high debt ratio or leverage ratio, , will hedge more than the ones with

lower debt ratio.

3 Bartram (2011)

4 Stulz(1996)


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Figure 1: Cash Flow distribution and Probability of Default

Risk management can reduce the probability and cost of financial distress, where X is the

level of Cash Flow where costs of financial distress begin to appear.

*Source: Valuation and Risk management (David A. DUbofsky and Thomas W.Miller)

2.2 Taxes

In U.S., as in the most countries, companies’ effective tax rates rises along with increase in

pre-tax income. Because of the convexity of the tax code, there are benefits to “managing”

taxable income so that as much of it as possible falls within an optimal range-that is, neither

too high nor too low5. For firms without using the hedging activities, their pre-tax income will

go through a “boom and bust” cycle. Under the convex tax schedule, a tax schedule that high

levels of taxable income should pay more tax than low levels, this “boom and bust” cycle of

pre-tax income will lead to a higher overall tax bill. A simple example in the table 1 below can

help illustrate this issue. Suppose the convex tax schedule is that tax rate of earning equal or

below 100,000 is 20% and the rate of earning above 100,000 is 30%. Firm A with hedging

activities has a smooth cash follow, while firm B without hedging activities has the cash flow

of higher volatility. With the same total earnings (200,000), firm A with hedging has a lower

overall taxes payment than firm B without hedging (Firm A pay 40,000 taxes overall while

firm B pay 50,000 taxes overall).

5 Stulz (1996)


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Table 1: Tax reduction effect of risk management

Firm A

Firm B

Earnings Taxes Earnings Taxes

1st year 100,000 20,000 0 0

2nd year 100,000 20,000 200,000 50,000

Total

200,000 40,000 200,000 50,000

Thus, to some extent, risk management can lead to a lower tax payment over a complete

business cycle. Smith and Stulz (1985) also demonstrate that a firm can reduce expected tax

liabilities by using financial hedging instruments to smooth taxable income, which

contributes to an increase of firm value.

Because of the fact that hedging can reduce the financial distress, hedging activities will lead

to an increase of optimal debt-equity ratio. This ability of financial hedging activity therefore

increases the associated tax shield and finally increases firm value. Stulz (1996) and Leland

(1998) argue further that a reduction in cash-flow volatility through hedging can increase

debt capacity and generate greater tax benefits, and Graham and Rogers (2002) provide the

empirical support for this hypothesis.

2.3 Underinvestment

Risk management can increase shareholder’s value by harmonizing financing and investment

policies6. Because of high transaction cost, raising external capital is costly for firms, thus it is

possible that firm may underinvestment. The conflict between shareholders and debt

holders can also contributes to the problem of underinvestment. Under the situation that

firms’ leverage is high and shareholders only have a small residual claim on firm’s asset, the

problem of underinvestment is more likely to happen and the benefit of safe but profitable

investment projects accrue primarily to bondholders and may be rejected by the managers7.

A suitable and credible risk management program can help mitigate the underinvestment

problem through reducing the volatility of cash flows and firm value.

Furthermore, if financing an investment project by using the internal funds is cheaper than

financing it from the external funds, hedging is a value creative activity, the reason is due to

the fact that risk management allows the firm to support more positive net present value

projects. Mayers and Smith (1990) argue that the volatility of cash flows is positively related

to the costs of financial distress and the underinvestment problem. Thus, hedging is

predicted to have a positive effect on firm value. As the underinvestment is likely to be more

prominent in firms with higher leverage, significant growth and investment opportunities,

6 Froot, Scharfstein, and Stein (1993)

7 Bessenbinder (1991)


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various measures such as the market-to-book ratio, research and development expenditure

to sales ratio, or capital expenditure to sales ratio are used for test the hypothesis with

respect to the underinvestment problem.

2.4 Management incentives

Because the conflicting interest in the agency relationship between managers and

shareholders, sometimes, managers have the incentive to use the derivatives for purposes

rather than hedging the risk. Most senior managers have a highly undiversified financial

position because they derive substantial (monetary and non-monetary) income from their

employment by the firm8. Consequently, risk aversion may cause managers to deviate from

acting purely in the best interest of shareholders (Stulz 1984; Mayer and Smith, 1982) by

investing lots of resource to hedge firm risk. Han (1996) and Stulz (1984) point out that

corporate risk management can mitigate this problem by linking manager’s payoff to firms’

stock price.

Additionally, managers can use the derivatives to speculate the movements of interest rate,

foreign currency exchange rate and commodity prices, which are supported by the previous

derivative survey. For instance, 90% of the derivatives users surveyed by Dolde (1993), and

over 40% of the firms surveyed by the Wharton Study of derivative usage (Bodnar 1995)

admit that they sometimes “take a view” about the movement of financial market when

they determine their derivative portfolios (Bartram 2003). Because speculative activity is on

average not expected to be related with firms’ underlying business exposure, derivative

activities used for this purpose are anticipated to increase, not reduce, firm risk9, which will

impact firms’ stock volatility and firm value.

8 Bartram (2003)

9 Bartram (2003)


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Chapter 3 Previous literature review

Overall, the previous literatures on the derivative use in the non-financial firms focus on the

two parts. Firstly, many studies try to analyze the determinants and the theoretical

motivation behind the using of the derivatives. Some papers support that firms use the

derivatives instrument in order to reduce the risk exposure. While, others researches

conclude that firms use the derivatives for speculation or for solving the conflicts between

managers and shareholders instead of risk management. Secondly, many researchers try to

test the relationship between the financial derivative activities and firm value. However, the

relationship between firm value and general derivatives’ use is still mixed, both for U.S. and

non U.S. firms. There are several significant results, but they are not all consistent with the

valuation hypothesis. While so far most studies test what determines the firms’ decision to

use the derivatives instrument, very little researches test the fundamental issue that

whether these hedging activities increase firm value or not.

Before the 1990s, a firm’s derivative position is not disclosed and is considered as an

important component of firm’s strategy. Given this fact, little data can be used to test the

effect of derivative usage on firm value. Most research at that time are focus on the

theoretical parts, and most of these researches are derived from the friction to the classic

Modigliani and Miller model which states that in a world of perfect capital markets, in the

absence of taxes, bankruptcy costs, agency costs and asymmetric information, the value of a

firm is unaffected by how that firm is operated. Others researches which do the empirical

research collected the data by using the survey. For example, Nance, smith and Smithson

(1993) makes a research about the derivative usage by using a sample of 159 large U.S.

non-financial firms based on the response to the questionnaire. They find that firms which

employ the derivative to hedge the risk have more growth options and more convex tax

function. Geczy and Schrand (1997) studies a sample of 372 firms which are Fortune 500

firms in the United States, and their study result shows that firms with greater growth

options, extensive foreign exchange rate exposure, tighter financial constraints, and

economies of scale in hedging activities are more likely to use the foreign currency

derivatives.

Since 1990s, the companies were required to report their notional amount of derivative

usage and derivative usage situation in the footnotes of the annual report. 1997 GAAP

pertaining to disclosure about financial derivatives is contained in the statement of Financial

Accounting Standard No.199 (SPSA 119). “Disclosure about derivative financial instrument

and fair value of financial instruments” was released in 1994. As accounting disclosure

requirement was regulated in the early 1990s, more academic and empirical researches have

examined the derivative usage by the nonfinancial firms. Most of these researches used the

U.S. nonfinancial firms as a sample, because information becomes more available and more


12

firms use the derivative in the U.S.

Bartram, Brown and Fehle (2003) makes a very large scale research on the derivative usage

in 50 countries by using a sample of 7,319 non-financial firms which together comprise

about 80% of the global market capitalization, and provides evidence that hedging is a value

creative corporate activity. At a basic level, this study finds strong evidence supporting the

hypothesis that interest rate risk management is closely related with higher firm value for

both the U.S. and international firms. But the result does not indicate whether the use of

foreign currency derivatives usage is also closely associated with firm value or not.

Concerning the determinants of firms’ risk management by using derivative activity, this

research finds evidence that the use of foreign derivative is, in fact, risk management rather

than simply speculation (Bartram 2003). For instance, firms that use foreign currency

derivatives have higher proportions of foreign asset, sales, and income and firms that use

interest rate derivatives have higher leverage10.

