Foreign Exchange Risk Hedging and Firm value: Empirical ...
Transcript of Foreign Exchange Risk Hedging and Firm value: Empirical ...
Foreign Exchange Risk Hedging and Firm value:
Empirical Study from MNCs in China
Meng Zhang
ANR: 355134
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Foreign Exchange Risk Hedging and Firm value:
Empirical Study from MNCs in China
Meng Zhang
ANR: 355134
Tilburg University
August 2013
Master in Finance 2012
Supervisor: Dr. J.C. Rodriguez
Second Reader: M.R.R (Michel) van Bremen
Tilburg School of Economics and Management
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Abstract
This paper examines the relationship between foreign currency derivative usage and
firm value. It broadly follows the work of Allayannis and Weston (2001) but differs in
sample selection and extends the work to find the determinants of hedging decision. I
use a sample of 97 Chinese multinationals during 2007-2012 to test whether firms
using FCD are valued more by investor with higher market value than firms without
using. With the reform of Chinese currency regime, a floating exchange rate system
makes Chinese multinationals exposed to more currency risk. Therefore, a substantial
growth of hedging activities in Chinese firms makes empirical studies on Chinese
samples available and meaningful. Firstly, I perform a univariate test to identify the
hedging premium between hedgers and nonhedgers and find insignificant results.
Secondly, a linear regression without control variables is run to test the hypothesis.
No significant result is obtained for the argument that hedging can create value for
firms with currency risk exposure. Thirdly, pooled regressions adding control
variables and those with firm-fixed effects are used to test whether hedging is
value-creating. A significant hedging premium is only found when using fixed effects
while no meaningful evidence on FCD usage is found when we use cluster option to
run the pooled regressions. Thirdly, a logistic regression is performed to examine the
determinants of hedging. Some variables are identified to play important roles in
determining hedging. In a nutshell, the results for hedging premium is positive but
insignificant at most times, therefore, this paper provides only limited empirical
evidence on Chinese samples to examine the hedging-creating effect.
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Contents
1 Introduction................................................................................................................... 6
2 Literature Review .......................................................................................................... 9
2.1 Financial Derivatives and China ............................................................................... 9
2.11 Forward Settlement and Sale of Foreign Exchange ............................................... 9
2.12 Non-deliverable Forwards ................................................................................ 10
2.2 Risk management Theory ...................................................................................... 11
3. Data and Statistics....................................................................................................... 12
3.1 Sample Description ............................................................................................... 12
3.2 Dependent Variable ............................................................................................... 13
3.3 Independent Variable ............................................................................................. 14
3.4 Other explanatory Variable .................................................................................... 15
3.5 Control Variables .................................................................................................. 15
4. Results ....................................................................................................................... 17
4.1 Descriptive Statistics ............................................................................................. 17
4.2 Hedging Premium ................................................................................................. 18
4.3 Univariate Test...................................................................................................... 19
4.4 Multivariate Test ................................................................................................... 20
4.5 Firm-fixed Effect................................................................................................... 21
4.6 Determinants of the decision to hedge ..................................................................... 22
4.7 Summary of the Results ......................................................................................... 23
5. Conclusion and Limitation........................................................................................... 25
5.1 Conclusion and Discussion .................................................................................... 25
5.2 Limitation and Recommendation ............................................................................ 26
Reference ....................................................................................................................... 28
Table 1: Summary statistics ............................................................................................. 31
Table 2: Profile of firm’s hedging over time ..................................................................... 34
Table 3: Comparison of Q: hedgers versus nonhedgers...................................................... 35
Table 4: Estimates of the Relation between Firm Value and Hedging Behavior ................... 36
Table 5: Determiants of FC derivatives hedging................................................................ 38
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Appendix 1: The Renminbi-dollar Exchange Rate Movements in the Period 2007-2012 ...... 39
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1 Introduction
Risk management plays an important role in modern business strategy. The ISDA
research (2009) on world’s 500 largest companies reports that 92 of which use
derivative instruments to manage business and financial risks. Financial derivatives,
such as currency, interest rate and commodity derivatives are widely used by
corporations to control risks.
Due to the friction of M&M model, a substantial literature is developed to illustrate
the relation between hedging and firm value. Smith and Stulz (1985) identified that
hedging was induced because of the convex structure of tax code and the reduced
contracting cost of financial distress. Stulz (1996) pointed out “the primary goal of
risk management is to eliminate the possibility of costly lower-tail outcomes-those
that would cause financial distress or make a company unable to carry out its
investment strategy”. According to Froot et al. (1993), when the external financing is
more costly than self- financing, hedging activities are value-increasing because
hedging ensures the capability of financing profitable investment, which alleviate or
avoid underinvestment problem.
Empirical examinations of hedging theories are widely conducted after the
availability of data on hedging activities. On the one hand, Allayannis and Weston
(2001) and Carter et al. (2006) find a positive association between hedging and firm
value, indicating that firms using currency derivatives have higher value than firms
without using by 5%. Furthermore, different types of hedging instruments (futures,
options, swaps and insurance) can result in different value-enhancing effect, ranging
from 11% to 34% (Clark& Judge, 2009).
On the other hand, some other research studies conclude that hedging is not always
value-enhancing. Guay and Kothari(2003) declare that the amount of hedging
premium can be overlooked when considering firm size, investing cash flow,
suggesting that the effect of hedging are probably be overvalued or the value created
may attributed to other risk management or luck. Magee (2009) also finds that
positive and significant relation between hedging and firm value disappears after
controlling for the possibility that past level of firm value affects current level of
foreign currency hedging. Even more, hedging are probably be value-diminishing,
based on agency problems that managers may hedge on the benefit of themselves, not
to maximize value for shareholders (Stulz, 1984; Smith and Stulz, 1985)
It is evident to notice that few empirical research studies are performed on Chinese
firms to examine the corporate derivative use and firm value according with corporate
risk-management theories. This fact may be related with the short period of floating
currency policy and data availability of currency derivative usage in China. The
reform of Chinese currency regime started in 2005, indicating a managed floating
exchange rate system. In particular, except for one-off appreciation against dollar by
2.1%, the peg against dollar was replaced by a link to a basket of currencies. Until
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May, 2013, the accumulated appreciation amounts to 25%, rising from 8.2765 in June,
2007 to 6.2072 in May, 20131 (middle rate of month).
With the continuous appreciation of renminbi, Chinese corporations with
substantial exporting activities suffer with decreased revenues because the raised price
of products marked by foreign currency has reduced the volume of exporting.
However, corporations with large importing benefits from that. 2
Most of the research studies of foreign currency risks in China focus on
macro-aspects, such as the effect of floating currency on international trade and
employment policy. Besides, some empirical research explores the currency influence
on specific industry, district and stock market. Very few studies test whether
corporations use currency derivatives to hedge according with their risk management
policies.
Until 2007, the data availability of currency derivatives is feasible on firm level,
making the empirical research examining effects of hedging activities available. The
new Corporate Accounting Principles was first implemented in public firms on 1st,
January, 2007. In details, it requires all firms to report risk exposure and the according
formative factors, the goal of the risk management, the way to measure risks and the
information about financial derivatives on fiscal years ending. In particular, firms
must report details about the types of derivatives (e.g., options, futures, NDF and
swaps), the face, contract or notional amount of the financial instruments together
with the information on the profit and loss of those financial instruments.
In this paper, the main goal is to address the question whether foreign currency
derivative usage contributes anything to firm value for Chinese multinationals. The
basic structure is largely based on Allaynnis and Weston (2001) who conduct a study
to examine that whether firms with FC derivatives are rewarded with higher value. I
follow the methodology of them but differ in the sample selection and timing. The
authors use a sample of large non-financial corporations with more than 500 million
dollar total assets in U.S. that are listed in COMPUSTAT database over 1990-1995
and separate into two subsamples, one with foreign sales and another not. However, I
use a random sample of 97 large nonfinancial firms, those of which all have a certain
amount of foreign sales 3 . All firms are traded at Shanghai or Shenzhen Stock
exchange markets from 2007 to 2012, and have more than 1000 million yuan total
assets. Finally, I obtain a set of 485 firm-year observations to study the relationship
between hedging and firm value.
