The Value Effects of Foreign Currency and Interest Rate Hedging: The UK Evidence
Yacine Belghitara, Ephraim Clarka and Amrit Judgeb,,
a
Accounting and Finance Group, Middlesex University, London NW4 4BT, UK b Economics Group, Middlesex University, London NW4 4BT, UK y.belghitar@mdx.ac.uk e.clark@mdx.ac.uk a.judge@mdx.ac.uk
7 January 2007
Abstract
In this paper we use UK data to present empirical evidence on the valuation and debt capacity effects of foreign currency (FC) and interest rate (IR) hedging. We build on recent studies that have presented mixed results on the link between hedging, leverage and firm value. Our results provide evidence of a significant relationship between firm value, measured as Tobin‟s Q, and foreign currency and interest rate hedging. These findings are much stronger than those found in previous studies that have examined US firms. Our empirical evidence suggests that this is due to the fact the US studies include in their non-hedging sample other hedging firms, such as firms using non-derivative methods for hedging, which can bias the results against finding positive leverage and firm value effects. The larger value effects in our results could also be due to institutional differences in the bankruptcy codes between the UK and the US that cause higher expected financial distress costs for UK firms and therefore greater benefits generated by hedging. When we look at debt capacity and the tax shield effects of hedging, we find that investors reward interest rate hedgers with a larger hedging premium than that rewarded for FC hedging. In fact, our results show that the debt capacity benefits of interest rate only hedging are around six times those generated by FC only hedging. Finally, the debt capacity results in relation to IR hedging and the Tobin‟s Q results show that derivative hedging generates more value than non-derivative hedging.
Keywords: Firm value, Foreign currency hedging, Interest rate hedging Derivatives, Debt capacity, Leverage, Financial distress. JEL Classification: F30; G32; G33.
Corresponding author. Tel: ++44 (0)20 8411 6344; Fax: ++44 (0)20 8411 4739; E-mail: a.judge@mdx.ac.uk. Helpful comments from seminar participants at Cranfield School of Management, Swansea University, Cass Business School, Middlesex University and the 2006 Multinational Finance Society Conference are gratefully acknowledged. The usual disclaimer applies.
The value effects of foreign currency and interest rate hedging
1. Introduction The positive theory of corporate hedging developed by Smith and Stulz (1985) is based on the demonstration that imperfect capital markets can create conditions where corporate hedging becomes economically justified because it can add value to the firm. Many studies have examined what these conditions are and why firms might be using derivatives for hedging. The key question for shareholders, however, is whether hedging does, in fact, add value to the firm. Empirical research on this question is relatively recent, generally focused on the US and, since commodity price hedging seems to be generally limited to specific industries, has concentrated on interest rate and foreign currency hedging. In this paper we extend this literature and study the value effects of the interest rate (IR) and foreign currency (FC) hedging practices of a sample taken from the top 500 non-financial firms in the UK ranked by market value as of year-end 1995. The UK data for this period is well adapted to the value testing we propose for several reasons. At the time the UK had (and still has) a large number of firms with foreign operations. These firms were facing continuous currency risk because the pound had been floating since its withdrawal from the European currency mechanism in 1992. The economy was highly industrialized and open with developed, generally unrestricted capital markets and trading partners that were predominantly in the same conditions. Thus, the financing and hedging decisions by the firms in our sample are likely to reflect economic and financial criteria rather than the result of constraints imposed by shallow domestic capital markets, bureaucratic controls and the like. Furthermore, the year 1995 is at the midpoint of the years included in the studies cited in this paper and, thus, serves as a good point of comparison.
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The value effects of foreign currency and interest rate hedging
The innovation in this study that makes our results so interesting is that we organize the tests so that the value effects of each type of hedging, both interest rate and foreign currency, and each type of instrument, both derivative and non-derivative, can be isolated and estimated independently in order to eliminate any potential bias. The failure of other studies to do this weakens their results and probably explains why the evidence is so mixed. For example, in a study that measures the effect of derivatives use on Tobin‟s Q as a proxy for firm value, Bartram, Brown and Fehle (2004) find a significant positive value effect for all derivative users taken together but perversely only for firms without any financial price exposure. Furthermore, when broken down according to hedging type, no value effects are found for FC derivative users and interest rate derivatives use generates positive valuation effects for firms with and without interest rate exposure. Also, contrary to expectations the extent of the increase in value is larger for firms with very little interest rate exposure. The problem is that when they break down the sample by hedging type, their sample of non-FC (IR) hedgers includes hedgers that also hedge other kinds of risk. Consequently, their tests are likely to understate the value generated from FC (IR) hedging. The other studies using Tobin‟s Q suffer from the same kind of problem and results are mixed. Allayannis and Weston (2001) find that FC derivatives use is associated with an increase in firm value while Allaynnis, Ihrig and Weston (2001) find that FC operational hedging increases firm value only when combined with derivatives. Kim, Mathur and Nam (2006) find that both operational hedging and financial hedging add to firm value but unlike Allayannis et al. (2001) they find that
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The value effects of foreign currency and interest rate hedging
operational hedging generates up to five times more value than financial hedging.1 Nain (2004) finds that firms that choose not to hedge FC risk in industries where FC derivatives use is prevalent had 5% lower Tobin‟s Q than their hedged competitors. Allayannis, Lel and Miller (2004) find that the FC hedging premium is statistically significant and economically large only for firms that have strong internal and external corporate governance. Where commodity hedging is concerned, results are also mixed. Lookman (2004) reports that once agency conflicts have been controlled for, valuation effects associated with hedging become largely insignificant. Carter et al. (2004) find that jet fuel hedging increases value while Jin and Jorion (2006) find no value effects from hedging in the US oil and gas sectors.2 Results are also inconclusive when the value added from hedging is associated with a specific explanation of why firms hedge. This literature revolves around the debt capacity benefits of hedging developed by Stulz (1996), Ross (1997), and Leland (1998), who show that by reducing the probability of financial distress, hedging increases debt capacity. In this framework hedging increases a firm‟s ability to take on more debt (i.e., debt capacity). If firms respond by adding to their leverage, this will lead to an increase in interest deductions, which in turn generates incremental tax shield benefits that can increase firm value. Three studies investigate the debt capacity effects due to FC hedging with mixed results. Using a hedging dummy dependent variable for a sample of US firms both Géczy et al. (1997) and Graham and Rogers (2002) find that leverage is not affected by FC hedging. Bartram et al. (2004) employ a sample of close to 5000 firms from around the world. They find that hedging is associated with an increase in leverage ranging from 3% for FC derivative users, 9% for all derivative users, 11% for IR derivative users and 15% for commodity
1
Kim et al. (2006) find that financial hedging adds 5.4% to firm value on average and operational hedging increase firm value in the range of 4.8–23.5%. 2 Carter et al. (2005) find that jet fuel hedging by airlines increases value in the range of 12-16%.
