effects
2
. For example, the use of both forward and futures contracts to hedge translation exposure can give rise to economic cash flow gainslosses which are
not off-set by lossesgains from the underlying exposure. Giddy and Dufey 1995 p. 51 also show that FX ‘‘…options are not ideal hedging instruments for
corporations’’ since the gainslosses which arise from their use are not linearly related to changes in the value of the currency, thereby, increasing the variability of
the firm’s real cash flow. But forward contracts can only hedge economic exposure optimally if managerial decisions regarding inputs and outputs are fixed; otherwise,
FX options may be more appropriate see Ware and Winter, 1988. In the absence of default, the use of forward contracts to hedge transaction exposure does not
result in any gain or loss. However, both long-term economic and translation exposures tend to have maturities which exceed those of FX forward, futures and
option contracts see also Neuberger, 1996 such that a mis-match of the cash flows from the derivatives and the gainloss from the underlying exposures will arise.
Further, because of basis risk, a one-to-one hedge ratio can increase the variability of the firm’s cash flow if short-dated futures contracts are used to hedge see Mello
and Parsons, 1995. Firms can also hedge with internal techniques, such as, leads and lags which do not give rise to the maturity problems of external techniques. In
this case, the impact on the financial measures would depend on the hedging effectiveness of the internal techniques that are used.
Finally, Glaum and Belk 1992 also examined the use of hedging techniques of 17 UK firms but they did not link the degree of usage to the characteristics of their
firms. This present study focuses on a much larger sample of UK firms across a broader set of hedging techniques. The degree of utilisation is also linked to the
characteristics of the firms.
The remaining sections of this study are as follows: Section 2 describes the theoretical framework and the research methodology. The empirical measures are
also described and the hypotheses are formulated in that section. Section 3 presents the empirical results. The results are summarised and their implications are evalu-
ated in the Section 4.
2. Background
2
.
1
. Theoretical framework for the use of hedging techniques To construct the theoretical framework for this study, we rely on existing work
which suggests that firms hedge to reduce: i the agency problem Bessembinder, 1991; ii effective corporate taxes Smith and Stulz, 1985; iii risk aversion
2
The recent case of Metallgesellschaft see Financial Times, 16th November 1994 arguable, illustrates the inappropriate use of futures and swap contracts to hedge economic exposure and the associated
adverse effects of their use on leverage and liquidity. In theory, the FX futures price is a biased predictor of the realised spot price. Under risk neutrality, the amount of bias depends on the covariance between
the reinvestment rate premium and the realised spot rate. Under risk aversion, the amount of the bias depends on three premia terms. see Tucker, 1991, pp. 165 – 166.
among managers and other contracting parties Stulz, 1984; iv the probability of financial distress Smith and Stulz, 1985, and v the adverse information content
of earnings DeMarzo and Duffie, 1995. The theoretical explanations identify those incentives for hedging which are likely to benefit contracting parties. How-
ever, hedging might not benefit all parties equally and therefore the hedging strategies of firms will vary see e.g. Tufano, 1996. In theory, shareholders can
implement terms of compensation which limit both the incentive to hedge and the choice of hedging technique
3
.
2
.
2
. Sources of data To obtain measures of the degree of utilisation of internal and external hedging
techniques, a questionnaire survey was mailed to either the finance director or the corporate treasurer
4
of UK industrial multinational enterprises MNEs during October 1994. Two hundred and ten firms were targeted within the top 300
category of The Times
1000: 1994
hereafter The Times companies. The MNEs were all quoted on the London International Stock Exchange. A total of 109
responses were obtained, of which 75 were satisfactorily completed 11 are anony- mous. The response rate 35.71 compares favourable with those of other related
studies see Nance et al., 1993. The firms in our sample are typically large. Their 5-year average sales value sample size, N = 64 to 1994 is £2 795 671 million
US4 673 803 million. Also, 76.56 of the firms are quoted in The Times top 200 category. On average, the firms hedged between 61 and 70 of their global
exposure N = 68 and they generated between 41 and 50 of their total sales N = 74 overseas. In addition to the firms’ total sales, other financial data was
obtained for the non-anonymous firms from the Datastream. This data set spans five financial year-ends to 1994 for most of the firms.
2
.
2
.
1
. Internationalisation measures A firm’s degree of internationalisation can affect the extent to which it uses
hedging techniques see Mathur, 1985. Since firms appear to initially use internal techniques to hedge exposure see Hakkarainen, et al., 1998, a positive relationship
is expected between the measures of internationalisation and the degree of utilisa-
3
Recent evidence indicates that institutional investors are attempting to monitor and control the operations of firms. Gaved 1997 reports that UK institutional investors can instigate change when the
firm’s performance is not consistent with their expectations. Smith 1996 also provides evidence on the success of US institutional investors — the California Public Employees’ Retirement System
CaLPERS — who were able to ensure that targeted firms adopt specific performance-related resolutions.