Like many previous research studies, I use Tobin’s q for firm value, stem from
Allayannis et al. (2009), whose formula requires basic financial and accounting
1 The data is derived from website of Stated Administration of Foreign Exchange www.safe.gov.cn 2 China has maintained great trade surplus for a few years , which is settled by foreign currency (e.g., dollar), indicating trading risk resulted by exchange rate movements for multinationals, for example, exporting activi ties or importing competi tion. 3 Some fi rms do not distinguish exporting sales and sales from foreign subsidiaries , so, in this paper, foreign sales
include both exporting sales and sales from foreign subsidiaries.
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information. Besides, I also use the simple approximation for Tobin’s q (Kee H.Chung
and Stephen W. Pruitt,1994) to test the hypothesis that hedging is value creating and
find the same results.
The main hypothesis is that for firms with foreign sales, the users of foreign
currency derivatives (FCDs) are more likely to be rewarded by investors with higher
valuation in the market place. For example, hedging can substantially reduce the
contracting cost of financial distress.
This paper first examines whether users of FCDs have higher value than nonusers,
and I find that groups with derivative usage have consistently higher mean Qs than
their counterparts, but the hedging premiums between two groups are not significant.
The directions of currency movement are also taken into consideration- those may
affect firm value, so I use the same tests for RMB-appreciation and RMB-no
appreciation periods (From 2007 to 2012, there are no RMB depreciation periods) and
also find the hedging premium is higher for derivative users during RMB appreciation
period, but not significant. Besides, I add the explanatory variables to further test
whether hedging is valuable for firms and find the hedging is value-creating after
controlling for size, leverage, profitability, access to financial markets, growth
opportunity, geographic and industry diversification, segment(GIC-sector) and time
effects but not significant. I further add the cluster options to capture the robust
standard errors but no significant evidence is found. Until now, I cannot argue that
hedging is value-creating for multinationals. Furthermore, to control unobservable
firm characteristic that may affect market value, such as corporate management, I also
estimate a firm-fixed effect model. The outcomes show a positive and significant
hedging premium for all multinationals, suggesting FC derivatives usage value-adding
activities. Finally, a logistic regression is run to examine the factors determining
hedging decision. Some meaningful evidence is found.
Unlike Allaynnis and Weston (2001) who use the four-digit SIC to control the
industry diversification, this paper use GIC-sector instead. Considering the majority
of firms in the sample are not diversified across different industrial segments, it is
adequate to use simple industry control to capture industry effect.
The major contribution of this paper is to illustrate the relationship between
hedging activity and currency derivatives at firm level with the sample that is based
on Chinese multinationals. Prior empirical studies are heavily relied on samples of
corporations in developed countries, such as U.S. and UK. In the meanwhile, few
studies in China have tried to address the issue on currency risks and hedging
management at firm level. One reason is that there are colossal public firms in
Chinese exchange stock markets, making the empirical studies difficult and
time-consuming at firm level, so most previous studies choose to focus on some
specific industries (e.g., oil and cooper industry) to examine the hedging effect.
The paper is organized as follows. Section 2 presents the current state of risk
management for multinationals in China and reviews theoretical arguments on
derivative hedging. Section 3 describes the sample selection and definitions of
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dependent variables, independent variables and control variables and the
corresponding signs to test the main hypothesis. Section 4 is the main part of this
paper, which provides the descriptive statistics, two sample tests and regression
analysis to test the hedging effect and the determinants of hedging activities. Section 5
is the final part and conclusion.
2 Literature Review
2.1 Financial Derivatives and China
China has made tremendous strides after three decades of reforms and progressive
opening of markets. Finance plays a crucial role in modern economy and thereafter
China’s financial system has made great progress, which is in line with rapid
economic growth. Financial derivatives, as an important part of modern financial
system, have also experienced continuous growth in China.
As China’s share of international trade grows, renminbi turnover has a dramatic rise,
suggesting importers and exporters have to find sophisticated ways to manage foreign
exchange needs. Thereafter,demand for derivatives, especially those related to risk
management, has increased steadily from financial institutions and even from
non-financial companies and individual investors.
The Chinese foreign currency derivative markets include two main types of FC
derivatives: foreign forward exchange transactions and Non-diverable forwards.
2.11 Forward Settlement and Sale of Foreign Exchange
The prevailing financial derivative between renminbi and foreign currency is
limited to forward exchange transaction. In April, 1997, Bank of China IFC Bulletin
No 35 first begin the RMB forward exchange settlement and sales business, making
an important step in the development of Chinese derivative market4. Later in 2003,
three big national banks: Industrial and Commercial Bank of China Limited (ICBC),
Agricultural Bank of China (ABC) and China Construction Bank (CCB) are approved
to set up this type of business for the capital accounts.
Forward settlement and sale of foreign exchange refers to the transaction between
clients and banks to designate currencies at a specific time in the future. Under the
contract, the currency type, amount, term and foreign exchange rate of the forward
transaction have been settled by two parties. At the date that the spot contract settles,
the clients can buy and sell foreign currencies at the specific exchange rate, avoiding
the possible changes in currency prices in the future.
4 Gao yang, He fan, in their paper the development of foreign currency derivatives, have mentioned the order of
derivative development.
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The forward settlements and sale business in China have been restricted in several
ways.
First, the forward settlement and sale business require all applicants to provide the
documents that reflect real international trading background or certain transactions
under capital accounts approved by the State Administration of Foreign Exchange
(SAFE), excluding most financial transactions in practice. This principle, on one hand,
restricts the scale of forward settlement and sale business, on the other hand, cannot
reflect the supply and demand conditions of forward foreign currency.
Second, the number of banks that are qualified to set up the forward settlement and
sale business is strictly limited, suggesting strong monopoly, and a substantial
regulations on forward transactions largely affects foreign currency operating
autonomy. In particular, this forward settlement can only be made between banks and
corporations, not within banks. The quota management on synthetic positions,
including both current positions and forward positions, prevents banks to adjust the
volume of forward settlement and sale business in line with its own demands.
Third, the pricing method of foreign exchange rate is inconsistent and not
authoritative. In details, the calculation is based on covered interest rate parity (CIRP),
using renminbi inter-bank lending/borrowing interest rate, international foreign
exchange inter-bank lending/borrowing interest rate and spot interest rate. But the
problem within this calculation is that spot interest rate cannot reflect the real supply
and demand under the low level of interest market development. Therefore, the
forward exchange rate cannot be seen as accurate expectation of spot exchange rate in
the future.
Due to the factors described above, the trading volume of forward settlement and
sale business is quite smaller compared to spot settlement.
2.12 Non-deliverable Forwards
The renminbi Non-deliverable Forwards, begin to trade actively in countries with
foreign exchange control in early 1996 in Singapore.
NDF contracts are traded offshore and used to hedge against exchange rate
movements in non-convertible currencies. Especially, reminbi non-deliverable
forwards, refers to foreign exchange contract with renminbi denoted as standard, in
which two parties agree to buy or sell renminbi at a specific future date at a fixed
exchange rate. At maturity, the contracts are settled using dollar and no renminbi
transferred. Dollar payments are based on the difference between the prevailing spot
rate and the NDF rate. If, at maturity, renminbi has depreciated against the dollar, the
holder of the NDF has to pay a certain dollar amount. If the renminbi has appreciated,
the holder earns a certain dollar amount.
In particular, Singapore and HongKong are the two main off-shore RMB NDF
markets in Asian, indicating the global expectation of RMB currency. The main
participants in RMB NDF markets are big banks and investing institutions in USA
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and Europe, whose clients are multinationals with colossal revenues in RMB, or
Chinese mainland corporations setting headquarter in HongKong.
2.2 Risk management Theory
In the market perfection assumption, hedging cannot create value for firms (M&M
propositions, 1958). The theory debates that private investors are assumed to manage
their risks by holding well-diversified portfolio, and financial policies adopted by
corporations cannot create value, suggesting hedging is value-neutral in a perfect
capital market. Second, on the condition that capital market is imperfect, risk
management is believed to create value for firms. The market imperfections can be
summarized as: taxation (Smith and Stulz, 1985; Leland, 1998), underinvestment
(Froot et al., 1993), financial distress cost (Mayers and Smith, 1982; Smith and Stulz,
1985) and costs of managerial risk aversion (Stulz, 1984; Smith and Stulz, 1985).
All of the risk management theories developed on the market friction indicates that
hedging can create firm value by mitigating varies types of risk exposures. Based on
the research of Smith and Stulz (1985), when a firm faces tax-function convexity,
hedging may lower expected tax liabilities by reducing the variability of taxable
income, thus inducing the firm to hedge and increase the expected post-tax income.