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The value effects of foreign currency and interest rate hedging
derivative users. These translate into a mean increase in value of 0.32% for currency derivative users, 0.82% for general derivative users, 1.28% for interest rate derivative users and 1.71% for commodity price derivative users. The larger debt capacity effect for commodity price hedging is curious, given that the link between interest rate hedging, debt capacity and leverage is a more obvious relation than commodity price hedging, debt capacity and hedging. Borokovich et al. (2004) also examine the debt capacity effects of IR hedging. They find a positive and statistically significant relationship between leverage and IR derivative use for a sample of U.S. firms, which is consistent with the argument that firms that hedge bankruptcy risk can increase leverage and make greater use of the interest tax shield from debt. Where commodity price hedging is concerned, Dionne and Triki (2004) find that the relation between debt and risk management for U.S. and Canadian gold mining firms goes mainly in the direction of firms hedging in order to decrease the financial distress costs caused by leverage, rather than firms managing risk in order to increase their debt capacity. Besides the problem in the Tobin‟s Q tests of including other hedgers in the sample of FC (IR) hedgers and thereby blurring the effect of the type of hedging being tested, debt capacity tests also include firms that might be hedging IR (FC) and/or commodity price exposure in the non-hedging sample. Under the reasonable assumption that the hedging activities of these “other” hedgers would also induce higher debt capacity, the inclusion of these “other” hedging firms in the non-hedging sample might make it more difficult to detect the leverage effects associated with hedging. This problem would be especially pronounced for FC hedging tests where
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The value effects of foreign currency and interest rate hedging
the majority of “other” hedgers are interest rate hedgers, for whom the leverage effects are likely to be relatively higher.3 In this paper, we first run the tests as in the foregoing papers. 4 We then correct for the potential bias by eliminating the “other” hedgers from the hedging and non-hedging samples and re-run the tests. This paper makes several contributions to the literature. First of all, we find that both FC and IR hedging are significant explanatory variables for firm value creation when measured as Tobin‟s Q and when measured as a tax shield through increased debt capacity. Their effects are also larger than those reported in previous studies examining US firms. Where FC hedging is concerned, this is probably due, at least in part, to the fact that UK firms face significantly higher levels of FC exposure relative to their US counterparts. For example, Allayannis and Weston (2001) report that the mean (median) level of foreign sales is 18 percent (3 percent) for their sample of US firms during the period 1990-95. For our sample (1994-95) the average level of foreign sales is nearly double at 35 percent and the median, at 29 percent, is over nine times that of US firms. The Tobin‟s Q and debt capacity effects might also be due to the fact that the UK bankruptcy code confers greater rights to creditors than the US code. Thus, if the UK rules make liquidation more likely for firms in financial distress, then UK firms potentially face higher expected costs of financial distress than firms in the US, thereby raising the potential gains to be made through hedging. In a second contribution we show that controlling for “other” hedgers in the samples of non-hedgers changes the results considerably. In the Tobin‟s Q tests for
3
Loan providers might insist that firms put in place interest rate hedges as part of their loan agreements, in effect the loan will only be made available if the firm agrees to hedge the resulting interest rate exposure. 4 Table 1 summarizes the relevant papers.
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The value effects of foreign currency and interest rate hedging
both FC and IR derivatives hedging, the coefficient is positive and significant with and without the controls. However, after controlling for “other” hedgers, the coefficient is 72% larger for FC derivatives and 52% larger for IR derivatives with higher p-values for both. The results are even more pronounced for the debt capacity tests. In the tests that include “other” hedgers in the non-hedging sample, the coefficient for all FC hedgers is small and not significant. When we exclude “other” hedgers from the non-hedging sample, the coefficient is over three times larger with a p-value of 0.000. When we look at “FC derivatives users” before controlling for “other” hedgers, the coefficient is negative and significant. After controlling for “other” hedgers, the coefficient is positive and significant. Interestingly, the inclusion of other hedgers in the IR analysis does not affect the sign or the significance of the IR hedging coefficient in the second stage estimation, which is positive and highly significant with or without other hedgers. A third contribution concerns the debt capacity effects of FC and IR hedging where we control for the cross effects of FC and IR hedging on debt capacity by using samples of FC only hedgers and IR only hedgers. Our results show that firms that only hedge FC generate significant positive debt capacity and hence value effects, but that IR hedging creates substantially more firm value from debt capacity (over 6 times as much) than FC hedging. This is consistent with the notion that IR hedging facilitates more leverage because lenders might make the incremental debt contingent on the commitment to hedge. Without the commitment to hedge, the new debt financing would not be forthcoming. Results for the Tobin‟s Q analysis are more ambiguous. FC only hedging generates similar value effects to that of FC hedgers who might also be IR hedgers while in the IR only hedgers specification the coefficient is not significant.