Bratram, Brown and Conrad (2011) also use a very large scale sample of non-financial firms

from 47 countries to test the effect of derivative use on firm risk and fire value. This research

uses a new method to reduce the effect of omitted variables bias and to improve the quality

of the result and finds a strong evidence to support the hypothesis that using the financial

derivative reduces both the total and systematic risk. However, this research still does not

make a clear conclusion that the derivatives activity would lead to higher firm value

compared with the firms without using the risk management activity. It mentions that the

effect of derivative use on firm value is positive but more sensitive to endogeneity and

omitted variable, however the usage of derivatives is related with firm value, abnormal

returns and larger profits during the economic downturn in 2001-2002, suggesting that firms

are hedging downside risk11.

Allayannis and Weston (2001) directly tests the potential impact of foreign currency

derivatives on firm value by using a big sample of 720 larger non-financial firms from 1990 to

1995 in U.S. Using Tobin’s Q defined as the ratio market value to replacement cost of assets,

this research concludes that the use of foreign currency derivative is positively related with

firms’ value. Specially, it finds strong evidence to support the hypothesis that firms which are

facing the foreign currency exposure and choose to use the foreign currency derivative, on

average, have a higher value as much as 4.87% than firms which do not use the foreign

currency derivatives. It also demonstrates that firms that begin a hedging policy experience

an increase in firm value above these firms that choose to remain un-hedged and that firms

that quit hedging activities experience a decrease in value relative to those firms that choose

10

Bratram (2003) 11

Bratram (2011)


13

to remain hedged12. Graham and Roger (2002) by using a broad sample also has a similar

conclusion that the derivatives use has a positive effect on the debt capacity and this debt

capacity leads to 1.1% firm value premium on average. While, Guay(2002) identifying an

initial sample of the 1000 largest non-financial firms as of the end of 1995 also tries to

estimate the relationship between the usage of derivatives and firm value. Contrary to

Allayannis(2001), this research indicates that even if firms with derivative usage have much

more information about the directional movements in interest rates, exchange rates and

commodity prices, most of the derivative positions appear too small to increase the firm

value by 4.87% as Allayannis(2001) demonstrates. Consistent with this conclusion, Jin and

Jorion(2006) also finds an insignificant effects of hedging on market value by using a sample

of oil and gas producers.

After Allayannis and Weston (2001), some researchers have focused on the estimation the

effect of the financial instruments on firm value. Some researchers exactly implement the

initial model used by Allayannis and Weston (2001), while others adjust it to the special

economic environment or industry situation. For instance, Carter, Rogers and Simkins (2004)

examine the relationship between the derivatives use and firm value in the U.S. airline

industry. Since the fuel cost accounts for on average 13% of firms operational cost, using the

derivative instrument to hedge the volatility of fuel price is a justifiable strategy for these

firms in the airline industry. The authors following the model of Allayannis(2001) with a little

adjustment find that hedging activity in the airline industry contributes to a premium of

14.94%-16.08% increase on firm value and the result is statistically significant at the level of

10% and 1%. The size of the hedging premium is much bigger than the one of Allayannis and

Weston (2001), which may be due to the fact that the firms in the airline industry spent a

larger income on fuel and this fact heavily influences the firm value. At the same time,

Weston (2001) and Carter (2004) also repeat the previous analysis in order to identify the

major source of hedging premium. They find that capital expenditures are valued higher for

the firms with fuel price hedging activity, and the positive ability of hedging to stabilize and

protect capital expenditure and to avoid underinvestment contribute to the 52%-100% of the

firm value premium on average.

Another empirical researchs also following the Allayannis and Weston (2001), but focus on

the U.S oil and gas producer industry are Jin and Jorion (2006) and Carter, Rogers and

Simkins (2004). The main contribution of Jin and Jorion (2006) is a new and simple

estimation of Tobin’s Q which is also proxy for firms’ value. Contrary to Allayannis and

Weston (2001), Carter, Rogers and Simkins (2004) shows that the derivative usage does not

have a significant impact on firm value. But it discloses that the usage of derivative reduce

the price sensitivity with respect to oil and gas prices. The authors attribute the

establishment of hedging to the personal benefit of the management team. Concerning the

12

Allayannis and Weston (2001)


14

hedging premium, the authors attribute it to the factors such as the information asymmetry

or the operational hedging which could be positively associated with the derivative usage.

From the perspective of managerial motives, Hagelin, Knopf and Prambory (2004) find the

evidence to prove that the firm value will decrease when the hedging activity is based on the

motivations from manager’s stock options. The authors make a conclusion that if the

hedging activities are used to reduce the stock price sensitivity of managerial stock options,

hedging will lead to a value discount. From the perspective of agency costs and monitoring

problems, the Fauver(2010) uses the derivative usage sample about over 1745 firms in the

U.S. during the period from 1991 to 2000, and finds that firms having greater agency and

monitoring problems (i.e., less transparent, greater agency costs, weaker corporate

governance, lager information asymmetry problem, poorer monitoring) are likely to have the

negative association between Tobin’s Q and derivative usage.

Except doing the research in the United States, some empirical researches also employ the

sample from other countries to test the effect of derivatives use on firm value. Berrospide,

Amiyatosh and Uday (2008) test the relationship between the foreign currency derivative

usage and firm value on Brazilian firm and find that firms using the derivative instruments

have a 6.7% to 7.8% higher value than firms without using the foreign currency derivatives.

They also make a conclusion that hedging with foreign currency derivatives permits the firm

to sustain larger capital investment and to reduce the sensitivity of investment to internally

generated funds, which has a positive influence on the mitigation of underinvestment

problems13 . Ameer and Rashid (2009) examine the statement of derivative usage in

Malaysian and try to evaluate the value-relevance of the notional amount of foreign

exchange and interest rate derivatives over the period between 2003 and 2007, however,

since few firms in Malaysian employed the derivatives, this research dose not find an

significant relationship between the derivative usage and firm value.

13

Amiyatosh and Uday (2008)


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Chapter4: research method

4.1 The sample collection and data collection

I examined the Fortune 200 firms in the U.S. from 2009 to 2011. I focused on these large

firms because previous literature showed that they larger firms are more likely to be

derivatives users (Nance 1993; Graham and Rogers 2002). From the initial sample, I selected

every firm by some criterions which I will describe below and reduced the sample to 94 firms.

This sample reduction permits my following hand collection with a significant quantity of

information about each firm’s derivatives position from the form 10-K annual report which I

downloaded from the database of the SEC (U.S. Security Exchange Commission). Note, even

though I gathered the derivative data from 2009 to 2011, I selected the sample from the

Fortune 200 firms as of 2011. In order to determine a desired sample for this research, it is

required to identify firms which have the foreign exchange rate exposure. In my research, a

firm is considered to have the foreign currency exposure if it reports foreign sales or income,

foreign asset or foreign debt in the three-year research period.

The criterions used in my research to collect the suitable firms are as followed. (a) Financial

firms should be excluded from the sample, since these firms are also derivative makers and

have different purpose for derivative using compared with the non-financial firms. Among

the initial 200 firms, 41 firms are financial firms. (b) 4 Firms having big merger or acquisition

activity between 2009 and 2011 are also dropped from my study. (c) Restricting the sample

to December year-end firms improve the analysis result with high quality, since it allows the

consistent assumptions about the financial market, and by this criterion I omited 24 firms

from the sample. (d) This criterion requires that firms have published a 10-K annual report

which can be retrieved from the database of the U.S. Securities and Exchange commission

(SEC) during my research period. These 10-K annual reports provide useful and accurate

information about the foreign currency derivative position at fiscal-year end. Without this

information from the 10-K report, it would be very difficult and practically impossible to

determine firms’ financial derivative instrument and to do the empirical analysis. Among the

200 firms, 22 firms do not meet this criterion. (e) Finally, 15 firms which do not mention any

foreign sale, foreign asset or foreign liability are also expected from my sample, since these

firms can be considered having little exposure to foreign exchange rate risk. At last, I got 94

firms and these firms have non-missing data about size (nature logarithmic of total asset)

and market value. To sum up, the number of firms that fulfill these above criterions is 94

from 2009 to 2011, which contributes to the balanced panel data of 282 firm-year

observations (both time-series and cross-sectional data). The main advantages of a balanced

panel data approach is that it allows for the control of individual heterogeneity, it gives more

informative data, more degree of freedom and more efficiency, at the same time, it can


16

eliminates some potential bias due to the aggregation over firms or individual14.