Ross (1996) and Leland (1998) argue that hedging can increase the firm’s debt
capacity through a reduction in variability of pre-tax income. After adding the
leverage, the firm gets tax reduction advantage through an increase in interest
deduction, leading to higher firm value. In the paper of Froot, Scharfstein, and Stein
(1993), when the external financing is costly, hedging can reduce the cash flow
volatility and thus reducing the underinvestment problem.
Financial distress costs are believed to generate costs associated with bankruptcy
costs, as well as moral hazard, contracting, agency costs, which can lead to decreased
market value (Myers, 1984). Hedging, as a useful way to reduce the variability of
earnings or cash flows, can then result to a lower possibility of expected costs of
financial distress according to Smith and Stulz (1985). Dolde (1995), Haushalter
(2000), and Howton and Perfect (1999) measure the expected costs of financial
distress using debt ratio and identify that higher debt ratio leads to greater hedging.
Higher expected costs of financial distress can cause firms to hedge more on the
assumption that firms with higher debt ratio would face higher possibilities of
financial distress. Geczy, Minton and Schrand (1997) have also claimed that firms
with greater growth opportunities and tighter financial constraints are more likely to
use currency derivatives by reducing cash flow variation and enable firms to perform
valuable projects. Further, Stulz (1996) argues that hedging can lower the likelihood
of left-tail outcomes that can cause distress costs or make firms unable to carry out
positive NPV projects.
Managerial risk aversion gives firms an incentive to hedge, but different
compensation plans for managers can influence the specific hedging choices (Smith
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and Stulz, 1985). Managers who own large proportion of shares would hedge more to
reduce the variance of share price. Then, the stock price volatility is the main risk
measure to be concerned for managers. On the contrary, for managers whose
compensation plans are option- like, they will hedge less to take more risks. The utility
function of managerial wealth has a shape of convex function of firm profits, and the
larger volatility of firm earnings, the larger possibility managers get greater benefits.
3. Data and Statistics
3.1 Sample Description
To carry out the empirical study, the initial sample consists of large nonfinancial
firms with A shares5 (include A+B shares and A+H shares types)6 that are listed in
Shanghai and Shenzhen exchange stock markets and have total asset larger than 1000
million renminbi in the period 2007-2012.
In this paper, I only examine whether multinationals7 with foreign sales can be
rewarded with higher firm value, so firms without foreign sales, having missing data
on important financial and transaction data (for example, total asset, size, revenues
and share price) are excluded. Geczy, Minton and Schrand (1997) have identified the
positive association between the value of firms exposed to extensive exchange rate
risks and currency derivatives usage. Moreover, because financial firms are the
providers of financial derivatives whose motivations of using financial derivatives are
different from nonfinancial firms (for example, financial firms use financial
derivatives for speculation, not for hedge risks), I also removed these data. Public
utilities are also deleted from the sample because of heavily regulation. Further, my
sample does not include those types of firms: Firms that are first listed during the
sample period8; ST firms9 or firms with significant reorganization during the sample
period (such as change the main business segment). Finally, I obtain 97 firms, a
sample of 485 firm-year observations during 2007-2012.
Most of the financial data can be obtained using Compustat database, and share
price of each firms in each fiscal year end are derived from Datastream database.
5 A share is specialized share of the renminbi currency that are purchased and traded on Shanghai and Shenzhen stock exchange markets . 6 B shares are traded using foreign currencies on Shanghai and Shenzhen s tock exchanges . H shares refer to
those companies incorporate in mainland China and traded on the HongKong s tock exchange. Many fi rms simultaneously traded on both two mainland China s tock exchanges and HongKong s tock market. 7 Multinationals refer to companies with foreign sales more than 10% of total sales. (Jorion, 1990; He & Ng, 1998) According to Corporate Accounting Principle NO.35, fi rms should report the business and district that generate 10 % revenues . But, in this paper, some fi rms in my sample do not have more 10% foreign sales, but the average of foreign sales ratio is more than 22%. 8 Fi rms that are fi rs t listed in two mainland China s tock exchanges during the period cannot have complete stock price data. 9 ST is short for Special Treatment, refers to stocks of listed companies with abnormal financial conditions . These
kinds of stocks have investment risks, which should be cautious for investing.
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However, some specific variables, which are not disclosed in main databases, such as
foreign sales, foreign currency derivative usage, geographic diversification, industry
diversification are hand collected from annual reports of each firm. Foreign currency
derive users are defined to those firms that make reference in the annual reports to
hedge FC exposure or report the notional value (or fair value) of foreign currency
derivative (or NDF) 10 or firms report the profits and loss by using FCDs in the
financial expense items. From the collected information on derivative usage, I find
that firms in China do not choose foreign currency swaps or foreign currency options 11to hedge currency risks, so in my sample, FCDs only include forward contracts and
NDF.
For the firms in my sample, I do not obtain all data of notional value on forward
contracts during 2007-2012. One important reason is that not all firms report the fair
or notional value of FCDs derivatives in their annual reports. Instead, they only make
reference on whether they use FCDs during the operating period in the footnotes.12
This incomplete information may lead to the measurement error and make this paper
unable to be performed using hedging ratio (a ratio of notional value of FCD to total
assets) as the measurement of foreign currency derivative level. 13 But Geczy, Minton
and Schrand (1997) also mentioned the samples of hedgers would decrease
dramatically when using the level of FCD usage to measure, and the notional amounts
as a risk exposure can be quite noisy because of aggregation and netting, so I perform
my test by constructing binary variable, 1 refers to firms using FCD, and 0 refers to
the counterparts.
3.2 Dependent Variable
The dependent variable in this paper is Tobin’s q, a proxy for firm value, defined as
the ratio of market value of a firm to the replacement cost of its assets. As previous
research study, I follow a methodology of Tobin’s q (Allayannis et al., 2009), defined
as the ratio of total assets minus the book value of equity plus the market value of
equity to the book value of assets. There are also some other methods to construct
Tobin’s q. L-R algorithm are quite complex and cumbersome that is highly unlikely to
undertake. A simple approximation of Tobin’s q proposed by Chung & Pruitt (1994)
can account for at least 96.6% of the variability of Tobin’s q, which is easy to perform.
Likewise, in Allayannis and Weston (2001) paper, three measures are used to test the
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Most fi rms disclosure the foreign currency derivative usage under the held for trading financial asset i tems or make any reference on FCDs usage when analyze currency risks . 11 SAFS firs t set up foreign currency swaps business in 2007 and until April , 2011, SAFS firs t set up foreign
currency option business only for European options . 12 According to Corporate Accounting Principles, fi rms should report the types of derivative usage, the notional or fair value of derivatives. However, because of the ineffective regulation of fi rms, a certain number of fi rms do not follow closely the rules of Accounting Principles , which make my empirical s tudy difficul t to collect that data. So, I decide not to collect the notional value of foreign contracts , but only obtain the information on whether fi rms use FCDs or not on year-end during 2007-2012. 13 Maker & Huffman, 2001; Kim et al . 2006 and Magee, 2009 all use hedging ratio to measure the level of FCD
usage.
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relationship, which make no significant difference in results. To test the robustness of
the results, alternative measures are also considered. One simple alternative measure
for Tobin’s q is the ratio of market value of the firm to the book value of the
assets.(Allayannis and Weston, 2001) Another measure is used by Chung & Pruitt,
1994, ), the ratio defined as the market value of equity plus the liquidating value of
preferred stock and plus the book value of debt14. We find the similar results by using
alternative measurements of Tobin’s q but not reported.
I calculate Tobin’s q for the whole sample and find the mean value is 1.70 while the
median value is 1.42, indicating the distribution of Tobin’s q is skew. In order to
control the skewness and make it more symmetric, I use the methodology by
constructing natural log of Tobin’s q and employ it in all multivariate tests (Allayannis
and Weston, 2001).
3.3 Independent Variable
The independent variable in this paper is the foreign currency derivative dummy
variable, with 1 indicates hedgers and 0 nonhedgers. As mentioned above, all data of
FCD usage are collected from annual reports of all firms. Clark and Judge (2009)
argues that the choice of hedging instruments depend on the type of exposure, with
short-term instruments such as FC forwards and options are used to hedge short-term
exposure generated from exporting activities, while FC debt and swaps into foreign
currency are used to hedge long-term activities with assets located in foreign locations.