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The value effects of foreign currency and interest rate hedging
The final contribution gives evidence that derivative only hedging is superior to other types of hedging. Although in the debt capacity tests we find that all FC hedging created more value than FC derivative hedging, IR derivative hedging created more value than all IR hedging. In the Tobin‟s Q analysis restricting hedgers to derivative users generated larger coefficients for both IR and FC hedging (after excluding other hedgers) than when the more inclusive definitions of hedging were employed. This suggests that derivatives hedging is more value enhancing than other hedging methods. The remainder of the paper proceeds as follows. Section 2 describes the sample. Section 3 and 4 present the results and section 5 concludes.
[INSERT TABLE 1 HERE]
2. Sample Description and Sources of Data on Foreign Currency and Interest Rate Hedging The sample consists of 412 non-financial firms taken from the top 500 nonfinancial firms in the UK ranked by market value as of year-end 1995. The data on FC and IR hedging was obtained from qualitative risk management disclosures in annual reports. This study classifies firms as FC (IR) hedgers as those that make any reference in their annual report to hedging their FC (IR) exposures. We recognise that firms utilise a range of hedging techniques, which include non-derivative as well as derivative based hedges. Therefore, our definition of FC (IR) includes both derivative and non-derivative hedging. Examples of the latter include the use of FC debt financing to hedge the exposures arising from foreign operations and the attempt to match the interest rate profile of the firm‟s debt with that of it‟s operating cash flows, such as the decision to issue fixed rate debt financing.
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The value effects of foreign currency and interest rate hedging
Panel A of Table 2 shows that 70.4 percent of firms in our sample are classified as foreign currency hedgers, whereas only 44.4 percent were deemed to be interest rate hedgers. Corresponding figures for US firms shows that FC hedging
activity is less widespread in the US but participation in IR hedging is comparable to that of the UK.5 We also provide a breakdown of FC (IR) hedgers by identifying the combinations of exposures hedged. Panel B shows that 47.2 percent of FC hedgers hedged both FC and IR and 44.1 percent only hedged FC. The corresponding figures for the IR hedging sample are 74.9 and 15.3 percent respectively. Panel C shows that the sample of FC (IR) non-hedgers consists of both non-hedging firms and firms hedging other exposures. In the FC non-hedging sample 25.5 percent are other hedgers, these being mostly IR hedgers. In the case of the IR non-hedging sample 60.3 percent are hedging other exposures. The inclusion of these hedgers in the FC and IR non-hedging sample might bias the empirical results against a significant positive hedging premium and or debt capacity effect. Since the IR non-hedging sample contains a far greater proportion of other hedgers we would expect the bias to be greater in the IR hedging value tests. Panel E shows that the FC and IR nonderivative using samples contain a majority of other hedgers, 53.8 and 63.6 percent, respectively. This suggests the potential for a greater bias when looking at the value effects of FC (IR) derivative hedging. [INSERT TABLE 2 HERE] Table 3 presents summary statistics of the main variables used in this study. The mean value of total assets for our sample is £1010 million and the mean market value of equity is £1582 million. In this study we employ Tobin‟s Q as a proxy for firm value. We define Tobin‟s Q as the book value of total assets minus the book
5
For example, Allayannis and Ofek (2001) report that 44% of US firms use FC derivatives and Howton and Perfect (1998) find that 45% of US firms use IR derivatives.
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The value effects of foreign currency and interest rate hedging
value of equity plus the market value of equity divided by the book value of total assets. The numerator approximates the market value of the firm and the denominator approximates the replacement cost of assets. The distribution of Tobin‟s Q in our sample is skewed, since the median value (1.887) is smaller than its mean (2.448). To correct for this we use the natural log of Q. Using the natural log has the additional advantage that changes in this variable can be interpreted as percent changes in firm value. The mean level of foreign sales as a proportion of total sales is 35 percent for our sample. This level of foreign sales activity is at least double that reported for US firms around the same period. For example, Allayannis and Weston (2001) indicate that foreign sales were on average 18 percent of total sales for 720 US firms during the period 1990-95 and Graham and Rogers (2002) reports foreign sales of 10 percent for their sample of US firms in 1994. [INSERT TABLE 3 HERE]
Table 4 presents the Pearson correlation coefficients for the variables used in our empirical tests. Consistent with our a priori expectations, the matrix shows that firm size, leverage, dividend payments and tax losses are negatively correlated with Tobin‟s Q and R&D expenditure, profitability and the firm‟s ability to service its debt payments are positively correlated. [INSERT TABLE 4 HERE] 3. Firm Value and Foreign Currency and Interest Rate Hedging: A Tobin’s Q Analysis Since there are so many well documented determinants of firm value, we employ a multivariate approach to investigate the value effects of hedging. To infer that
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The value effects of foreign currency and interest rate hedging
hedging increases the value of the firm, we need to exclude the effect of all other variables that could have an impact on firm value (Tobin‟s Q). In common with several previous studies we control for size, profitability, leverage, growth opportunities, ability to access financial markets, geographic and industrial diversification. The rationale for including these variables is as follows:
1. Size: There is ambiguous evidence for firms as to whether size leads to higher profitability. However, as large firms are more likely to use derivatives, for example, because of economies of scale in transactions costs, we use the natural log of total assets to control for the effect of size. 2. Profitability: A firm‟s profitability is expected to have a positive impact on firm value. Thus if hedgers are more profitable, they will have higher Tobin‟s Qs.