The new accounting standards are one of the reasons why I choose to pick up the sample in

U.S. The available data due to the regulation of the accounting standards make it possible to

make the empirical research to investigate the effect of foreign currency derivatives on firm

value. According to the International Financial Reports Standards (I.F.R.S.), firms must

disclose in their annual report whether they use derivative or not and their purpose is for

hedging or trading. At the same time, they have to report the information about the whole

specters of the risk they face in their business operations and the activity they take to handle

these risks. Statement of Financial Accounting Standards (SFAS) 105 requires all firms to

report information about financial instruments with off-balance sheet risk. For example,

futures, forwards, options and swaps. Before the implementation of these disclosure

regulations the sole method to get the derivative information is by the survey activity. SEC

requires firms to report seven specific parts of information about financial derivative in their

footnotes of annual report. The section “Quantitative market risk disclosures” requires firms

to provide detailed and prospective information on the market risks that can be related with

the firm’s active position in financial instruments. The quantitative information about the

firms risk and the financial instruments make it possible for readers of the financial

statements to interpret the market risk which firms face in their business activity.

In this part, I will describe the process of data collection. I obtained the 10-K fillings annual

report of these 94 firms from the database of U.S. Securities and Exchange Commission (ESC).

Extracting the information about the foreign currency derivatives position from the 10-K

reports was done manually. In most of the 10-K form reports, the section 7a called

“Quantitative and Qualitative disclosure about the market risk” provides much more detailed

information about the market risk that the firm faces and the derivative usage position for

each market risk. Furthermore, footnotes of the financial statements present valuable and

detailed information about the active hedging position of the firm as well.

For each firm I collected the detailed and useful data by searching information in the annual

reports about the financial derivative position. In order to capture all relevant hedging

information in the 10-K reports of all observations, a manual search is carried out to

investigate all related words about the foreign currency derivatives. I search the following

important keywords on hedging: “hedge”, “hedging” “risk”, “derivative”, “foreign currency”,

“interest rate”, “commodity price”, “forward”, “swap”, “option”, “future”, “collar”, “market

risk”, “risk management”, “call ” etc. Firms are classified as foreign currency derivative

users, if their annual reports mention the use of foreign currency derivatives exactly. The

others are classified as non-foreign currency derivative. To improve the quality of data

collection in my research, I also try to collect the data about notional amount of these

14

Baltagi (1995).


17

derivatives. Unfortunately, few firm disclosures this information. Thus, a hedging dummy is

used in my following analysis, and it indicates to “1” when the company has the derivatives

instrument and to “0” when the company was not active in hedging position in that fiscal

year.

Besides the hedging data, the data used to calculate the dependent variable which is Firm

value (Tobin’s Q) and other control variables, like firm size, leverage, profitability, investment

growth, access to financial market, industry diversification, geographic diversification and

advertisement expenditure, are also extracted from annual report .The calculation about the

firm value (Tobin’s Q) and other control variables will be described in the following part.

4.2 Firm value

In order to determine whether foreign currency derivatives add firm value or not, it is

necessary to measure this value. Followed by Allayannis (2001), I use Tobin’s Q as a proxy for

a firm’s market value. Tobin’s Q is defined as the ratio of market value of the firm to the

replacement cost of asset, which is evaluated at the end of the fiscal year for each firm. If

Tobin’s Q has the value higher than one unit, the market appreciates the value of the firm to

be higher than the next best use of firm’s assets which is the replacement cost (Kapitsinas

2008).The methodology for constructing the replacement cost employed by Allayannis(2001),

and Lewellen and Badrinath(1997) is the sum of the replacement cost of fixed asset plus

inventories. However, due to the lack of data, the replacement cost of the firm’s asset is hard

to determine. Thus, in my research, I estimate Tobin’s Q in an algorithm undertaken by most

of the previous researchers in similar studies which use the book value of total assets as an

approximation of the replacement value of the assets. Ultimately, the formula used to

determine the firm value (Tobin’s Q) in my research is:

𝑄 =𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 − 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑢𝑞𝑖𝑡𝑦

𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡

4.3 Control variable

To effectively explain the effect of foreign currency derivative usage on firm value, it needs to

exclude the noise resulting from other variables which also have effect on firm value. Based

on the literature review, several control variables which are assumed to have a relationship

with the dependent variable are selected. As followed, I will describe these control variables,

the theoretical reasons why I choose these factors as control variables in my research and

the expected relationships between these control variables and firm value.

4.3.1 Size

According to the previous literature, there are lots of empirical researches on the effect of


18

the size on the determinant of derivative instruments. For example, Bartram, Brown and

Stulz(2011) find that firm size is an important determinant of both total risk and systematic

risk. Booth, Smith and Stolz(1984) State that because setting up an effective hedging

program is related to the economies of scale, larger firms are more likely to use the

derivative instrument compared with the smaller companies.

The evidence about the effect of firm size on firm value is ambiguous. Larger firms have

more capital and human resource which contribute to economies of scale and high

profitability, thus a positive relationship is expected. However, some previous literature point

out that the relationship between firm value and firm size is negative. Warner (1977) find

that the direct cost of financial distress is not positively associated with firm size. Therefore,

the benefits stemming from hedging activities are expected to be greater for smaller firms

than for larger firms (Smith and Stulz, 1985). Allayannis (2001) also find evidence to support

that the relationship between the firm size and firm value is negative. In my research, I use

the nature log of total asset which is measured by the book value of total asset to control

this variable.

4.3.2 Profitability

It is expected that higher profitable firms have a higher firm value on average. Firms with

higher profitability are expected to have lower financial distress costs and have more

resource to invest in the positive net present value project, which lead to higher cash flow to

equity holders. The high returns of profitable firms will be reflected in the stock price, which

will consequently have a positive impact on the market value of the firm. All these benefits

will lead to a higher firm value and higher Tobin’s Q for the higher profitable firms. In order

to adjust the effect of profitability on firm value, the return of asset which is defined as the

ratio of net income to total asset is used as a control variable and the coefficient between

the profitability and Tobin’s Q is expected to be positive.

4.3.3 Investment growth

Myers(1977), Smith and Watts(1992) have found that firm value depends on the future

opportunities. If there are lots of investment opportunities available to the firms, it seems

that this firm has the capability to generate more cash flow to the firm and to the

shareholders. Consequently, this will be reflected in the stock price. So, the firm value of a

firm having much more investment opportunities will be higher compared with the one of a

firm with limited set of investment opportunities, which is supported by the result form

Allayannis(2001). As an indicator of investment opportunities for the company, the ratio of

capital expenditure to total sale is employed. Companies with high percentage of capital

expenditure are expected to have higher Tobin’s Q. At the same time, the Allayannis(2001)

also point out that intangible asset, for instance, consumer goodwill, also affect firm value

for the same reason as capital expenditure. Similar to Morck and Yeung (1991) and Allayannis


19

(2001), I use the percentage of advertising cost to total sales as a proxy for the consumer

goodwill.

4.3.4 Leverage

A firm capital structure also has effect on firm value. Graham and Rogers (2002)

demonstrated that the increase in debt capacity and leverage associated with hedging

contribute to an increase in firm value by an average of about 1.1% increase. However, too

much debt will means high risk of bankruptcy and the expected bankruptcy costs, which

leads to low premium of firm value and low expectation from shareholders. All the

advantages and disadvantages resulting from leverage will be incorporated by investors and

be reflected in the share price of the firms. Thus, it is necessary to include one control

variable to filter out the effect of leverage on firm value. In my research, I use the control

variable defined as the ratio of long-term debt to book equity as a proxy for leverage.

4.3.5 Access to financial market

The position of accessing to financial market is closed related with the probability of

underinvestment problems for non-financial firms. Thus firm value may be also associated

with firm’s access to financial market. If firms’ internal capital resource is limited and the

ability of getting access to the financial market is also restricted, the firm will only be able to

invest the project with the highest net present value or forgo this project which can

contribute cash flows to shareholders. This capital restriction will yield to a lower total return

for the firm. Consequently, this will lead to a lower share price and to a lower firm value. As

most literatures do, the payment of dividend can be interpreted as the ability to get access

to the financial market, since these firms which have the capital to pay the dividend are less

likely to be financially constrained. In my research, I use dummy variable to control whether

firm get access to financial market or not. If firm pays the dividend in that year, the dividend

dummy variable is equal to 1. If it does not pay the dividend, then the dummy variable

equals to 0.