This paper aims to explore whether the firms with currency exposure can generate
higher value by using FCD, without distinguishing the long-term or short-term
exposure.
Like U.S. firms, the currency forward is by far the most popular financial
instruments. Forward-type (volatility reduction) instruments are arise to hedge foreign
exchange rate risk in U.S. contractual commitments (account payables/receivables), as
recommended by international financial literature (Shapiro, 1996). Some other
hedging channels are combined to be used in corporate practice, for example,
operational hedging (Pantzalis, Simkins and Laux, 2001), impacts significantly on
exchange rate exposure. Firms with greater breadth 15of MNC network are less
exposed to currency risk whereas firms with more concentrated networks (greater
depth) are more exposed. However, due to the limited accounting disclosure, this
paper primarily examines the FC derivative usage at firm level (Bartram et al. 2009).
Allayannis et al, (2009) use foreign currency derivative as proxy for hedging as well.
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The book value of debt here refers to the value of short-term liabilities minus short-term assets and plus the book value of long-term debt. 15 Pantzalis, Simkins and Laux, 2001 examine the influence of foreign operating hedging on exchange rate risk exposure. Breadth and depth measure the different dimensions of fi rm’s degree of multinationality. Greater breadth means the fi rm is spread out over many countries and greater depth indicates a large proportion of the
link is concentrated within two top countries of the MNC network.
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3.4 Other explanatory Variable
This paper focus on the FCD use of multinationals, indicating one of the top
variables is the amount of exposure of foreign currency rate risks, defined as
geographic diversification.
A substantial number of surveys have examined characteristics and practices of U.S.
nonfinancial firms using derivatives (Bodnar and Gebhardt, 1998; Treasury
Measurement Association, 1996; Papaioannou) and find that the larger currency risk
exposure of U.S. nonfinancial firms, the more likely is to use financial hedging
instruments. Following Allayannis et al. (2009) and Lel (2009), this study uses the
ratio of foreign sales to total sales as the measure for geographic diversification. All
the data are hand collected from annual reports of each firms, and then I exclude all
the firms without foreign sales and only keep firms with sales from other countries.
The difference between this paper and the literature by Allayannis and Weston
(2001) lies in the sample selection. The financial derivative markets in China are in
the beginning developing stage, suggesting the lack of financial hedging instruments
usage among Chinese firms. In particular, with the great loss of several big Chinese
firms using financial hedging instruments, great debate on the influence and
characteristics of financial derivatives are prevalent16. Thus, firms without sales from
other countries are less likely to use FDC to hedge currency risks. For the accuracy of
the research, firms without foreign sales are excluded.
. Previous studies have not reach a common conclusion on the effect of
geographical diversification. Allayannis and Weston (2001) find positive relation
between geographic diversification and firm value based on 508 U.S. firms. Kim et.al
(2006) find that firms with only exporting activities are more likely to use FCD to
hedge, but both foreign operating and FCD usage can increase firm value, except the
foreign operating have better hedging effect.
3.5 Control Variables
In order to get rid of other factors that may affect firm value, previous empirical
literature have provided us with ample reference (Lang and Stulz, 1994; Allayannis
and Weston, 2001).
One of the variables is size. Based on the method of Wald (1999) and Mackay and
Philips (2002), this paper uses the log of total assets to measure firm size. Small firms
are more likely to encounter financial distress or bad operating conditions, so they
have more incentive to carry out hedging activities. But due to the set-up costs of
16 In 2008, Standardization Administration of China (SAC) counts at least 23 national fi rms suffered great financial loss by using financial hedging derivatives. For example, CITIC Pacific aims to lock the cost of buying Australian dollar by purchasing Accumulator option. However, this option cannot effectively hedge and reduce risks, but
lead to great defici t.
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hedging, larger firms are more likely to hedge than smaller firms in empirical studies.
To control for the profitability of firms, I include return on assets, defined as net
income divided by total assets (Allayannis et al, 2009). And the profitability is
expected positively related with firm value.
Another factor should be controlled is future investment opportunities. Smith and
Watts (1992) have claimed that investment opportunities can affect firm performance
in a positive way. Thus, firms with more investment opportunities can have better firm
performance. In line with Yermack (1996), I use the ratio of capital expenditure to
sales as the measure of future investment opportunities. Alternative measurements,
such as R&D expenditures are used in several papers to proxy for growth
opportunities (Allayannis and Weston, 2001). However, due to the disclosure
restriction of R&D expenditure, this paper does not use this measurement.17
Moreover, a variable to control the access to financial market is included. Serveas
(1996) have argued that firms with restricted access to financial markets obtain
greater firm value because those constrained firms would only choose positive and
highest net positive value (NPV) projects to undertake while bypass the less highest
NPV projects. Follow Allayannis and Weston (2001), I construct dividend dummy
variable to proxy for the ability to access financial markets, with dummy variable
equals to 1 if the firm pays dividends in the current year. And I expect a negative
association between dividends paid and firm value.
Besides, the firm’s leverage should also be taken into account. A variable defined as
long-term debt divided by equity is used as a measure. Haushalter (2000) have found
that the financial derivative use can lead to the reduction of expected bankruptcy costs,
which should increase firm value. Firms with larger leverage ratio are more likely to
hedge, and the hedging can increase more value for firms with more debt. A positive
relation between leverage and firm value is expected.
Furthermore, a dummy variable indicates the industry diversification is included. If
it equals to 1, then the firm operates in more than one business segments at the
GIC-sector factor, and zero otherwise. The effects of industry diversification on firm
value are mixed. Berger and Ofek (1995) find an industry diversification discount for
U.S. firms while in Lins and Servaes (1999) literature, they find that industry
diversification is not value-destroying for German firms.
Finally, the paper controls the industry and year effect. I use a 2-digit GIC-sector to
construct a dummy variable for industry effect and a year dummy for each of the four
years examined in the sample.
17 In most Chinese fi rms annual reports, no specific item on R&D expenditures in profi t and loss accounts are
reported.
17
4. Results
4.1 Descriptive Statistics
Panel A of table 1 provides summary statistics for all firms in the sample. There is a
large cross-sectional variation in the FCD usage among the firms, ranging from 100%
to 0%. On average, 29% of the sample firms uses foreign currency derivatives to
hedge currency risks, which is smaller compared to 60% of all U.S. firms with foreign
sales in Allayannis and Weston (2001) study and 61% in Bartram et al (2009b). The
facts that less multinationals would like to use financial instruments to hedge are
associated with the ability of risk avoidance, the type of risks that firm would like to
bear and the level of risks occurred to different types of firms.
Moreover, the mean (median) value of Tobin’s q is 1.70 (1.42), suggesting the
average firm is profitable with valuable investment opportunities. At the same time,
these numbers are larger than U.S. based study, for example, the average (median)
value reported in Allayannis and Weston (2001) is only 1.20 (0.99). However, the
average value is not as large as the one reported in Allayannis et al, (2009), 1.70
compared to 2.213.
The distribution of Tobin’s q is skewed, with mean 1.70 and median 1.42. To
eliminate the effect of skewness, a natural log of tobin’s q is used to run all the
regressions (Belghitar et al, 2008).
The mean (median) value of total assets is 29189 (5870) and the mean (median)
value of sales is 158234 (4182). The mean (median) foreign sales to total sales ratio is
0.22 (0.15).
The table also shows that only 31% of all firms are industry diversified in my
sample, while in U.S. based study, the percentage amounts to 68.3% (Allayannis et
al, 2009) and 70.2% (Magee, 2009), suggesting the low level of industry
diversification of Chinese multinationals.
The average profitability, defined as the ratio of net income to total assets, is
quite low, only at 4% and has large variation, ranging from 0.2% to 10.2%.
The mean value of leverage is only at 0.26, and some firms in my sample even
do not borrow any debt to run the operations. This big difference among between my
study and other U.S. based study lies in the types of firms and the specific strategy
used in the firms.
Panel B of table 1 provides information of variables for hedgers and Pane C for
non-hedgers. It is obvious to find that hedgers have larger total assets than nonhedgers,
29218.38 compared to 29176.52. This is in line with Allayannis and Weston (2001)
that larger firms are more likely to hedge currency risks than small firms because
hedging is costly and small firms would not like to bear the large fixed set up costs.