Profitability is controlled for by the return on capital employed. 3. Leverage: A firm‟s capital structure may also be related to its value. We use the book value of total debt and preference capital as a proportion of the book value of total debt plus the market value of equity to control for the effect of leverage on firm value. 4. Access to financial markets: If hedgers have limited access to financial markets, their Q ratios may be high because they are constrained to take on only those projects with the positive NPVs. To proxy for a firm‟s ability to access financial markets, we use the dividend yield. Given this interpretation, the coefficient should be negative. On the other hand, dividends can be viewed as a positive signal from management, which should imply a positive coefficient (Jin and Jorion, 2006). 5. Investment growth: Myers (1977) and Smith and Watts (1992) have argued that firm value firm value may also depend on future investment opportunities. Since firms with large growth opportunities may be more likely to use derivatives we
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The value effects of foreign currency and interest rate hedging
control for investment growth with the ratio research and development expenditure (R&D) to sales. 6. Industrial diversification: Previous empirical evidence suggests that diversification is negatively related to firm value (Berger and Ofek, 1995; Lang and Stulz, 1994; Servaes, 1996). We control for industrial diversification with the number of business segments that make up the firm‟s revenue. We obtain this data from a firm‟s annual report. 7. Geographic diversification: Several studies have documented positive valuation effects for operating in several countries (Morck and Yeung, 1991; Bodnar, Tang and Weintrop, 1997). Including the ratio of foreign sales to total sales in the regressions controls for the impact of geographic diversification, since it indicates operations in more than one country. We employ three variations for our measure of hedging. In common with much of the extant empirical literature we define FC (IR) hedging as the use of FC (IR) derivatives, in our second definition we incorporate non-derivatives FC (IR) hedging, our third definition looks at FC (IR) only hedgers. Table 5 presents the regression results for both FC (models 1 to 5) and IR hedging (models 6 to 10). When we define FC (IR) hedging as the use of FC (IR) derivatives then firms that hedge FC (IRs) using non-derivative methods will be effectively defined as non-hedgers. We expect this to have an adverse impact on the size of hedging premium since hedging theory predicts that any type of hedging should have a positive effect on firm value. Model 1 shows that the coefficient on the FC derivative dummy is positive and significant despite the inclusion of other hedgers (IR hedgers and non-derivative FC hedgers) in the non-hedging sample. In model 2 we transfer non-derivative FC hedgers into the FC hedging sample (i.e., adopt a wider definition of FC hedging), as
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The value effects of foreign currency and interest rate hedging
expected, this results in an increase in the hedging coefficient, the hedging premium is now 13.1% up from 8.5%. This suggests that non-derivative FC hedging also adds to firm value. Models 3 and 4 rerun the specifications in models 1 and 2 but exclude other hedgers from the non-hedging sample. In both instances the coefficient
increases, albeit only slightly for all FC hedgers. A comparison of the hedging coefficients in models 3 and 4 indicates that restricting the definition of hedging to derivatives (model 3) generates a larger hedging premium than the more inclusive definition (model 4). In specifications 1 to 4 the sample of FC hedgers include firms that are also IR hedgers. Therefore, it is possible that some proportion of the resulting hedging premium is due to IR hedging. In model 5 we examine how much of the hedging premium is the result of FC hedging in particular by excluding from the FC hedging sample firms that also hedge IR exposure. The results show that the hedging premium is significant and slightly larger at 15.3 percent. As with FC hedging, for both definitions of IR hedging we see an increase in the size of the hedging coefficient (premium) when we remove the other hedgers from the non-IR hedging sample. The IR hedging results also provide further evidence that derivatives hedging is potentially more value enhancing than non-derivative hedging. In the bias free tests of model 8 and model 9 the IR hedging premium is 18.6% when hedgers are defined as IR derivative users and 15.6% when we expand our hedging definition to include firms that use only non-derivative IR hedging techniques. At first glance this result is unusual since a firm‟s final interest rate exposure would be the same irrespective of the method of hedging. For example, a firm that issues fixed rate debt has the same interest rate exposure, and therefore would be expected to achieve the same value benefits, as one that issues floating-rate debt and swaps it to a fixed rate. However, it could be argued that hedging IR exposure with
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The value effects of foreign currency and interest rate hedging
derivatives confers greater flexibility in altering interest rate characteristics of a debt portfolio, particularly in response to changing company circumstances (the generation of large levels of surplus cash) or changes in the macroeconomic environment (the steepness of the yield curve).6 For example, an advantage of an interest rate or currency swap is that it allows firms to adjust exposure profiles without having to undo the underlying transactions. The major advantages of swaps in restructuring corporate debt are lower costs, increased flexibility, and more rapid execution. They have also been used to create lower-cost synthetic debt issues. Therefore, the inherent flexibility that derivative tools possess over substitute hedging strategies is possibly a driver of the greater value. It might also be that, because of accounting disclosure requirements, derivatives hedging can be more readily observed by investors whereas non-derivative hedging is less transparent or that it might be difficult to disentangle (or distinguish) non-derivative hedging from other financial activities of the firm. In model 10 we examine the value effects for IR only hedgers and find, contrary to expectations, that the hedging coefficient is negative and statistically insignificant. This suggests that it is FC hedging that is driving the results, but, since this specification contains only 15 IR hedgers the power of the tests are very weak, which might explain the result. Our overall results, however, suggest that investors reward IR hedgers with a larger hedging premium than that generated by FC hedging. The IR hedging coefficient in models 6, 8 and 9 is higher than the corresponding coefficients for FC hedging (models 1, 3 and 4). For example, model 3 indicates a 14.7% value effect from FC derivative hedging, the corresponding result for IR derivative hedging is 18.6% (model 8).
6
The steeper the yield curve the more attractive floating interest rates become relative to long-term fixed rates. The slope of the yield curve might also pick up expectations of a recession.