4.3.6 Industry diversification

There are several researches about the effect of corporate diversification on firm value or

firm performance. Larry and Stulz (1993) demonstrate that through the late 1970s and the

1980s, single diversified firms are valued more highly by the capital markets than diversified

firms, and highly diversified firms (defined as those firms that report sales for five segments

or more) have both a mean and a median Tobin’s q below the sample average for each firm.

Additionally, other arguments also suggest that the outgrowth of agency problems between

managers and shareholders is negatively associated with firm value. However, other

researches, for example Willianson(1970) and Lewellen(1986), supported that industry

diversification increase firm value. I use dummy variable to control the effect of industry

diversification. If firm report that it operates in more than one segment in the 10-K annual


20

report, the dummy variable of industry diversification equals to 1. Otherwise, it equals to 0.

4.3.7 Geographic diversification

In previous literature, some authors indicated that geographic diversification or

multinationality has positive effect on firm value. Coase(1937) and Dunning(1973) find

several reasons to explain why multinationality does in fact add share value. Firstly, some

intangible asset, such as increasing production skill or superb consumer goodwill, will

promote the firm to make some foreign direct investment, which will contribute to the

increase of firm value. Secondly, because of the imperfect world capital market, the

institutional constraints on international capital flows, information asymmetries and other

reasons make it difficult for investors to optimally diversify their portfolio internationally in a

direct manner. However, multinational firms can offer shareholders this opportunities by

their direct investment abroad. These benefits will be reflected in share prices and thus lead

to a relatively high stock price for these multinational firms. However, some researchers also

pointed out that, like industry diversification, the geographic diversification also cause the

outgrowth of agency problem, which is negatively associated with firm value. In my research,

firms which have business operation outside the USA are considered as multinational firms.

To control for the effect of geographic diversification, I use the ratio of foreign sale to total

sales as a continuous measure of multinationality.


21

Chapter 5 Empirical research

5.1 Summary statistics of derivative use

The Table 2 reports the percentage of firms using derivatives of different types from 2009 to

2011. Among the whole sample of 94 non-financial firms, about 72%, 69% and 71% of firms

use the foreign currency derivative in 2009, 2010 and 2011 respectively and the result is

showed in panel 1. The statistical summary for interest rate usage is presented in panel 2.

68%, 63% and 64% of my sample use the interest rate derivative to reduce the interest rate

exposure respectively during my research period. At last, panel 3 presents the result for

commodity price usage situation, which is 43%, 42% and 43% in 2009, 2010 and 2011

respectively.

Across the whole sample of 94 firm of Fortune 200, most common is the use of foreign

exchange rate derivatives (around 70%), followed closely by interest rate derivatives (around

65%) with commodity price derivative a distant third(around 42%). Bartram(2003) also made

a similar summary about these three kinds of derivative usage situation about 2841 firms in

U.S. in 2000 and the results show that 63.2%, 34.7% and 16.7% of firm use the foreign

currency derivative, interest rate derivative and commodity price derivative respectively.

Compared with Bartram(2003), among my sample all three kinds of derivative instrument

have higher usage rate. This can be illustrated by two reasons. Firstly, as the financial market

become more and more mature in U.S., more firms choose to use the derivatives instrument

to hedge the risk. Secondly, as most literatures point out, bigger firms are more likely to use

the financial derivatives because of the high cost to get access to the derivative market.

Table 2

Summary of hedging activities by years

This table reports the summary statistics for derivative usage situation which covers the foreign

currency derivative usage, interest rate derivative usage and commodity price derivative in the fiscal

year-end 2009, 2010 and 2011. The initial sample includes all top furniture 200 firms from the U.S. in

2011. Among this initial sample, 41 firms are financial firms, 4 firms have big merger or acquisition

activities during my research period, 46 firms did not report the annual report at the December

year-end and 15 firms are not have foreign sales, foreign asset or foreign liability. Finally, my research

sample contains 94 firms which contribute to the panel data of 282 observations. The panel A, panel B

and panel C below present the foreign currency derivative, interest rate derivative, commodity price

derivative usage situation in the fiscal-end year 2009, 2010 and 2011 respectively.


22

Panel A: foreign currency derivative

Year Observations Hedgers Non-hedgers Percentage

2009 94 68 26 72.34%

2010 94 65 29 69.15%

2011 94 67 27 71.28%

Panel B: Interest rate derivative


2009 94 64 30 68.09%

2010 94 60 34 63.83%

2011 94 61 33 64.89%

Panel C: Commodity price derivative


2009 94 41 53 43.62%

2010 94 40 54 42.55%

2011 94 53 41 56.38%

5.2 Sample description

In this paragraph, I will describe the firm characteristics of the 282 observations of my

research sample. The subsamples are classified according to whether the firm has the foreign

currency derivative instruments to hedge the foreign exchange rate risk or not. In my

research, the firm characteristics consistent of firm size, profitability, access to financial

market, leverage, advertisement expenditure, industry diversification and geographic

diversification. These characteristics are analyzed not only for the complete sample, but also

for sub samples.

Table 3

Summary of firm characteristics

The table below shows the firm characteristics of the sample consisting of 94 firms in the period from

2009 to 2011 which contribute to the panel data of 282 observations. The chosen firm characteristics

are geographic diversification (the foreign sale divided by the total sale), size( the natural logarithmic

of total asset), profitability( the net income divided by total asset), leverage(long –term debt divided

by the shareholders’ equity), investment growth(the capital expenditure divided by total sales),

advertisement exp(advertisement cost divided by total sales), dividend(dummy variable and equals to

1 if firms pay the dividend), industry diver( dummy variable and equals to 1 if firms have more than

one segment), Tobin’s Q ( nature logarithmic the ratio of market value of common stock plus the book

liability to the total asset). The table firstly presents these firm characteristics of all observations, then

presents the ones with foreign currency derivatives usage, and finally presents the ones with no

foreign currency derivatives usage.


23

The table 3 above presents the summary statistics of the main firm characteristics of the

firms in the sample which consists of 94 firms and 282 firm-year observations. I used the

mean, median, maximum, minimum and standard deviation to basically describe these firm

characteristics. Compared with subsample without foreign currency derivatives usage, the

subsample with foreign currency derivatives usage has a higher mean value of Tobin’s Q.

For the full sample, the standard deviation of Tobin’s Q is relatively large, which means that

my research sample includes some firms with high Tobin’s Q as well as some firms with low

Tobin’s Q, which is very good for my research. One firm characteristic that is deserved to be

mentioned is leverage. For the all observations, the maximum leverage is 279.429 and the

(1) (2) (3) (4) (5) (6)

Observations Mean Median Maximum Minimum Std.Dev

Total sample 282

Geographic Diver 202 0.402 0.425 0.893 0 0.213

Size 282 4.477 4.478 5.893 3.762 0.397

Profitability 282 0.071 0.06 0.871 -0.147 0.081

Leverage 277 1.76 0.493 279.429 -53.979 17.657

Investment 260 0.054 0.034 0.598 0 0.036

Advertisement Exp 153 0.022 0.02 0.717 0 0.088

Dividend 282 0.798 1 1 0 0.402

Industry Diver 282 0.801 1 1 0 0.399

Ln(Tobin’s Q) 282 0.422 0.349 1.739 -0.192 0.362

Hedgers 200


Size 200 4.484 4.49 5.893 3.762 0.392

Profitability 200 0.07 0.059 0.241 -0.147 0.061

Leverage 195 1.214 0.494 70.196 -9.879 5.271

Investment 185 0.027 0.035 0.598 0.001 0.072

Advertisement Exp 103 0.032 0.025 0.717 0.002 0.104

Dividend 200 0.79 1 1 0 0.407

Industry Diver 200 0.835 1 1 0 0.371

Ln(Tobin’s Q) 200 0.436 0.333 1.739 -0.192 0.389

Non hedgers 82


Size 82 4.458 4.371 5.52 3.867 0.407

Profitability 82 0.072 0.061 0.871 -0.11 0.115

Leverage 82 3.06 0.476 279.429 -53.979 31.379

Investment 75 0.058 0.03 0.314 0.003 0.067

Advertisement Exp 50 0.012 0.015 0.067 0 0.018

Dividend 82 0.817 1 1 0 0.387

Industry Diver 82 0.72 1 1 0 0.449

Ln(Tobin’s Q) 82 0.387 0.354 1.088 -0.08 0.283


24

minimum is -53.979, which implies that in the sample some firms have a very high long-term

debt and some firms have a very small even negative shareholders’ equity. Concerning other

control variables, on average, the value of size and advertisement expenditure of hedger

firms is bigger than the same firm characteristics of non-hedgers. However, the firm

characteristics of investment growth and profitability for firms with hedging activities are

lower than the same characteristics of firms without hedging instruments.