18
On average, firms with FCD usage are more profitable (0.05 versus 0.04), and have
larger total sales (28410.06 versus 10598.15), better access to external financial
markets (0.13 versus 0.04), lower leverage and growth opportunities. Moreover,
hedgers are less industry diversified but more geographic diversified.
The hedgers have larger Tobin’s q than nonhedgers (1.77 versus 1.67). It seems that
hedging can increase firm value. But only based on these facts, I still cannot make
sure whether the difference in premium between hedgers and nonhedgers is caused by
hedging decision. Some other variables that may affect firm value, such as size,
profitability, access to financial market should be examined. The further tests will go
deep to examine these questions.
Panel D of table 1 provides an overview of financial instruments usage by each
industry. The percentage of FCD usage among different industries varies. For example,
50% of firms in Information Technology industry choose to hedge whereas only 18%
in Materials industry use FCD to hedge. The difference in using FCD among different
industries indicates the importance to control industry in further regressions. At the
same time, these results may be related with the number of firms in different
industries, which can influence the results of the study. For example, the sample
number in Energy industry is only 2, with all firms being nonhedgers. The sample
collection is quite time-consuming, and I only include firms with foreign sales and
require no missing data on all important financial information for 5 years. Therefore,
the number of firms in different industries is varied.
4.2 Hedging Premium
Like Allayannis and Weston (2001), I first examine the number of firms using
currency derivatives over time in my sample. Table 2 provides the summary statistics
on the usage of FC derivatives for the whole sample over 2007-2012. But the
difference between their study and this paper is that no gross notional value of foreign
currency derivatives is reported because of the incomplete information of notional
value of FCD disclosed by firms in my sample. Therefore, I cannot figure out whether
the level of FCD usage increases in my sample during the whole period.
The percentage of firms using FCD goes upward over time. In specific, only 17.65%
of firms in 2007 choose to hedge currency risks whereas the percentage rises
dramatically to 35.19% in 2012, suggesting more firms are engaged in hedging
activities over time. This is in line with the results of Allayannis and Weston (2001),
in their paper, a certain increase in the percentage of hedgers is found during 1990 to
1995, for example, 32% in 1990 rises to 40% in 1995.
Furthermore, the increase of FCD usage in Chinese firms is more dramatic, 17.54%
compared to 8%. The great increase may be related with the development of financial
instruments in China. SAFS first set up foreign currency swaps business in 2007 and
until April, 2011, SAFS first set up foreign currency option business only for
European options.
19
4.3 Univariate Test
In this part, I test my hypothesis that whether firms with currency derivatives have
greater value, by comparing the Tobin’s q of hedgers and nonhedgers. The tests are
performed for all firms in my sample. As mentioned above, all firms have foreign
sales, which are assumed to be exposed to exchange rate risk. Firms with exporting
activities are influenced by exchange rate movements by foreign revenues and foreign
debt. Firms with foreign subsidiaries are affected through translation into compound
reports.
Allayannis and Weston (2001) documents that the direction of dollar movement can
affect firm value when they are exposed to exchange rate risks. In specific, the
hedging premium among firms with foreign currency exposure is highest in dollar
appreciation period, suggesting investors have higher valuation on hedging firms in
which hedging activities can provide positive payoffs. Cater, Rogers and Simkins
(2006), in their study on U.S. airplane study also identifies that hedging premiums
increased over time and reach the highest in 2002 and 200318. For example, if a
Chinese exporting firm has foreign sales 6 months later, in order to prevent renminbi
appreciation, the firm will hedge. The value of hedgers is higher than that of
nonhedgers, when the renminbi appreciates, while the hedgers will destroy value
when the renminbi depreciates. The difference in value between hedgers and
nonhedgers should not fluctuate a lot when the renminbi remains stable. Unlike
Allayannis and Weston (2001), this paper separates between years in which renminbi
appreciates and in which renminbi not appreciates. Since the renminbi regime begins
to change in 2007, there is a huge renminbi appreciation except a stationary in 2009.
Appendix 1 provides the chart of exchange rate of renminbi to dollar.
Table 3 provides the mean value of Tobin’s q for all firms in my sample.
In the whole period, column (1) shows that the average firm value for nonhedgers
is 1.67 and column (2) shows that the average firm value for hedgers is 1.77. Column
(3) presents the difference in premium between hedgers and nonhedgers when they all
have currency risk exposure. The hedging premium is 0.1, but not significant, as
shown in column (6) (t-statistics -1.11). Therefore, I cannot conclude that hedgers are
rewarded with higher valuation by investors than nonhedgers. Contrary to my results,
Allayannis and Weston (2001) find a significant hedging premium at the 1% level.
In the further tests during the years in which renminbi appreciate or remain stable,
the results are different with the ones derived by Allaynnis and Weston (2001). In
their study, they find a significant hedging premium regardless the behavior of dollar.
On the contrary, in my study, when renminbi appreciated, the mean Q for those do not
use foreign currency derivatives is 1.78, compared with a mean value for those use
foreign currency derivatives by 1.91, suggesting a hedging premium of 0.12. Like my
first test, this hedging premium is not significant, with a t-statistics of -1.12.
18
The dollar began a long upward climb in 2002
20
Furthermore, during years in which renminbi without fluctuation, the opposite results
are obtained. The average value of nonhedgers is higher than that of nonhedgers, 1.17
compared to 1.16, suggesting a small hedging discount of 0.01. Due to the low t-stat,
no conclusion about value-destroying of hedging is included.
4.4 Multivariate Test
In this section, I use multivariate methods to test the influence of hedging on firm
value after control the explanatory variables. I start by analyzing the relationship of
FCD usage and firm value in a univariate setting using a simple OLS regression
(regression 1). Then, I add some explanatory variables that may affect firm value to
further test the relationship in regression 2 and use cluster option in regression 3.
Regression 1 of table 4 presents the outcome of OLS regression to test the effect of
hedging on firm market value without control variables. More specific, the coefficient
shows that the value of those who use currency derivatives is higher than those who
do not use by 2.76%. The hedging premium is not significant. The results are
consistent with my univariate tests in 4.3. The argument that hedging is value-adding
is not inclusive.
In regression 2 of table 4, the control variables are added into the OLS regression.
My model is constructed similar to those used by Allayannis and Weston (2001) and
the following explanatory variables are included. (1) The amount of currency risk
exposure (geographic diversification), defined as the ratio of foreign sales to total
sales. (2) Size, defined as the natural log of total assets. (3) Profitability, defined as
the net income divided by total assets. (3) Leverage, defined as the long-term debt
divided by common equity. (4) The growth opportunity, defined as capital expenditure
divided by total sales. (5) Industry diversification, using dummy variable equals to 1
if firm operates in more than business segments. (6) Dividend dummy variable equals
to 1 if firms pay dividends that year. (7) Industry effect, using 2-digit GIC-sector as
controls. (8) Year effect, using year dummy.
Regression 2 of table 4 presents the results of my hypothesis by controlling
explanatory variables. The R2 increasing from 0.44 to 0.54 shows the improvement of
the regression after adding control variables. The coefficient shows the consistent sign
with my first tests in regression 1 that users of currency derivatives are rewarded with
higher valuation than nonusers (2.18% hedging premium). The hedging premium
decreased a little after control some explanatory variables, from 2.76% to 2.18%. On
the contrary, the t-statistics is only 0.6, which is too low to reject the null hypothesis.
Therefore, no statistical difference in the value is found between users of FC
derivatives and nonusers.
Previous empirical studies also get mixed results on this relationship. Allayannis
(2009) do find a statistical significant relationship between the use of FCD and firm
value in their study for firms with foreign sales. Carter et al.(2006) also documents a
substantial hedging premium, over 10% in airline industry when tests whether
21
hedging can increase firm value. On the contrary, Belghitar, Clark and Mefteh (2012)
examines that FC derivative usage is not significant for the samples, indicating FC
derivative cannot create value for firms. It argues that hedging can effectively reduce
risks but the profits gained from risk reduction are not large enough to offset the
hedging costs.
Most of the control variables show the expected effect on firm value and
statistically significant, which is in line with Allayannis and Weston (2001). In
specific, the firm size is negatively related with firm value; the larger geographic
diversification, the larger firm value; the profitability of firm is positive with its
market value; the coefficient on growth opportunities is positive, indicating firms with
more growth opportunities are rewarded by investors with higher market valuation.