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The value effects of foreign currency and interest rate hedging
Finally, the coefficients on several of the control variables are in line with what earlier literature finds. For example, size, leverage and dividend yield are negatively related to value, whereas growth opportunities (measured by R&D expenditure scaled by total sales) and profitability are positively related to firm value. [INSERT TABLE 5 HERE] 4. Hedging, Debt Capacity and Firm Value To estimate the valuation effects from enhanced debt capacity and leverage due to hedging we follow Graham and Rogers (2002) and estimate the determinants of the capital structure and FC and IR hedging decisions simultaneously with a twostage estimation technique. In the first stage, two separate regressions are performed using FC (IR) hedging and the leverage ratio, respectively, as dependent variables. We use equation 1 to obtain predicted probabilities of FC (IR) hedging:
log
P i 0 1Taxi 2 Leverage 3Expi 4Subi 5TCostsi i i 1 P i
(1)
where Tax = Tax loss carry forward Leverage = Leverage Exp = Financial price exposure Sub = Hedging substitutes Tcosts = Transaction costs. We specify the model of the capital structure decision following Rajan and Zingales (1995) to obtain predicted leverage ratios:
Leverage( Firm i) 0 1Tangible assetsi 2 R&Di 3 Log sizei 4 Pr ofitabilityi i (2)
In the second stage, structural equations are estimated using the predicted values from the first-stage regressions as explanatory variables. equations are: The structural
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The value effects of foreign currency and interest rate hedging
FC (IR) hedging decision:
log Pi 0 1Tax i 2 Leverage *i 3 Exp i 4 Subi 5 TCostsi i (3) 1 Pi
Capital structure decision:
Leverage( Firm i ) 0 1Tangible assetsi 2 R & Di 3Log size i 4 Profitabil ity i 5 Hedging * i (4)
In equation (3), Leverage* is the predicted value of the leverage ratio obtained from the first-stage estimation of the capital structure decision equation (equation (2)). In equation (4), Hedging* is the predicted probability of hedging obtained from the firststage estimation of the FC (IR) hedging equation (equation (1)). We report the results for FC and IR hedging in table 6. The first row of table 6 reports the estimated coefficient on the FC hedging variable and its p-value in the second stage leverage regression. We initially estimate stages one and two of the simultaneous equations system with our full sample which incorporates non-FC hedgers that include other hedgers, such as firms that only hedge interest rate exposure. In the second stage leverage regression column 1 of table 6 shows that the predicted probability of hedging is positively related to leverage but not statistically significant. This indicates that FC hedging by UK firms does not increase their debt capacity. We re-estimate both stages of the simultaneous equations system but this time excluding other hedgers from the non-hedging sample, which are made up mainly of interest rate hedgers. The results in column 2 of Table 6 show that the predicted probability of foreign currency hedging is now a significant factor in determining leverage. The estimated coefficient from a second-stage leverage regression suggests that foreign currency hedging is associated with a 0.1867 increase in the leverage
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The value effects of foreign currency and interest rate hedging
ratio. We quantify the size of the tax benefit provided by the increased debt capacity for each foreign currency hedging firm by taking the product of the estimated coefficient on the foreign currency hedging variable, the firm‟s average tax rate, and value of total debt and then scale this by the market value of the firm‟s assets (lagged one year). For all foreign currency hedgers the increase in leverage translates into a mean (median) estimated increase in firm value of 1.29 (1.04) percent. This value effect of foreign currency hedging is larger than the 0.32 percent reported by Bartram et al. (2004) for a sample of over 4000 worldwide firms. Furthermore, for a sample of US firms and using a binary foreign currency hedging variable both Géczy et al. (1997) and Graham and Rogers (2002) do not find that currency hedging significantly increases the leverage ratio in their second stage regressions. All three studies investigate foreign currency derivative use rather than foreign currency hedging. This narrow definition of foreign currency hedging might bias the results if firms use tools other than derivatives for foreign currency hedging. Furthermore, if the non-currency derivative sample also includes interest rate or commodity price derivative users the bias will be more severe. [INSERT TABLE 6 HERE]
4.1 Using An Alternative Definition of Hedging The definition of FC hedging employed in this study is more inclusive than that used in several previous studies, which tend to restrict their analysis to FC derivative users. In order to facilitate comparisons with these studies we repeat the above analysis but define FC hedgers as firms that use FC derivatives and firms that hedge FC exposure but use methods other than derivatives are classified as non-FC derivative users together with firms that do not hedge FC exposure. The results in column 3 of table 4 show that the hedging coefficient is negative and significant. This
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The value effects of foreign currency and interest rate hedging
perverse result implies that hedging lowers debt capacity opposite to that predicted. In similar analyses Géczy et al. (1997) and Graham and Rogers (2002) report an insignificant hedging coefficient in their second stage leverage regression. These results might be due to the fact that non-currency derivative users include interest rate hedgers and other foreign currency hedgers. Since the capital structure effects are not unique to the source of exposure hedged, nor which method of hedging is used, the inclusion of other hedgers in the non-FC derivative sample makes the detection of a leverage effect more difficult. Column 4 of table 6 shows that when interest rate hedgers and other foreign currency hedgers are removed from the non-FC derivative user sample, the estimated hedging coefficient in the second stage leverage regression is 0.0938 and significant at less than one percent, which implies an increase in firm value of 0.63 percent. This suggests that how non-derivative using foreign currency hedgers and interest rate only derivative users (or hedgers) are treated has a significant bearing on the estimated effect of FC hedging on leverage and consequently the estimated tax benefits of hedging.