5.3 Univariate analysis

The main hypothesis that the previous hedging literature deals with is that firms that the

derivatives usages for hedging are rewarded by investors with higher value compared with

non-users, thus a significant difference of firm value between the hedgers and non-hedgers

should be expected. This part will examine and statistically test whether the firm value

measured by Tobin’s Q is different between the firms using foreign currency derivatives and

the ones without using foreign currency derivatives. The 282 observations are classified as

hedger or non-hedger based on whether the firm uses the foreign currency derivative or not.

By conducting the univariate analysis, it is possible to test the difference of firm value

between the foreign currency hedgers and foreign currency non hedgers. The difference of

firm characteristics, firm size, profitability, investment growth, leverage, access to financial

market, industry diversification, geographic diversification, and advertisement expenditure

are also tested by employing this analysis. This statistical test is performed by using the

student t-test and the for the firm characteristics (Tobin’s Q, size, profitability, leverage,

investment growth, access to financial market, industry diversification, geographic

diversification and advertisement expenditure) equal variances are not assumed.

The table 4 below reports the results obtained from the statistical test. Column 1 and

Column2 describe the mean value for the firm characteristics of the sub sample foreign

currency hedging observations and sub sample non foreign currency hedging observations.

The mean differences of firm characteristics between these two sub-samples are presented

in column 3. The column 4 and column 5 show the t-statistics and the p-value with two tailed

respectively. The p-value is important since it can be used as a statistical support to make a

conclusion whether the Tobin’ s Q and firm characteristics with foreign currency derivative

usage and without foreign currency derivatives usage are statistically different with each

other. In my empirical analysis, the result is considered to be significant different from zero at

5% level, if the P-value is below than 0.05.

Table 4

Univariate Analysis: Foreign currency hedging versus non-foreign currency hedging

The table below shows the result of univariate analysis which statistically tests the difference of

Tobin’s Q and firm characteristics between firms with foreign currency derivative activities and firms

without foreign currency derivatives activities. The sample of univariate analysis consists of 94 firms


25

which are included in Fortune 200 in the U.S. from 2009 to 2011. The column 1 and column 2 show

the mean value of variable of the firms which use the derivative and which do not use the derivative

respectively. The column 3 shows the difference of the mean values presented in column 1 and

column 2. The column 4 and column 5 present the statistical information about the student t-statistics

and the p-value. The Tobin’ Q is defined as the ratio of market value of common stock plus the book

liability to the total book asset. The explanatory variable is foreign currency derivative dummy variable

which equals to 1 if firms report the foreign currency derivative usage in the annual report. The

control variable include size( the nature logarithmic of total book asset), profitability( the ratio of net

income to total book asset), Investment growth(the ratio of vthe capital expenditure to sales),

leverage (the ratio of long term debt to the book shareholder’s equity), dividend( dummy variable

equals to 1 if firm pay the dividend), industry diver(dummy variable equals to 1 if firms have more

than one segment operations), advertisement exp( the ratio of advertisement cost to sales),

geographic Diver( the ratio of foreign sales outside the U.S.A. to sales). The estimations are conducted

by using the Stata econometric software.

(1) (2) (3) (4) (5)

Variable Hedger Nonhedger difference t-statistics P-value

(200) (82) (Mean)

(2-tailed)

Ln(Tobin’s Q) 0.436 0.386 0.493 1.037 0.150

Size 4.484 4.458 0.026 0.500 0.309

Profitability 0.070 0.072 -0.001 0.102 0.459

Investments 0.057 0.063 -0.006 0.625 0.266

Leverage 1.214 3.060 -1.846 0.793 0.214

Dividend 0.790 0.817 -0.027 0.513 0.304

Industry Diver 0.835 0.720 0.115 2.219 0.014

Advertisement Exp 0.053 0.021 0.032 0.473 0.019

Geographic Diver 0.338 0.167 0.171 5.333 0.000

As showed in the Table 4, the univariate analysis demonstrates that the firms with foreign

currency derivative activities have higher firm value (Tobin’s Q) compared with the ones

without foreign currency derivative activities, however, the result is not statistically

significant, since the P-value is bigger than 0.05. It is possible to conclude that there is no

statistical difference between the firm value of foreign currency hedging and one of

non-foreign currency hedging.

According to the result from the univariate analysis, the two-tailed p value of advertisement

expenditure, the industry diversification and the geographic diversification is smaller than

0.05, which show that the means value concerning these firm characteristics of these two

subsamples are statistically different from each other. By conducting the univariate analysis,

it can be concluded that firms with foreign currency derivatives activities may have higher

Tobin’s Q and these firm have these firm characteristics with lower advertisement


26

expenditure, higher industry diversification and higher geographic diversification. Concerning

other control variables, I want to highlight the geographic diversification. The mean

difference of this variable between these two subsamples is 17.1% and the P-value is 0.000,

and this result shows that firms that use the foreign currency derivative have higher

proportions of foreign sales, which may provide some support for the argument that firms

are hedging rather than speculating with the derivatives to some extent. Bartram(2011) also

shows that derivatives users are significantly more geographically diversified. Unfortunately,

other control variables ((Size, profitability, leverage, dividend, investment growth) do not

show statistically significant difference between hedgers and non-hedgers.

The univariate analysis gave us a surface understanding of the relationship between the firm

value measured by Tobin’s Q and foreign currency derivatives usage measured by dummy

variable, and also show the characteristics of the firms with foreign currency derivative

activity compared with these without the usage of foreign currency derivative. However, the

univariate analysis does not take some unobservable factors into account. It is just consider

whether the foreign currency activities has effect on firm value or not and it does not qualify

this effect, however the multivariable analysis can overcome this problem and qualify the

relationship between using of foreign currency derivative and firm value. Moreover, the

multivariate analysis can also include the control variables, which makes it possible to

investigate and isolate the effect of foreign currency derivatives on firm value. Therefore, the

following part will focus on the multivariate analysis to investigate the relationship between

the using of foreign currency derivatives and firm value.

5.4 Multivariate analysis

In this paragraph, I will present and examine the result of multivariable analysis. As previous

paragraph, the univariate analysis just gives the surface relationship of firm value and the

usage of foreign currency derivative. However, the multivariable analysis will give the deeper

understanding of this relationship. It will isolate the effect of foreign currency derivative

usage on firm value. In this analysis, the same control variable, as described in the univariate

analysis, will be included to control the influence coming from the control variables on firm

value and to isolate the real effect of foreign currency derivatives usage on firm value.

The multivariate analysis is estimated based on the following regression models:

ln (Q) = α + β ∗ Hedge_dummy + ∑ 𝛾𝑖 ∗ 𝑐𝑜𝑛𝑡𝑟𝑜𝑙_𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑖

+ 𝜀

Q is the dependent variable which describes firm value in my research. Since the mean value

of Tobin’s Q is higher than the median value of Tobin’s Q, suggesting that the distribution of

Tobin’s Q is skewed, in the multivariate analysis, I use the nature logarithmic of Tobin’s Q as a


27

proxy for firm value. The Hedge_dummy is the explanatory variable which describes whether

the firms have the foreign currency derivative activity or not. The coefficient of the hedge

dummy β is interpreted as a premium or a discount on firm value because of the hedging

activities, depending on the sign of the coefficient. However, other factors also have

influence on firm value in my research. These factors are control_variables which are

size( the nature logarithmic of total book asset), profitability( the ratio of net income to total

book asset), investment growth( the ratio of the capital expenditure to total sales), leverage

(the ratio of long term debt to the book shareholder’s equity), dividend( dummy variable

equals to 1 if firm pays the dividend and to 0 if firm does not pay the dividend), industry

diver(dummy variable equals to 1 if firm has more than one segment operations and equals

to 1 if firm focuses on one segment), advertisement exp( the ratio of advertisement cost to

total sales) and geographic Diver( the ratio of foreign sales outside the U.S.A. to total sales)

in my research. Because there are many variables even unobservable variables which also

have effect on firm value and it is impossible to contain all these variables in one model, the

random disturbance term denoted by 𝜀 is added.