Unlike Allayannis (2009), the coefficient of industry diversification is positive with
Q. This is in line with Magee (2009) who also find a positive relationship between
industry diversification and firm value. But this coefficient is not statistica l significant,
I cannot conclude that more diversified firm have higher value. The relationship
between the access to financial markets and firm value is positive but not significant
in my study.
A difference in the methodology from Allayannis, et al (2009) is that I use cluster
options to specify that observations are not independent within the firm or cluster at
the firm level. The reason to use this methodology is that usage of FCD and other
control variables may correlated with each other within the firm, which makes the
residuals of the regressions are not independent at the firm level. These facts are
contrary to the assumptions of OLS regression that residuals are independent.
Regression 3 of table 4 provides the outcomes of multivariate tests with control
variables and cluster options. The R2 remains the same at 0.54. The coefficients on all
the variables do not change, while the t-statistics decreased substantially. The hedging
effect cannot be identified by the low t-stat (0.39). Only limited evidence is provided
by this test.
4.5 Firm-fixed Effect
It is well understood that unobserved firm heterogeneity is a fundamental challenge
in empirical study. Without controlling the unobservable firm heterogeneity that is
common across groups of observations, the common errors come out. The factors that
are related with variables of interest can lead to biased estimated parameters. For
example, unobserved factors- like corporate governance is common cross firms and
affect firm value. Failing to control such factors can cause spurious relationship
between firm value and hedging. Therefore, to consider the unobservable firm factors
that may affect firm value, I use a firm-fixed effect model to perform a test. For each
firm, the unobservable factors are assumed to be time-invariant.
Regression 4 in table 4 presents the results. I find a positive and significant
22
relationship between firm value and currency derivative usage. In specific, the users
of currency derivatives are valued about 13.83% more than nonusers. The magnitude
of hedging premium is much larger than that in the pooled regression (2.18%).
Therefore, the value-creating hypothesis of hedging is conclusive with controlling
firm heterogeneity.
Some outcomes on control variables are not similar to those in pooled regression:
size and firm value are positively related; more profitable firms have lower value; and
firms with more growth opportunities are valued less. Some of results are striking and
not intuitive, but these coefficients are not significant. Then, the conclusions on
control variables cannot hold in this regression. Other explanatory variables have
similar results but few of them are statistically significant.
4.6 Determinants of the decision to hedge
To test the factors that affect firms’ decision to hedge, I employ logistic (logit)
analysis. The FCD dummy variable is considered as dependent variable, with 1
indicating firms set up hedging activities and 0 otherwise. The natural log of Tobin’s q
is treated as independent variable, and all the control variables performed in the
pooled regressions are also used as continuous indicators.
Follow the definitions in Carter (2006), the ratio of capital expenditure to total sales
and Tobin’s q are used as proxy for the amount and productivity of investment
opportunities, respectively. Both variables are expected positively related with the
decision to hedge since hedging can alleviate the underinvestment problem (Froot et
al., 1993). Firm size, measured as the natural log of total assets, should be negatively
related with hedging decision, because the larger firm, the smaller possibility to go
bankruptcy. The leverage rises with the decision to hedge, suggesting the more debt
will lead more hedge activities (Ross, 1996). The geographic diversification is
expected to cause more hedging since firms with foreign sales are more influenced by
exchange rate movements. Other financial policies and operating method can also be
substitutes for hedging, because it reduces the transaction costs, agency costs or
expected taxes. The substitutes for hedging can lower the possibility to use financial
instruments. In Nance (1993), it uses convertible debt/value, preferred stock/value,
liquidity and dividend yield as proxy for alternative hedging to examine the ir
relationship with FCD usage decision. My study does not use this method because
few Chinese firms employ the alternative hedging through preferred stock.
The results are displayed in table 5. The coefficient (0.38) of Tobin’s q suggests that
the firm value is positively related with the decision to hedge, which is in line with
my expectation. The standard derivation of Tobin’s q is 0.47, one standard derivation
increase in Tobin’s q increase the possibility to hedge by 17.86% (=0.47*0.38). This
seems to indicate high firm value leads to higher probability of hedging. However, the
p-value is only 0.14, indicating the statistical insignificant result. I cannot conclude
that firms with higher firm value are more likely to hedge based on my analysis.
23
The relationship between firm size and hedging decision is positive and significant,
derived by the coefficient 0.62 and p-value 0.00, respectively. Although hedging is
more valuable for small firms in theoretical study, large firm are proved more likely to
hedge, indicating the information and transactional scale economies of hedging.
Combine this conclusion with the results of pooled regression, larger firms responds
to lower firm value, leading to the arguments that hedging destroys firm value.
The more extent of geographic diversification responds to higher possibility to
hedge, with the statistical significant coefficient by 3 and p-value 0.00. Following the
results of pooled regression, the coefficient of geographic diversification, measured
by foreign sales/total sales, is positive and statistical significant on firm value. I can
derive the conclusion that hedging can create firm value for firms with more currency
risk exposure.
The negative sign of growth opportunities on hedging decision is surprising
because normally the future growth options should be positively related with hedging
decision. Hedging can guarantee that positive NPV projects can be carried out when
the firm is underinvestment. Nance (1993) uses R&D/ value proxy for growth options
finds firms with more future growth opportunities are more like to hedge.
The estimated coefficient of the profitability is 5.41 and statistically significant at 1%
level, indicating the positive relationship between profitability and hedging decisions.
Other variables in this logit regression cannot provide meaningful results because
of the large p-value.
4.7 Summary of the Results
Firstly, I have split the samples into two groups: hedgers and nonhedgers. F rom the
descriptive statistical analysis, I can get the conclusion that firms have currency
derivative usage are valued more by investor than those have no currency derivative
usage, with Tobin’s q at 1.77 compared to those at 1.67. Moreover, firms who employ
hedging activities have larger sales, larger book assets, more exposure to currency risk
(more geographical diversification) and larger firm size. The average debt ratio is
around 0.2, as well as ROA about 0.05, respectively for both firms with FCD usage
and without, which are dramatically smaller compared to firms in U.S. In particular,
Allayannis and Weston (2001) document the mean debt ratio by 167, as well as ROA
by 4.03. This big difference illustrates the different financing policy between firms in
two countries.
Secondly, I perform the univariate tests in two ways to explore the hedging effect
on firm value. The first method is two-sample t test with equal variances. The results
show in the full year period, hedgers have greater value than nonhedgers, while the
difference in value is not significant with t-statistical by 1.11. The same results are
obtained in dollar appreciation period whereas nonhedgers are valued more than
hedgers in dollar without fluctuation period. The conclusions that hedgers have higher
24
value than nonhedgers are not hold because of the small t-statistic. The second
method is to use pooled regression without control variables. In line with the first
approach, I also find that firms with FCD usage have greater hedging premium
(2.76%) but not statistical significant.
Third, pooled regressions with control variables and firm-fixed effect model are
employed to documents the relationship between financial instruments usage and firm
value. The normal pooled regressions find a positive but not significant hedging
premium, on the contrary, firm-fixed effect model derives a positive hedging premium
by 13.83% and is statistical significant at 5% level. Then, the hedging value-creating
hypothesis can hold when the unobservable firm factors are fixed at firm level.
In terms of control variables in pooled regressions, most of the results are in line
with my expectation. Specifically, firm size has negative and statistical significant
relationship with firm value. Firms with more exposure to currency risk exposure are
more likely to have higher value, with the coefficient of foreign sales/total sales is
0.27 and significant at 5% level. The relationship between profitability and firm value
is positive and significant, indicating an intuitive argument that profitable firms are
rewarded by investors. The leverage ratio is negatively related with firm value and
significant at 5% level. The research on growth opportunities indicates that firms can
be valued more with greater growth opportunities, which corresponds to the
underinvestment hypothesis. Hedging can be value-adding when firms expect more
growth opportunities under the underinvestment circumstance.
After adding the firm-fixed effect, I cannot get the fruitful conclusion because most
coefficients of control variables are not statistical significant. This is due to the
unobservable variables affect both hedging decision and other control variables, as an
exogenous factor.
Fourthly, the logistic regression is used to examine what factors determine the firm
to hedge. The results of firm size declare that larger firms have more likelihood to use
currency derivatives to hedge, which is in line with the economy scale of risk
management. Large firms are more mature, have more capital and better governance,
indicating the ability to perform the hedging activity better compared to small firms.