4.2 The Value Effects for Foreign Currency Only Hedgers The results in the previous sections indicate that foreign currency hedging increases firms‟ debt capacity and consequently leads to an increase in firm value. However, the validity of the strength of this link can be called into question because of the structure of the foreign currency hedging sample. Closer inspection of the foreign currency hedging sample reveals a few interesting characteristics. Panel B of Table 2 shows that 44.1 percent of foreign
currency hedgers are foreign currency only hedgers and 53.4 percent of foreign currency hedgers also hedge interest rate exposure. It could be argued that since over
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The value effects of foreign currency and interest rate hedging
half the sample of foreign currency hedgers are also interest rate hedgers it is quite possible that this group of firms is driving the leverage results. This is because leverage is potentially of greater relevance to interest rate hedging firms because firstly it is a source of interest rate exposure and secondly lenders might agree to providing debt finance if firms commit to hedging the resulting interest rate exposure. Since foreign currency hedging firms include interest rate hedgers these results might in part be driven by interest rate hedgers. The Bartram et al. analysis suffers from this problem since they include all FC derivative users, which incorporates firms that use both interest rate and FC derivative users. The empirical tests in this section control for this by investigating the value effects for firms that only hedge foreign currency exposure. We firstly exclude “other” hedging firms from the non-foreign currency hedging sample. We then re-run the regression excluding interest rate hedgers and or commodity price hedgers from the FC hedging sample leaving a sample of firms that only hedge FC exposure. The result in column 5 of table 6 shows that the predicted probability of foreign currency only hedging is a significant factor in determining leverage. The estimated coefficient from a second-stage leverage regression suggests that foreign currency only hedging is associated with a 0.1388 increase in the leverage ratio, which generates a mean estimated increase in firm value of 0.78 percent. As expected the value effect for FC only hedgers is lower than that observed previously for all FC hedgers (which include interest rate hedging firms). An important implication of this result is that it shows that the observed link between leverage and foreign currency hedging and therefore the resulting value effect is not driven by the inclusion of foreign currency hedging firms that also hedge interest rate exposure. This demonstrates empirically, to our knowledge for the first time, an
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The value effects of foreign currency and interest rate hedging
unequivocal link between firm leverage, firm value and the foreign currency hedging decision.7
4.3
The Debt Capacity Benefits of Interest Rate Hedging There is much anecdotal evidence which suggests that banks and other lending
institutions will provide external debt funding on the understanding that borrowing parties commit to hedging existing or any resulting interest rate exposure. These hedging requirements might be set out in a loan covenant. This implies that there is a clear link between IR hedging and a firm‟s ability to raise debt capital. Given this link, we believe it follows that there should be a stronger relationship between interest rate hedging and debt capacity than that observed between FC hedging and debt capacity. This will manifest itself in the form of greater debt capacity benefits from interest rate hedging than foreign currency hedging. The results in table 6 show this to be the case. Firstly, for IR hedging we find that the estimated coefficient on the IR hedging variable in the second stage leverage equation is positive and highly significant with or without other hedgers (mainly FC hedgers) in the non-IR hedging sample. To facilitate comparisons with the FC hedging results we report the IR hedging results with other hedgers excluded from the non-IR hedging sample. Column 6 shows that the mean debt capacity benefits generated by IR hedging amount to 3.99 percent of the market value of assets, which is three times that achieved by FC hedging (1.29 percent). When we restrict IR hedging to firms that use IR derivatives (column 7) our results show that the average debt capacity benefit goes up to 5.98 percent. This suggests that IR derivatives hedging generates more
7
In unreported analysis we ran the regressions including “other” hedgers in the non-hedging sample. The results showed that the hedging coefficient in the second stage leverage regression was no longer significant.
20
The value effects of foreign currency and interest rate hedging
debt capacity than non-derivatives IR hedging, which is consistent with our earlier findings using Tobin‟s Q. The results in columns 6 and 7 suggest that IR hedging confers greater debt capacity benefits than FC hedging. An interesting question is by how much. One
way to look at this is to compare the benefits generated by FC only hedging with those generated by firms that hedge both FC and IR. Column 8 reports the results for the latter. These results indicate that a combination of FC and IR hedging generates more than double the debt interest tax shield benefits than that generated by FC hedging alone (1.87 percent versus 0.78 percent). However, since the samples of IR hedgers in these tests are also FC hedgers it is not possible to discern from this the extent to which IR hedging generates more debt capacity. We investigate this by estimating the value effects of IR only hedging. Column 9 of table 6 presents the results for IR only hedgers. The results show that, as expected, the debt capacity benefits of IR hedging are greater than those generated by FC only hedging (column 6). Our analysis indicates that the value effects due to IR hedging are six times greater than those generated by FC hedging.
5. Conclusion In this study we employ UK data to quantify the effects of FC and IR hedging on firm value. We find that both FC and IR hedging are significant explanatory variables for firm value creation when measured as Tobin‟s Q and when measured as a tax shield through increased debt capacity. Their effects are also larger than those reported in previous studies examining US firms. We show that controlling for “other” hedgers in the samples of non-hedgers makes the value creation effect both larger and more significant. When we control for the cross effects of FC and IR hedging on debt capacity by using samples of FC only hedgers and IR only hedgers,
21
The value effects of foreign currency and interest rate hedging
our results show that firms that only hedge FC generate significant positive debt capacity and hence value effects, but that IR hedging creates substantially more firm value from debt capacity (over 6 times as much) than FC hedging. Where Tobin‟s Q is concerned, FC only hedging generates similar value effects to that of FC hedgers who might also be IR hedgers while in the IR only hedgers specification the coefficient is not significant. When we compare hedging techniques, we find that derivative only hedging is generally superior to other types of hedging. Although in the debt capacity tests we find that all FC hedging created more value than FC derivative hedging, IR derivative hedging created more value than all IR hedging. In the Tobin‟s Q analysis restricting hedgers to derivative users generated larger coefficients for both IR and FC hedging (after excluding other hedgers) than when the more inclusive definitions of hedging were employed. This suggests that derivatives hedging is more value enhancing than other hedging methods.