Followed by Allaynnis(2001), in my research I use two regression methods. One is pooled

Ordinary Least Squares regression (Pooled OLS regression) and the other is the fixed-effect

regression. The Pooled-OLS regression pools the data and estimate an OLS regression. The

pooled OLS regression is a most common method to analysis the panel data. However,

sometimes, it is leads to some biased estimator, since the pooled OLS regression does not

take into the effect of the individual heterogeneity. Due to this reason, I also use the fixed

effect regression to test the relationship between the firm value and the foreign currency

derivative usage. In fixed effect regression, the unobserved heterogeneity is no longer a

problem, since in this model, the assumption that the unobserved factors are unrelated with

the control variable or explanatory variable is no longer needed.

The following part will show my statistical regression result about the effect of foreign

currency derivative usage and other control variables on firm value. The Pooled OLS

regression will firstly be presented and then the Fixed-effect regression.

The table 5 describes the result of multivariable analysis by using the Pooled OLS regression.

The missing data advertisement expenditure has big influence on the sample size, but based

on the previous literature and research (Allayannis,2001; Kapitsinas,2008). This variable is

important to control in order to get the real relationship between the firm value and foreign

currency derivative usage. Thus, I did not omit this variable form my research. The column

one shows the result of Pooled OLS regression without the control variable of advertisement

expenditure. The column 2 shows the result Pooled OLS regression with all control variables

that may have influence on firm value.


28

Table 5

The Pooled OLS regression: the relationship between foreign currency derivative usage and

firm value

This table presents the result of Pooled OLS regression on the use of foreign currency derivative on

firm value. The missing data advertisement expenditure has big influence on the number of

observations, but previous literatures demonstrate that this variable also have significant impact on

firm value. Thus, the Pooled OLS regression is done twice for these two situations, which are

presented in column 1 and column 2 separately. The column 1 presents the Pooled OLS regression

result without the control variables of advertisement expenditure. The column 2 presents the result of

pooled OLS regression with all control variables. For every control variable, the result firstly shows the

coefficient whose sign determines that the relationship is positive or negative, and below the

coefficient the P-value which determines the result is statistically significant or not is presented. The

Tobin’s Q, foreign currency derivative dummy and the control variables have the same definition as

the univariate analysis in the previous part. The estimations are conducted by using the Stata

econometric software.


29

Pooled OLS

Ln(Tobin's Q) (1) (2)

Foreign currency dummy 0.005 0.029

(0.914) (0.698)

Size -0.088 -0.221

(0.113) (0.004)

Profitability 2.235 2.000

(0.000) (0.000)

Geographic Diver 0.150 0.347

(0.066) (0.009)

Leverage 0.000 -0.001

(0.726) (0.582)

Dividend 0.027 -0.081

(0.582) (0.246)

Industry Diver -0.029 0.027

(0.555) (0.675)

Investments -0.194 0.299

(0.474) (0.559)

Advertisement Exp

-0.144

(0.729)

The Tobin’s Q in both Pooled OLS regression are positively related with firm value, however

the result are not statistically significant due to the fact the P-value is bigger than 0.05. Thus,

the conclusion that firms using foreign currency have the higher value compared to the firms

without the foreign currency usage can’t be drawn. Among all the control variables, the

control variables of geographic diversification and of profitability are statistically significant in

these two situations, which imply that firms’ geographic diversification and profitability have

the big influence on firm value. The coefficient between geographic and diversification is

positive, which also support the result of Allayannis(2001), showing that firm’s expanded

operation outside the U.S. is a value-creative strategy for these firms. The coefficient of

profitability which is defined as the ratio of net income to total asset is also positive. This

result supports that higher profitable firms are traded with a higher premium compared with

the low profitable firms and is consistent with Allayannis(2001), Bartram(2003,2011) and Jin

and Jorion(2006). In the regression without omitting the advertisement expenditure, the size

displays the negative and statistically significant relationship with firm value, and this result is

consistent with that of Allayannis and Weston(2001) and carter, Roger, and Simkins (2003,

2006) and Bartram(2011) , which may indicate that larger firms can’t contribute to the higher

firm value by taking the advantage of economies of scale.

In my research, I also did the fixed effect regression to improve the quality of regression


30

result. In the fixed effect regression, the assumption that the unobserved factors are

unrelated with the control variable or explanatory variable is no longer needed. The table 6

below presents the result of fixed effect regression.

Table 6

The fixed-effect regression: the relationship between the foreign currency derivatives

usage and firm value

This table presents the result for fixed effect regression on the use of foreign currency derivative on

firm value. The missing data advertisement cost has big influence on the number of observations, but

previous literatures demonstrate that this variable has significant impact on firm value. Thus, the fixed

effect regression is done twice for these two situations, which are presented in column 1 and column

2 separately. The column 1 presents the result without the control variables of advertisement

expenditure. The column 2 presents the result of fixed effect regression with all control variables. For

every control variable, the result firstly shows the coefficient whose sign determines whether the

relationship is positive or negative, and below the coefficient the P-value which determines whether

the result is statistically significant or not is presented. The Tobin’s Q, foreign currency derivative

dummy and the control variables have the same definition as the univariate analysis in the previous

part. The estimations are conducted by using the Stata econometric software.

The fixed effect regression also shows that the coefficient of foreign currency derivative and

firm value is positive, which means that the foreign currency derivative usage may increase

Fixed-effect

Ln(Tobin's Q) (1) (2)

Foreign currency dummy 0.044 0.145

(0.615) (0.122)

Size -0.386 -0.686

(0.003) (0.003)

Profitability 0.284 0.245

(0.144) (0.189)

Geographic Diver -0.08 -0.066

(0.572) (0.737)

Leverage 0.000 0.000

(0.968) (0.889)

Dividend -0.114 -0.209

(0.184) (0.028)

Industry Diver -0.263

(0.125)

Investments growth 0.667 2.056

(0.045) (0.000)

Advertisement Exp

-2.026

(0.000)


31

firm value. However, the P-value of foreign currency derivative is higher than 5%, which

demonstrates that the result is not statistically significant. Thus, the result that the usage of

foreign currency derivatives has a positive effect on firm value cannot be concluded through

the fixed effect regression. The firm size and investment growth show the statistically

significant relationship with firm value. The coefficient of investment growth is positive

which support that the firm value of a firm having much more investment opportunities will

have be higher compared with the one of a firm with limited set of investment opportunities.

Other control variables, beside dividend that is as proxy to getting access to financial market

and advertisement expenditure that is proxy to consumer goodwill, do not demonstrate the

statistically significant relationship with Tobin’s Q in the fixed effect regression model.

To sum up, I finished the multivariate analysis by employing two regression models that are

pooled OLS regression and fixed-effect regression model. Since the missing data of

advertisement expenditure has big influence on the sample size, but this control variable is

also a major one which also leads to impact on firm value, I did each regression two times.

Both Pooled OLS regression and Fixed-effect regression demonstrate that the foreign

currency derivative instruments at the fiscal year-end do not have significant relationship

with firm value. The estimation for firm size in both regressions is negative and statistically

significant, supporting the result of Allayannis(2001), Lang and Stulz(1994), Kapitsinas(2008)

and Bartram(2003, 2011). The result for investment growth in fixed-effect regression model

is also statistically significant and the coefficient is positive, which is consistent with the one

of Allayannis(2001) and Bartram(2011). Concerning to the other control variables, the

geographic diversification and profitability only show statistically significant result in the

pooled OLS regression, and both are positively related with firm value. This result is similar

with the result from Allayannis(2001) and Kapitsinas(2008).

