Journal of Multinational Financial Management 10 2000 161 – 184
The choice of hedging techniques and the characteristics of UK industrial firms
Nathan Lael Joseph
Manchester School of Accounting and Finance, Uni6ersity of Manchester, Manchester M
13 9
PL, UK Received 8 August 1998; accepted 15 April 1999
Abstract
This study presents the empirical results for the relationship between the use of hedging techniques and the characteristics of UK multinational enterprises MNEs. All the firms in
the sample hedge foreign exchange FX exposure. The results indicate that UK firms focus on a very narrow set of hedging techniques. They make much greater use of derivatives than
internal hedging techniques. The degree of utilisation of both internal and external tech- niques depends on the type of exposure that is hedged. Furthermore, the characteristics of
the firms appear to explain the choice of hedging technique but the use of certain hedging techniques appears to be associated with increases in the variability of some accounting
measures. This adverse impact of hedging has not been emphasised in the finance literature. The results imply that firms need to ensure that the appropriate techniques are used to hedge
exposures. © 2000 Elsevier Science B.V. All rights reserved.
JEL classification
:
F23; F30; G10 Keywords
:
Multinational enterprises; Foreign exchange exposure; Hedging techniques www.elsevier.comlocateeconbase
1. Introduction
Most theoretical studies that seek to explain why industrial firms hedge exposure focus on differences in the financial characteristics of users and non-users of
hedging techniques
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. The empirical work which seeks to test the theoretical predic-
Tel.: + 44-161-2754029. E-mail address
:
nathan.josephman.ac.uk N.L. Joseph
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For a review of the literature see Levi and Sercu 1991, Nance et al. 1993 and Joseph and Hewins 1997.
1042-444X00 - see front matter © 2000 Elsevier Science B.V. All rights reserved. PII: S 1 0 4 2 - 4 4 4 X 9 9 0 0 0 2 5 - 0
tions takes a similar focus. However, the findings for certain hypothesised rela- tionships are often weak in both univariate and multivariate statistical tests see
Dolde, 1993; Nance et al., 1993. One possible explanation for the weak empiri- cal results of certain theoretical predictions relates to research design. For exam-
ple, to identify US industrial firms as hedgers users and non-hedgers non-users, both Nance et al. 1993 and Dolde 1995 used a questionnaire
survey which required respondents to indicate whether or not they use one or more of four currency derivatives, i.e. forward, futures, swap andor option
contracts. In contrast, Berkman and Bradbury 1996 choose to categorise the firms in their study in terms of the hedging information contained in their
audited financial reports see also Francis and Stephan, 1993; Geczy et al., 1997. Since firms are only required to disclose exposure information if such
information is material, this latter approach may not fully capture the hedging activities of firms. However, both approaches seem restrictive since firms use a
wide range of internal and external techniques including derivatives to hedge foreign exchange FX and interest rate exposures see Stanley and Block, 1980;
Khoury and Chan, 1988. Furthermore, some firms may not hedge simply be- cause they have no exposure while others may not hedge or partially hedge
depending on their perception about FX rate behaviour andor their confidence in using derivatives see Dolde, 1993. These considerations therefore have im-
portant implications for the empirical results of prior studies.
This study seeks to provide additional insights into the hedging behaviour of UK firms by focusing on: i the degree of utilisation of a broad set of hedging
techniques; ii the maturity structures of those hedging techniques; and iii the sources or types of exposures that are hedged. Those aspects are examined
because firms are known to make use of a wide range of techniques when hedging exposure and to exercise substantial flexibility in hedging decisions see
Hakkarainen et al., 1998. Although newer financial innovations can reduce the demand for traditional types of hedging techniques see Tufano, 1995, empirical
evidence indicates that firms are not very receptive to the newer and more complex types of derivatives. This is because firms are concerned about the
banks’ commitment to those products and their ability to provide real solutions to exposure problems see Fairlamb, 1988; Glaum and Belk, 1992. Furthermore,
managers can always adjust their hedging decisions to reflect their expectations of changes in financial prices. Thus, if the forward rate is a biased predictor,
managers can alter their hedging strategies to accommodate this effect. Here, a partial or no hedge or fully hedged strategy can be optimal for both transaction
and economic exposures see Berg and Moore, 1991; Schooley and White, 1995. Since firms tend to place more emphasis on transaction exposure than on eco-
nomic and translation exposures Khoury and Chan, 1988; Joseph and Hewins, 1991, their use of hedging techniques may reflect the types of exposures they
hedge.
An examination of a broad set of hedging techniques is also warranted since in certain situations, the use of some techniques can give rise to adverse
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