22
The value effects of foreign currency and interest rate hedging
REFERENCES Allayannis, G., and J.P. Weston, 2001, “The Use of Foreign Currency Derivatives and Firm Market Value,” Review of Financial Studies, 14, 1, 243-276. Allayannis, G., J. Ihrig, and J.P. Weston, 2001, “Exchange Rate Hedging: Financial versus Operational Strategies,” American Economic Review, 91, 2, 391-395. Allayannis, G., U. Lel, and D. Miller, 2004, “Corporate Governance and the Hedging Premium Around the World,” Working paper, Darden School of Business, University of Virginia. Berger, P., and E. Ofek, 1995, “Diversification‟s Effect on firm Value,” Journal of Financial Economics, 37, 39-65. Bartram, S.M., G.W. Brown, and F.R. Fehle, 2004, “International Evidence on Financial Derivatives Use,” Working paper, University of North Carolina. Bodnar, G., C. Y. Tang, and J. Weintrop, 1997, “Both Sides of Corporate Diversification: The Value Impacts of Corporate Geographic and Industrial Diversification,” Working paper 6224, NBER. Borokhovich, K.A., K.R. Brunarski, C.E. Crutchley, and B.J. Simkins, 2004, “Board Composition and Corporate Investment in Interest Rate Derivatives,” The Journal of Financial Research, 28, 2, 199-216. Carter, D.A, D.A. Rogers, and B.J. Simkins, 2005, “Does Fuel Hedging Make Economic Sense? The Case of the US Airline Industry,” Working paper, Oklahoma State University. Dionne, G., and T. Tricki, 2004, “On Risk Management Determinants: What Really Matters?,” Working paper, HEC Montreal. Géczy, C., B.A. Minton, and C. Schrand, 1997, “Why Firms Use Currency Derivatives,” Journal of Finance, 52, 4, 1323-1354.
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The value effects of foreign currency and interest rate hedging
Graham, J.R., and D.A. Rogers, 2002, “Do Firms Hedge in Response to Tax Incentives?,” Journal of Finance, 57, 2, 815-839. Guay, W., and S.P. Kothari, 2003, “How Much do Firms Hedge With Derivatives?,” Journal of Financial Economics, 70, 423-461. Jin, Y. and P. Jorion, 2006, “Firm Value and Hedging: Evidence from U.S. Oil and Gas Produces,” Journal of Finance, 56, 2, 510-536. Kim, Y., I. Mathur, and J. Nam, 2006, “Is Operational Hedging a Substitute For or a Complement to Financial Hedging?,” Journal of Corporate Finance, 12, 834-853. Lang, L., and R. Stulz, 1994, “Tobin‟s Q, Corporate Diversification and Firm Performance,” Journal of Political Economy, 102, 1248-1280. Leland, H.E., 1998, “Agency Costs, Risk Management, and Capital Structure,” Journal of Finance, 53, 4, 1213-1243. Lookman, A., 2004, “Does Hedging Increase Firm Value? Evidence from U.S. Oil and Gas Producing Firms,” Working paper, Carnegie Mellon University. Morck, R., and B. Yeung, 1991, “Why Investors Value Multinationality,” Journal of Business, 64, 165-187. Myers, S.C., 1977, “Determinants of Corporate Borrowing,” Journal of Financial Economics, 5, 147-175. Nain, A., 2004, “The Strategic Motives for Corporate Risk Management,” Working paper, University of Michigan. Ross, M.P., 1996, “Corporate Hedging: What, Why and How,” Working paper, University of California, Berkeley.
24
The value effects of foreign currency and interest rate hedging
Servaes, H., 1996, “The Value of Diversification During the Conglomerate Merger Wave,” Journal of Finance, 51, 1201-1225. Smith, C.W., and R. Watts, 1992, “The Investment Opportunity Set and Corporate Financing, Dividend, and Compensation Policies,” Journal of Financial Economics, 32, 263-292. Stulz, R., 1996, “Rethinking Risk Management,” Journal of Applied Corporate Finance, 9, 8-24.
25
The value effects of foreign currency and interest rate hedging
Appendix 1 Variable Definitions
This table presents the definitions of variables employed for the analysis of hedging value for UK non-financial firms. It provides the variable‟s definition and the source of data for the variable. All variables are computed as three-year averages upto one year prior to the 1995 year -end, unless stated otherwise.
Variable Total assets Market value of equity Tobin‟s Q Leverage Dividend yield Foreign sales ratio Industry diversification dummy Research and development expenditure Return on capital employed Tax loss carry forwards Interest cover ratio Cash ratio Average tax rate Market-to-book value ratio Asset tangibility
Variable Description (Source) Book value of total assets less current liabilities. (Datastream) Share price multiplied by the number of ordinary shares in issue. (Datasteam) Book value of total assets minus the book value of equity plus the market value of equity divided by the book value of total assets. (Datastream) Book value of total debt and preference capital as a proportion of the book value of total debt plus the market value of equity. (Datastream) Gross dividend divided by share price. (Datastream) Foreign sales by destination divided by total sales for the year ended 1994. (Annual report) Industry diversification dummy takes on the value of one if the firm operates in more than one business segment. (Annual report) Research and development expenditure divided by total sales. (R&D Scoreboard compiled by Company Reporting Ltd.) Pre-tax profit plus total interest charges divided by total capital employed plus borrowings repayable within 1 year less total intangibles. (Datastream) A dummy variable equal to 1 if the firm has tax loss carry forwards for the year ended 1995. (Annual report) Profit before interest and tax divided by interest payments. (Datastream) Total cash and cash equivalents divided by total current liabilities. (Datastream) Published tax divided by published pre-tax profit. (Datastream) The market value of equity divided by book value of equity, where the book value of equity is measured as equity capital and reserves (excluding preference capital) less goodwill and other intangibles. (Datastream) Total assets minus current assets divided by total assets. (Datastream)