5.5 Alternative control variable

In an attempt to eliminate the deviation coming from the definition of the parameters of the

investigated relationship between the foreign currency derivatives usage and firm value, I

repeated the initial regression, the pooled OLS regression and Fixed effect regression with

the ratio of capital expenditure to total asset as a proxy for investment growth and the ratio

of advertisement cost to total asset as a proxy for consumer goodwill, and the result will be

displayed in the table 7.

Table 7

The result of Pooled OLS regression and fixed effect regression of Alternative control

variable

This table presents the result for pooled OLS regression and the fixed effect regression on the use of

foreign currency derivative on firm value. The missing data advertisement expenditure has big effect

on the number of observations, but previous literatures demonstrate that this variable also has


32

influence on firm value. Thus, both regressions are done under two situations. The column 1 and

column 2 present the pooled OLS regression and fixed effect regression separately without the control

variable of advertisement cost. Column 3 and column 4 present result of both regressions with all the

control variables. For every control variable, the result firstly shows the coefficient whose sign

determines that the relationship is positive or negative, and below the coefficient the P-value which

determines the result is statistically significant or not is presented. The Tobin’s Q, foreign currency

derivative dummy and the control variables have the same definition as the univariate analysis in the

previous part. The estimations are conducted by using the Stata econometric software.

Multivariate Analysis

Pooled OLS Pooled OLS fixed effect fixed effect

Tobin's Q (1) (2) (3) (4)

FC derivative dummy 0.073 0.126 0.143 0.240

(0.386) (0.424) (0.403) (0.264)

Size -0.232 -0.32 -0.579 -1.421

(0.020) (0.034) (0.021) (0.012)

Profitability 4.098 3.522 0.525 0.455

(0.000) (0.000) (0.176) (0.296)

Geographic Diver 0.245 0.663 -0.002 -0.141

(0.103) (0.016) (0.993) (0.764)

Leverage -0.001 -0.001 -0.001 -0.001

(0.872) (0.855) (0.780) (0.501)

Dividend -0.003 -0.234 -0.183 -0.370

(0.972) (0.087) (0.278) (0.094)

Industry Diver -0.064 0.029 -0.371

(0.488) (0.816) (0.271)

Investments growth 0.804 3.616 3.324 5.861

(0.413) (0.044) (0.041) (0.013)

Advertisement Exp 3.183

1.090

(0.009)

(0.885)

In comparison with the result of my initial regression as presented in table 5 and table 6, the

Tobin’s Q in both repeated pooled OLS regression and fixed effect regression are positively

related with firm value, however the result are also not statistically significant due to the

high p-value which is bigger than 0.05. These results are consistent with result of my initial

regressions. Concerning the control variables, the statistically result of size (natural

logarithmic of total asset) and investment growth (Ratio of capital expenditure to total asset)

are similar with the initial regression on size (natural logarithmic of total asset) and

investment growth (Ratio of capital expenditure to sales). But, the coefficient of the size

proxy become more negative and more significant (P-value decreased from 0.02 to 0.003) in

the model of alternative control variable, however, the other control variables display no

substantial change.


33

To sum up, compared the Pooled OLS and Fixed effect regression model of alternative control

variable with the initial Pooled OLS and Fixed effect regression model, the conclusion that

the using of foreign currency derivative does not have a significant impact on firm value is

consistent. As respect to the control variables, the finding that firm size has negative effect

on firm value and the investment growth has positive effect on firm value is also compatible.


34

Chapter 6 Determinants of hedging

Since I have collected the data and information on the foreign currency derivatives of my

research sample consisting of 94 firms of Fortune 200 in U.S., I want to supplement my

empirical research on the foreign currency derivative by investigating the determinants of

firm’s decision of using the foreign currency derivatives.

Under the basic Modigliani Miller (MM) model with the absence of financial distress costs,

taxes, information costs, underinvestment problems, management incentives and capital

market imperfection, the hedging activities is unnecessary. In the real world, however, it is

impossible to get access to this perfect market, the demand for corporate hedging may be

derived by relaxing one or more of the MM perfect market assumption.

The same as the research on the effect of hedging activities on firm value, before the

accounting regulations on the derivatives information, most researches focus on the

theoretical discussion about the determinants of derivative usage. Some researchers conduct

the empirical analysis and collect the data by survey or questionnaire. For instance, Nance,

smith and Smithson(1993) obtain the data based on the questionnaire from 159 large U.S.

non-financial corporations and they find that corporations with the derivatives instruments

have more growth investment, larger size, fewer hedging substitutes and more convex tax

functions. Recently, amounts of literatures work on this research through the empirical

analysis, which is stimulated by the data availability of derivatives position of each company.

While, many empirical analysis are carried out to test the hypothesis put forward by the

theoretical prediction.

Mian(1996) utilize a large sample consisting of 3022 firms in year 1992 and obtain the data

from the annual reports. The result demonstrates that the association between hedging and

market-to-book value is negative, which supports that firms with less investment

opportunities are more likely to use the hedging instruments. The evidence in support the

hypothesis that reducing the taxes payment is a motivation for firms to use the derivatives

instrument is very weak. However, this research finds strong evidence to support that size

has a positive relation with hedging dummy and points out that the information and

transaction cost have more influence on the decision of hedging than the cost of raising

financial capital or the cost of financial distress problem, which supported the theoretical

hypothesis that hedging activities demonstrate the economies of scale.

The same as Mian(1996), Geczy, Minton and Schrand (1996) also study a large sample of 372

Fortune 500 non-financial firms in the U.S. to test the hedging motivations of firms. The

result demonstrates that corporations with tighter financial constraints, higher foreign

exchange rate risk, and economies of scale are more likely to employ the currency derivatives


35

to reduce the risk exposure.

Bartram, Brown and Fehle(2003) test the rationales for corporate hedging on an

international scale. The same as the other previous literatures, they also test the hypothesis

that are mostly derived from the existing theories describing that the incentives for

derivatives come from the financial distress cost, underinvestment problems, taxes and also

the management incentives. By using the sample of 9292 companies in the 48 countries, the

result of this research shows that financial distress and taxes have positive coefficient with

firm’s hedging activities. However, contrary to the prediction, this research provides mixed

support for the management incentives and underinvestment hypothesis.

In this part, I conducted the empirical analysis to test the determinants of decision of

hedging activities for the nonfinancial firms in the U.S. I employed the logistic regression to

investigate this issue. The outcome variable in the logistic regression is binary or

dichotomous and in my research the hedging dummy is the dependent variable which is

equal to 1 if firm use the foreign currency derivative at the fiscal end year and equal to 0 if

firm does not utilize the foreign currency derivative to hedge the foreign currency exposure.

The independent variables in this regression is the firm size(nature logarithmic of total book

asset), profitability(ratio of net income to total book asset), investment growth(ratio of the

capital expenditure to total asset), leverage(ratio of long term debt to the book shareholder’s

equity), dividend(dummy variable equals to 1 if firm pays the dividend and to 0 if firms does

not pay the dividend) and geographic diversification (ratio of foreign sales outside the U.S. to

total sales). The table 8 below presents the result the logistic regression.

Table 8

The determinants of the decision of using the foreign currency derivatives

The table below presents the result of logistic regression relating the probability of hedging to the

determinants of hedging. This regression is also based on the sample of 74 firms of Fortune 200 firms

in the U.S. from 2009 to 2011 which contributes to 282 observations. The dependent variable is

foreign currency dummy. The independent variables are size, profitability, geographic diversification,

leverage, dividend dummy and investment expenditure. The column 1 shows the coefficient and the

column 2 shows the P-value.


36

Logistic regression

(1) (2)

Hedge-dummy Coefficient P-value

Size -0.126 0.772

Profitability -3.502 0.079

Geographic diver 3.427 0.000

Leverage -0.007 0.429

Dividend -0.324 0.407

Investment -1.544 0.439

The result from the logistic regression demonstrates that the geographic diversification has a

strong positive impact on hedging, and the result is statistically significant at 5% level, which

supports that the foreign exchange risk plays an important role in firms’ decision of hedging

activities. The profitability has a negative impact on the firms’ decision of the using of foreign

currency derivative and the result is statistically significant at 10% level. The logistic

regression finds no evidence to support that firms with more investment opportunities are

more likely to use the foreign currency derivatives than non-hedgers. The data also does not

support the hypothesis that hedging is based on the financial restriction, since the dividend

does not show a statistically significant relationship with hedging dummy. The logistic

regression also demonstrates that the hedging activities do not exhibit the economies of

scale and firm size is not a major determinant to the decision of hedging activity for

non-financial firms.