4
The degree of utilisation was requested for each type of exposure. To save space, the hedging techniques and the types of exposures are not specifically defined here. McRae and Walker 1980
provide useful definitions of some of the techniques and how they can be used for hedging. Also, this study adopts the standard definitions of exposures that are found in the finance literature see McRae
and Walker, 1980. A copy of the questionnaire survey as well as the statistical results that are not fully presented can be obtained from the author.
tion of internal techniques. In contrast, a negative relationship is expected between the rate of utilisation of external techniques and the internationalisation measures
since the greater use of internal techniques implies less use of external techniques. To measure the degree of internationalisation,
5
the following measures are used: i the number of foreign countries in which the group operates NCOUNT; ii the
number of foreign subsidiaries within the group NSUBS; iii the percentage of the groups’ total sales that is generated overseas PERSALE; and iv the percent-
age of the groups’ global exposure that is hedged PERHEDGE. These measures also proxy for the effects of the firm’s size and scale economies on the choice of the
hedging technique used see Shirreff, 1994.
2
.
2
.
2
. Financial measures Smith and Stulz 1985 suggest that hedging can reduce the potential for financial
distress by reducing the variability of certain financial measures. But the choice of the hedging instrument can increase the variability of the firms’ cash flow. Firms
that make greater use of: i foreign currency borrowinglending; ii cross-currency interest rate swaps; and iii foreign currency swaps are expected to exhibit greater
variability on cash flow, liquidity and leverage. The cash flow and liquidity measures are the coefficient of variation of: i gross cash flow to market value
GCASHMV; ii cash and marketable securities to market value CASHMV; iii quick asset ratio QAR; and iv working capital ratio WCR. The leverage
measures are the coefficient of variation of: i interest charges to operating and non-operating income IGEAR; ii preference capital and total borrowing to total
capital employed CGEAR; iii total borrowing to ordinary shareholders’ equity plus reserves TLBOR, and iv long-term borrowing to market value LT-
BORMV. Since foreign currency borrowing can increase the probability of finan- cial distress, firms with greater variability in their leverage measures are expected to
make greater use of internal techniques.
Hedging can also mitigate the under-investment problem by reducing both the cost of external funds and the firm’s dependence on external finance Froot et al.,
1993. In the absence of hedging, the greater the growth opportunities of the firm the more it will depend on external finance. Thus firms are more likely to hedge the
greater their growth options Lessard, 1991. Since the returns from growth options are likely to have long leads, firms with more variability in their growth options are
expected to make greater use of internal hedging techniques thereby reducing the adverse cash flow impacts of derivatives and the associated default risk. This
5
The measures of internationalisation were provide by our respondents as part of their responses to the same questionnaire survey. The aggregate index of the degree of internationalisation of Sullivan
1994 was not applied because there were insufficient variables to implement it see Ramaswamy et al., 1996, for a critique. However, PERSALE and NSUBS which are used in the study are contained in
Sullivan’s index in one form or another. Also, no information was requested about operational hedges such as, currency sourcing of inputsoutputs and the relocation of operating facilities. Both anecdotal
evidence see Lewent and Kearney, 1990; Dolde, 1993 and current thinking see Glaum, 1990 suggest that the transaction costs that are associated with those hedging strategies are likely to outweigh the
potential benefits of the hedge.
relationship is tested by using the coefficient of variation of: i sales to market value SALESMV; ii the firm’s book value to its market value BOOKMV; and iii
dividend yield. Here, a negative relationship between the degree of utilisation of derivatives and our growth option measures is expected. Following DeMarzo and
Duffie 1995, high quality managers are more likely to hedge. But the choice of hedging technique and the type of exposure that is hedged can reflect managers’
perceptions of the economic effects of hedging. Titman 1992 also shows that a firm that has an optimistic outlook can use interest rate swaps to benefit from borrowing
and the expected cost of financial distress will not increase. Thus a positive relationship is predicted between the use of cross-currency interest rate swaps and
variability of the leverage measures.
The tax treatment of both the exposure and the hedging technique can have important implications for the firm’s hedging strategy see Kramer et al., 1993. Under
UK tax laws, the use of derivatives to hedge translation exposure may give rise to cash flow gains which are taxable and losses which are not tax allowable see Buckley,
1992. To avoid the adverse impacts of asymmetry in taxation, firms are likely to place more emphasis on internal techniques when hedging translation exposure. The use
of forward contracts to hedge the transaction exposure emanating from re6enue transactions, results in taxabletax allowable gains and losses in the UK. All those
impacts will in turn affect the level of profitability. Assuming that the tax credits can be utilised, a lower degree of variability is expected on the tax measures for firms
that use forward contracts to hedge transaction exposure. The tax and profitability measures are the coefficient of variation of: i tax charge on profitloss to pre-tax
profitloss TAXRATIO; ii tax charge on profit loss to market value TAXMV; iii operating profit to sales OPM; and iv trading profit to sales TPM.
The terms of managers’ and employees’ compensation plans can also impact on the choice of hedging technique see Smith, 1993. Managers will use those derivatives,
e.g. FX options, which increase the volatility of the firm’s stock price if a large part of their compensation is in the form of stock options. Following Smith and Stulz
1985 a positive relationship is expected between both managers’ and employees’ wealth and the extent to which the firms use derivatives, particularly when hedging
economic and translation exposures. The measures of wealth are the coefficient of variation of: i directors’ remuneration to market value DIRECMV; ii employees’
remuneration to market value EMPMV; and iii BOOKMV. The predictions are further summarised in Appendix A.
3. Empirical results