The large fixed costs of currency derivatives also prevent small firms with margin
profits to carry out the hedging project.
Regarding the level of geographical diversification, the larger level of geographical
diversification leads firms to hedge. This result is intuitive since firms with more
currency risk exposure can be affected more by exchange rate movements.
More profitable firms have higher possibility to use FCD to hedge because those
firms have ample capital and effective management to perform the hedging activity. It
seems firms with high leverage ratio should be more likely to hedge since they face
larger possibility of financial distress. On the contrary, my result on debt ratio shows a
negative relationship with hedging decision but not significant. Besides, the
coefficient of growth opportunities is negative, indicating firms with more future
growth opportunities hedge less. Although this result violates my expectation that
25
firms with greater growth should hedge more under the underinvestment circumstance,
the low t-stat cannot hold the result.
5. Conclusion and Limitation
5.1 Conclusion and Discussion
This paper addresses the question whether firms that face currency risks using
foreign currency derivatives are rewarded with higher valuation by investors, based
on a sample of 485 firm-year observations in Shanghai and Shenzhen exchange stocks
during the year 2007-2012.
The outline is mainly developed based on Allayannis and Weston (2001). But
contrary to their results, we do not find a significant relationship between FC
derivatives usage and firm market value in both univariate tests and multivariate tests
with cluster options. While in a firm-fixed effect regression, we do find that users of
FC derivatives that exposed to currency risk have a 13.83% higher value than
nonusers at 10% level. Therefore, the conclusion that a hedging premium exists in
firms that face currency risks and have FC derivative usage is only inclusive in
regressions with controlling for firm-heterogeneity.
In addition, we further test what factors determine the firms to hedge by employing
a logistic regression. The FCD dummy variable is used as dependent variable with 1
refers to firms using FC derivatives and 0 otherwise. The results show that hedging
decision is significantly and positively related with geographic diversification, size,
profitability, access to financial markets, and negatively related with industry
diversification.
Finally, I cannot reach the conclusion that hedging can increase firm value
according to the empirical results of my research. It seems no difference in value
creating for users of FC derivatives and nonusers. This is in line with Belghital, Clark,
Mefteh (2012) who also find a positive but insignificant hedging premium based on a
sample of French firms. They already suggested that hedging can be only effective
when the overall gains from exposure reduction are greater than the costs and then
add value to the firms. But the evidence seems to indicate that FC derivative is
effective in reducing risk exposure of firms, but failed to add value because of the
greater costs.
There are some reasons to explain why FC derivatives cannot create value and have
little impact on firm performance. Copeland and Joshi (1996) have argued that risk
management may be ineffective to reduce exposures to losses. For example, when use
hedging derivatives to hedge price fluctuation, some other economic factors can also
be influenced and lead to greater risk exposure. Even when hedging activities are well
performed, gains from hedging may be inadequate to cover the costs associated with
human resource, physical, financial needed to execute hedging activities. Moreover,
26
financial instruments may be used to speculate rather than reduce risks, which may
lead to more risk exposure.
Endogeneity seems to be a big concern and Bartram et al, (2011) also find that the
premium is sensitive to endogeneity and measured with low precision. In particular,
Allayannis et al (2009) gives an example that an omitted variable can affect both firm
value and FC derivative usage. For example, an unobserved factor at firm level
increases the firm value, at the meanwhile raises the possibility of using FC
derivatives. Therefore, a biased conclusion that hedging may increase firm value is
included without considering the endogeneity.
5.2 Limitation and Recommendation
One of the limitations in this paper is the approximation of firm value, Tobin’s q,
defined as the ratio of total assets minus the book value of equity plus the market
value of equity to the book value of assets. This is a simple and general method to
construct Tobin’s q. Unlike Lindenberg and Ross (1981), who use a complicated
methodology to construct Tobin’s q:
RCt = TAt + RNPt - HNPt + RINVt - HINVt
RC: replacement cost
TA: total asset
RNP: net plant at replacement cost
HNP: net plant at historical value
RINV: inventories at net value
HINV: inventories at historical value
However, this method is too difficult to adopt and need much more financial
information, some of which may be not acquired directly from annual reports.
Besides, all firms in different industries use the same Tobin’s q to run all
regressions. However, a industry-adjusted Tobin’s q can be more effective to control
industry effects. Allayannis and Weston (2001) use a industry-adjusted Tobin’s q to
test the hypothesis whether hedging can add value to firms. They do this because of
greater percentage of industry diversification of firms in their sample (63%). While in
my paper, only 34% firms operate in more than one business segments, and I also use
GIC-sector to control industry effect, as well as variable indicates industry
diversification.
Another drawback of this paper is the lack of time-series analysis. I only test the
relationship between FC derivative usage and firm value, but not identify whether
hedging increase firm value or firms with large value are more likely to use FC
derivatives, leading to the reverse causality problem. One factor that limits this
analysis is the short-term disclosure of derivative usage information, which makes
difficult to perform the study in terms of time.
Finally, the measurement of hedging policies can be improved. In this paper, I
follow Allayannis and Weston (2001) to use a dummy variable to indicate whether
27
firms use FC derivatives or not. A more appropriate way used by Maker & Huffan
(2001) is to construct hedging ratio to proxy for the scale of hedging policy.
In spite of some rooms leaving for improvement, this paper clearly constructs the
model and the results show some useful insights of the FC derivatives usage for
Chinese firms with foreign sales. But it should be noticed that although firms in my
sample are exposed to currency risks, I cannot distinguish the reasons why they use
financial derivative (risk reduction or speculation), the level of hedging (single
derivative or portfolio) or the scale of hedging (hedging ratio). Therefore, I cannot
conclude firms using FC derivatives can increase firm value.
For future empirical studies on Chinese firms, more observations and derivative
information can be collected to increase the statistical power. Besides, more
complicated and accurate variables, such as hedge ratio are used to construct the
model. Furthermore, more tests can be added to examine the causality between
hedging policy and firm value. Last but not least, endogeneity should be mitigated, for
example, using instrumental variables approach (Allayannis et al, 2009).
28
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31
Table 1: Summary statistics
This stable illustrates summary statistics for my sample of all nonfinancial COMPUSTAT firms
with more than 1000 renminbi total asset in the period 2007-2012. All the firms in the sample have
foreign sales during the sample period. The FCD dummy equals to 1 if the firm make reference
the usage of FCD in their annual reports. Tobin’s q is defined as the ratio of market value of the
firm to the replacement cost of the firm. I follow the Allayannis (2009) to construct the Tobin’s q
by using the ratio of total assets minus the book value of equity plus the market value of equity
divided by the book value of assets. Return on asset is compounded net income divided by total
assets. Growth opportunities are proxied by the ratio of capital expenditure to total sales. Debt to
equity is the ratio of total debt to common equity. The dividend dummy is set equal to 1 if the firm
pays dividend that year and 0 otherwise. The industry diversification is included at dummy
variable at 2-digit GIC-sector, and 1 refers to more than one business segment.