37

Chapter 7 Discussion of the result

The research of Allayannis(2001) directly test the effect of foreign currency derivative on firm

value and find that firm value is 4.87% higher for U.S. firms which employ the foreign

currency derivative to reduce the foreign exchange rate exposure than firms which do not

employ hedging instrument. Allayannis(2001) also find the evidence that firms that begin a

hedging policy experience an increase in value above those firms that choose to remain

un-hedged and firms that quit hedging experience a decrease in value relative to those firms

that choose to remain hedged. Bartram also conducted a research concerning the

relationship between derivative usage and firm value separately in 2003 and 2011. By using a

huge sample(7279 firms and 6888 firms), Bartram (2003,2011) do not find a strong result

indicating that foreign currency derivatives is associated with higher firm value for both U.S.

and international non-financial firms. Bartam(2011) suggest that the effect of derivative

usage is associated with a decline in both total and systematic risk and the effect of

derivative on firm value is not statistically significant. Guay(1999) investigate a sample of 234

U.S. nonfinancial firms that began using derivatives in the early 1990s and find no significant

evidence for changes in systematic risk and firm value. To sum up, limited researches test the

effect of foreign currency derivative usage on firm value and the results are mixed. My

research result is consistent with the finding of Bartram (2003 and 2011) and Guay(1999).

There are some possible explanations to figure out the insignificant relationship between the

foreign currency derivative usage and firm value.

1. Both the Pooled OLS regression and the fixed effect regression cannot totally prevent the

unmeasured selection bias in the sample. It is possible that some unmeasured characteristics

(e.g. the characteristics of CEO or managers) would have to be quite economically significant

and have huge influence on firm value.

2. Although I carefully examine the annual report of each firm from 2009 to 2011, some

firms did not give clear report or evidence to demonstrate whether the firm uses the foreign

currency derivative or not. For example, some firms state that “we may use the foreign

currency derivatives or contract” to hedge the foreign currency exposure. Given this facts,

users appear to be misclassified as nonusers under some unclear conditions, the regression

result maybe suffered from this noise.

3. As Bartram (2011) pointed out, the value effects of derivative use are quite sensitive to

selection bias. Even small differences of sample construction, control variable definition and

estimating method may totally change the study result.

4. The industry effect and the regulation about the risk management in different industry


38

also may have influence on the estimating of the effect of foreign currency derivatives on

firm value. As Jin and Jorion(2006) point out, firms in certain industry may be more likely to

hedge, for example, if they are exposed to more readily identified, larger, or more easily

hedged types of risk15.

5. Getting access to the derivative market and setting up a good hedging program is a very

expensive activity, which may lead to a negative effect on firm value. It is possible that the

foreign currency derivative activities increase the firm value, however, the huge cost of

hedging activity outweighs this benefit to some extent.

6. Under some situations, it is possible that executives use derivatives to smooth earning

performance due to the accounting-based bonus compensation. In larger firms with

diversified segment operations or with geographically diverse operations, the divisional

managers may engage in hedging to smooth their divisional performance. Thus, under this

situation, the real relationship between the hedging activity and firm value becomes more

difficult to estimate.

7. Sometimes, firm can use the operational hedges to reduce risk. For instance, a

manufacturing firm with production and sales operations in foreign countries is exposure to

foreign exchange rate. However, this multinational corporation can use the revenue in

foreign currency to buy the raw material, pay the wages or repay the loan without exposure

to foreign exchange rate risk. This operational hedging is helpful to reduce the foreign

exchange rate risk and maybe has influence on firm value as well.

8. A limitation of this research is that the regression only test whether the using of foreign

currency derivative create a higher firm value or not but not test whether the firms with

higher Tobin’s Q have an incentive to hedge. Another limitation is that firms in some special

industry will have a higher firm value compared with other industry. In the research of

Allayannis and Weston (2001), they control this effect by the industry adjusted Q. However,

because of the lack of data, this effect is difficult to control in my research.

9. Another limitation of my research is that it did not investigate the issue of reverse

causality because of the lack of data. The usage of the currency derivatives may reduce the

risk exposure and has positive influence on firm value. However, if the firms with higher firm

value (Tobin’s Q) have more investment opportunities, then they have more incentive to

hedge the risk exposure. As Allayannis(2001) demonstrate higher values for firms that use

derivatives may simply reflect the fact that high-Q firms have an incentive to hedge, and not

that hedging cause higher values16.

15

Jin and Jorion(2006) 16

Allayannis(2001)


39

Chapter 8 Conclusion

The main goal of this research is to investigate whether hedging foreign exchange rate risk

with foreign currency derivative instrument creates firm value or not. I used a sample of 94

firms among Fortune 200 firms from 2009 to 2011 in the U.S. and manually collected and

exacted the information on the foreign currency derivative position in the annual report

which I got from the U.S. Securities Exchange Commission (SEC). In order to test the

influence of foreign currency derivative on firm value, a hedge dummy indicating whether or

not the firm has hedging activities is utilized. Tobin’s Q defined as the natural logarithmic of

the ratio of market value of the firms to the total asset is as a proxy for firm value. While,

other control variables consisting of firm size, profitability, access to financial market,

investment growth, industry diversification, geographic diversification, advertisement

expenditure are also used to control the influence on firm value. The relationship between

the hedge dummy and Tobin’s Q is tested by the Pooled OLS regression and Fixed effect

regression.

Descriptive statistics reveals that the Tobin’s Q ratio is higher for firms that engaging in the

foreign currency derivatives compared to the Tobin’s Q ratios for firms that do not have

active position in the hedging activities. The descriptive statistics also reveals that the

geographic diversification (foreign sales divided by total sale), size (the nature logarithmic of

total asset), advertisement expenditure (advertisement cost divided by sales), access to

financial market (equals to 1 if firm pay the dividend, equals to 0 if firm does not pay the

dividend) and industry diversification (equals to 1 if firm reports more than one operation

segment, and equals to 0 if firm focuses only on one segment) are higher for firms with

hedging activities compared to the same characteristics for non-hedging firms.

The univariate analysis revealed that the firm value of foreign currency derivative users is

larger compared to the firm value without foreign currency derivatives, however, the result is

not statistically significant. The industry diversification, advertisement expenditure, and

geographic diversification of hedging companies show higher result than the same firm

characteristic of non-hedging companies, and these positive coefficients are statistically

significant. While, other differences of the firm characteristic between the foreign exchange

rate hedgers and non-foreign exchange rate hedgers are not statistically significant.

The multivariate analysis makes it possible to include the quantity of hedged position into

the regression model. Furthermore, it is possible to include the control variables which also

have influence on firm value and can explain the variation in the dependent variable Tobin’s

Q. Additionally, the multivariate analysis can isolate the effect of foreign currency derivative

usage on firm value from the effect of other control variables on firm value. The main

conclusion can be drawn based on the multivariate analysis is that having a foreign currency


40

derivative does not have a significant impact on the firm value of my sample. The control

variable size is statistically significant in both regression and the coefficient is negative, which

supports the hypothesis that it is difficult for firms to increase the market value just by the

economies of scale. The profitability has a positive effect on firm value and the result is

statistically significant in the Pooled OLS regression. Concerning the investment growth, it is

positively associated with firm value, but the result is just significant in fixed-effect

regression.

The conclusion can be derived from my research is that the using of foreign currency

derivatives does not have significant impact on firm value. This is contrary to the result of

Allayannis and Weston (2001) which find that the hedgers have a 4.7% higher firm value

compared with the non-hedgers. But it is consistent with Weston (2001) and Carter, Rogers

and Simkins (2004) whose analysis results show that the derivative usage does not have a

significant impact on firm value.

In order to supplement my research, I also tested the determinants of the decision of

hedging. The geographic diversification (foreign exchange rate risk) and profitability have

significantly statistical relation with firm’s decision of using the foreign currency derivative

for the non-financial firms in the U.S.

In this research, I did not control the effect of industry influence on firm value and did not

investigate the reverse causality issue because of the lack of data. However, these limitations

will be covered in my future research.


41

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