Variables No.obs Mean Std.Dev Median
10th
percentile 90thpercentile
Panel A:
All firms
Sample description
Total assets (millions) 485 29189 310140 5870 1594 36463
Total sales (millions) 484 158234 37055 4182 912 40546
Foreign sales/ total sales 478 0.22 0.20 0.15 0.027 0.53
Market value of equity 485 11960 25232 4866 1301 23978
Market value of 485 26260 236245 6569 1791 36343
debt and equity
Derivative use
FCD dummy 485 0.29 0.46 0.00 0.00 1.00
Tobin’s Q 485 1.70 0.93 1.42 0.90 2.89
Log(Tobin’s Q)
389 0.49 0.47 0.44 -0.03 1.12
Controls
Size 485 8.81 1.21 8.68 7.37 10.50
Return on assets 485 0.04 0.05 0.032 0.002 0.102
Growth (Capex/sales) 484 0.11 0.13 0.07 0.02 0.26
Debt to equity ratio 485 0.26 0.44 0.11 0 0.57
Dividend dummy 485 0.07 0.25 0 0 0
Industry diversification 485 0.31 0.46 0 0 1
MNC 485 0.52 0.50 1 0 1
32
Variables No.obs Mean Std.Dev Median 10th
percentile
90th
percentile
Panel B:
Firms with FCD
Sample description
Total assets (millions) 142 29218.38 51383.90 7838.59 1573.71 74014.31
Total sales (millions) 142 28410.06 58996.99 5940.21 1279.69 59329.77
Foreign sales/ total
sales
142 0.28 0.23 0.19 0.06 0.64
Market value of
equity
142 22340.95 42494.13 7575.47 1610.40 58716.27
Market value of 142 29224.86 50786.56 9812.63 1951.85 78897.75
debt and equity
Derivative use
Tobin’s Q 142 1.77 0.99 1.47 0.90 2.94
Controls 142
Size 142 9.20 1.48 8.97 7.36 11.21
Return on assets 142 0.05 0.06 0.05 0.00 0.11
Growth (Capex/sales) 142 0.10 0.10 0.08 0.02 0.22
Debt to equity ratio 142 0.23 0.31 0.13 0.00 0.53
Dividend dummy 142 0.13 0.34 0.00 0.00 1.00
Industry
diversification
142 0.23 0.42 0.00 0.00 1.00
MNC 142 0.75 0.44 0.00 0.00 1.00
33
Variables No.obs Mean Std.Dev Median 10th
percentile
90th
percentile
Panel C:
Firms without FCD
Sample description
Total assets (millions) 343 29176.52 367471.40 5138.31 1627.57 21634.15
Total sales (millions) 342 10598.15 20305.64 3489.38 872.58 27865.24
Foreign sales/ total
sales
337 0.19 0.18 0.14 0.03 0.47
Market value of
equity
343 7661.80 9655.51 4284.80 1168.33 17224.52
Market value of 343 25033.12 279135.50 5893.28 1774.98 25152.26
debt and equity
Derivative use
Tobin’s Q 343 1.67 0.90 1.41 0.90 2.79
Controls
Size 343 8.65 1.04 8.54 7.39 9.98
Return on assets 343 0.04 0.05 0.03 0.00 0.09
Growth (Capex/sales) 342 0.12 0.14 0.07 0.01 0.27
Debt to equity ratio 343 0.27 0.49 0.10 0.00 0.59
Dividend dummy 343 0.04 0.19 0.00 0.00 0.00
Industry
diversification
343 0.34 0.47 0.00 0.00 1.00
MNC 343 0.42 0.49 0.00 0.00 1.00
Panel D:
Industry diversification
FCD users FCD non-users Total
Industry category NO. Percentage NO. Percentage NO.
Energy 0 0% 10 100% 10
Materials 31 18% 139 82% 170
Industrials 53 39% 82 61% 135
Consumer Discretionary 35 35% 65 65% 100
Consumer Staples 4 20% 16 80% 20
Health Care 4 20% 16 80% 20
Information Technology 15 50% 15 50% 30
Total 142 343 485
34
Table 2: Profile of firm’s hedging over time
This table illustrates the use of foreign currency derivatives of all firms over the period 2007-2012.
A firm with FCD usage defined as firm report any forward contracts, NDF usage in their annual
reports. If firms do not report the notional or fair value of contracts, but instead, they mention the
use of financial derivatives to hedge currency risks or disclosure the profits or loss by using
financial instruments for hedging, they are assumed to be hedgers.
2007 2008 2009 2010 2011 2012
Number of firms using
FCD
1 12 26 27 31 27 19
Number of firms not
using FCD
2 56 60 69 64 59 35
Percent of sample using
FCD
3 17.65% 30.23% 28.13% 32.63% 31.40% 35.19%
35
Table 3: Comparison of Q: hedgers versus nonhedgers
Foreign sales > 0
Nonhedgers Hedgers
Difference
t-statistics
(1) (2) (3)=
(1)-(2)
Difference in means
All years
Mean 1.67 1.77 -0.10 -1.11
Std.Dev 0,05 0,09
N 343 142
Renminbi
appreciation
(2007-2008,2010-201
2)
Mean 1.78 1.91 -0.12 -1.12
Std.Dev 0,06 0,10
N 274 115
Renminbi without
fluctuation
(2008-2009)
Mean 1.17 1.16 0.01 0.13
Std.Dev 0,43 0,07
N 69 27
36
Table 4: Estimates of the Relation between Firm Value and Hedging Behavior
Table 4 provides the outcomes of the pooled and fixed-effect regressions for the whole sample to
examine the use of FCD on firm value. Panel A provides the results from OLS regressions. Panel
B shows the results from an firm-fixed effect. The sample is consists of firms with foreign
currency risk exposure, measured by foreign sales. The independent variable is firm value,
measured using ln(Tobin’s q), defined as the natural log of the ratio of total assets minus book
equity plus market equity to the book value of assets. The independent variable is foreign currency
derivative usage, measured using FCD dummy variable, one refers to those firms that report
currency derivative usage and zero otherwise. The firm size is defined as the natural log of total
assets in millions. ROA is defined as net income divided by total assets. Debt to equity is defined
as the ratio of long-term debt to common equity. Growth is defined as the ratio of capital
expenditure to total sales. Industry diversification is the dummy variable, one indicates firm
operates in more than one business segments, and zero otherwise. Dividend dummy variable
equals to 1 if firm pays dividends in that year and 0 otherwise. The regressions also include year
effect and 2-digit GIC sector industry control (only for regressions 1 and 2 in Panel A) but not
reported. ***, **,*, denote signif icance at the 1%, 5%, 1% levels, respectively.
Panel A
All firms with foreign sales>0
Pooled regression
Dependent variable: log (Tobin’s q) 1 2
Observations 485 478
R2
0.44 0.54
FCD dummy 0.0276(2.76%) 0.0218(2.18%)
0.44 0.6
Foreign sales/total sales 0.27
3.19
**
Size (log of total assets) -0.08
-5
ROA
1.36
4.33
***
Debt to equity -0.09
-2.23
**
Growth (Capex/sales) 0.24
1.82
*
Industry diversification 0.04
1.07
Dividend dummy 0.04
0.6
Year effect fixed fixed
Industry effect control control
37
Panel B All firms with foreign sales>0
Pooled regression Fixed effects
Dependent variable: log (Tobin’s q) 3 4
Observations 478 478
R2
0.54 0.80
FCD dummy 0.0218(2.18%) 0.14(13.83%)
0.39 2.23
**
Foreign sales/total sales 0.27 0.34
2.02
** 1.28
Size (log of total assets) -0.08 0.09
-3.57
*** 0.8
ROA 1.36 -0.11
2.30
** -0.19
Debt to equity -0.09 0.02
-2.66
** 0.32
Growth (Capex/sales) 0.24 -0.15
1.63
* -1.09
Industry diversification 0.04 1.12
0.56 5.86
***
Dividend dummy 0.04 0
0.31 -0.01
Year effect fixed fixed
Industry effect control control
38
Table 5: Determiants of FC derivatives hedging
Table 5 provides the results of regressions explaining the determinants of currency derivatives
used by firms for the whole sample. All firms are influenced by exchange rate movements,
measured by foreign sales. The dependent variable is an indicator equals to 1 if the firm use
currency derivatives to hedge currency risks and 0 otherwise. The independent variable is the firm
value, measured by the natural log of Tobin’s q. The firm size is defined as the natural log of total
assets in millions. ROA is defined as net income divided by total assets. Debt to equity is defined
as the ratio of long-term debt to common equity. Growth is defined as the ratio of capital
expenditure to total sales. Industry diversification is the dummy variable, one indicates firm
operates in more than one business segments, and zero otherwise. Dividend dummy variable
equals to 1 if firm pays dividends in that year and 0 otherwise. ***, **,*, denote significance at
the 1%, 5%, 1% levels, respectively.
Random effects logit
Dependent variable: FCD dummy variable
p-value
Observations 478
Pseudo R2 0.14
Tobin's q 0.38 0.14
1.49
Foreign sales/total sales 3.00 0.00
5.09
***
Size (log of total assets) 0.62 0.00
5.57
***
ROA 5.41 0.02
2.36
**
Debt to equity -0.28 0.40
-0.84
Growth (Capex/sales) -0.73 0.49
-0.69
Industry diversification -0.66 0.01
-2.61
**
Dividend dummy 0.75 0.09
1.72
*
39
Appendix 1: The Renminbi-dollar Exchange Rate Movements in the Period
2007-2012
5
5.5
6
6.5
7
7.5
2007/1/1 2009/1/1 2011/1/1
The renminbi-dollar exchange rate