26
The value effects of foreign currency and interest rate hedging
Table 1 Empirical Studies Investigating The Relation between Hedging and Firm Value
Author(s) of Study
Géczy, Minton & Schrand (1997) Graham & Rogers (2002) Bartram, Bown and Fehle (2004)
Area of Study
Foreign currency derivatives Foreign currency derivatives All derivatives, foreign currency, interest rate & commodity derivatives – Interest rate derivatives
Country Hedging Value measure measure
US Dummy Debt capacity Debt capacity Debt capacity
Value effect
None
US 47 countries worldwide US
Dummy Dummy
None All derivatives = 0.82% FC derivatives = 0.82% IR derivatives = 1.28% CP derivatives = 1.71% Yes (not quantified)
Borokovich, Brunarski, Crutchley & Simkins (2004) Dionne & Tricki (2004) Allayannis, Irhig & Weston (1999) Allayannis & Weston (2001) Nain (2004) Bartram, Bown & Fehle (2004) Lookman (2004) Carter, Rogers & Simkins (2005) Kim, Mathur & Nam (2006)
Continuous
Debt capacity Debt capacity Tobin‟s Q Tobin‟s Q Tobin‟s Q Tobin‟s Q Tobin‟s Q Tobin‟s Q Tobin‟s Q
Gold derivatives Foreign currency hedging (financial and operational) Foreign currency
US & Canada US
Continuous Dummy
None 6.6-21.8%
US
Dummy
4.87% (3-8%) 5% 6-9% for interest rate hedging
Foreign currency US Dummy derivatives All derivatives, foreign 47 Dummy currency, interest rate & countries commodity derivatives worldwide Oil and gas price hedgers US Continuous Jet Fuel Foreign currency hedging (financial and operational) US US Dummy & Continuous Continuous
Primary risk = -15% Secondary risk = 30% 12-16% Financial hedging = 5.4%. Operational hedging = 4.8 – 23.5%
27
The value effects of foreign currency and interest rate hedging
Table 2 Foreign Currency (FC), Interest Rate (IR) and Commodity Price (CP) Hedging Activity Disclosures by UK Firms
Table 2 presents data on the number of FC (IR) hedgers amongst the sample of 412 firms. Panel A provides data on the number of FC (IR) hedging firms. A firm is defined as a FC (IR) hedger if it provides a qualitative disclosure of any FC (IR) hedging activity in its annual report. Panel B presents data on combinations of exposures hedged by FC (IR) hedgers. Panel C gives details of other exposures hedged by firms not hedging FC (IR) exposure. Panel D provides details of the use of FC (IR) derivatives for FC (IR) hedging and panel E presents a breakdown of the constituents of FC (IR) nonderivative users. Foreign Currency Panel A: FC (IR) Hedging Activity Hedging FC (IR) exposure Not hedging FC (IR) exposure No disclosure on FC (IR) hedging Total Panel B: FC (IR) Hedgers Hedging Other Exposures FC (IR) hedging only FC & IR hedging FC & CP hedging FC & IR & CP hedging Total Panel C: FC (IR) Non-Hedgers Hedging Other Exposures Not hedging any category of exposure IR hedging FC hedging FC (IR) & CP hedging CP hedging Total Panel D: Firms Using Derivatives For Hedging FC (IR) derivatives FC (IR) non-derivative user Total Panel E: FC (IR) Non-Derivative Users Not hedging any category of exposure IR hedging FC hedging FC (IR) & CP hedging CP hedging Total No. 290 6 116 412 No. 128 137 7 18 290 % 70.4 1.5 28.1 100.0 % 44.1 47.2 2.4 6.2 100.0 Interest Rate
No. 183 9 220 412 No. 28 137 0 18 183
% 44.4 2.2 53.4 100.0 % 15.3 74.9 0.0 9.8 100.0
No. % 91 74.5 28 23.0 0 0.0 0 0.0 3 2.5 122 100.0 No. 215 197 412 No. 91 28 75 0 3 197 % 52.2 47.8 100.0 % 46.2 14.2 38.1 0.0 1.5 100.0
No. % 91 39.7 0 0.0 128 55.9 7 3.1 3 1.3 229 100.0 No. 162 250 412 No. 91 21 128 7 3 250 % 39.3 60.7 100.0 % 36.4 8.4 51.2 2.8 1.2 100.0
28
The value effects of foreign currency and interest rate hedging
Table 3 Variables – Summary Statistics
Table 3 provides summary information for the variables used in the analysis. Total assets is the book value of total assets less current liabilities. Market value of equity is the share price multiplied by the number of ordinary shares in issue. Tobin‟s Q is the book value of total assets minus the book value of equity plus the market value of equity divided by the book value of total assets. Leverage is the book value of total debt and preference capital as a proportion of the book value of total debt plus the market value of equity. Dividend yield is the gross dividend divided by share price. Foreign sales ratio is the foreign sales by destination divided by total sales. Industry diversification dummy takes on the value of one if the firm operates in more than one business segment. R&D ratio is research and development expenditure divided by total sales. Return on capital employed is the pre-tax profit plus total interest charges divided by total capital employed plus borrowings repayable within 1 year less total intangibles. Tax loss carry forwards is a dummy variable equal to 1 if the firm has tax loss carry forwards. Interest cover ratio is the profit before interest and tax divided by interest payments. Cash ratio is total cash and cash equivalents divided by total current liabilities. Average tax rate is the firms published tax divided by published pre-tax profit. Market-to-book value ratio is the market value of equity divided by book value of equity, where the book value of equity is measured as equity capital and reserves (excluding preference capital) less goodwill and other intangibles. Asset tangibility is total assets minus current assets divided by total assets.
Variables Total assets (millions) Market value of equity (millions) Tobin‟s Q Leverage Dividend yield (%) Foreign sales ratio (%) Industry diversification dummy R&D ratio (%) Return on capital employed (%) Tax loss carry forwards dummy Interest cover Cash ratio Average tax rate Market-to-book ratio Asset tangibility
N
Mean
Median Std. Dev.
Min
Max
400 1010.2620 244.3600 2592.0530 11.3326 28741.2000 400 1582.0132 423.5782 3520.6053 64.6956 31658.6300 356 2.4480 1.8872 1.9864 0.4219 17.8054 364 0.1869 0.1517 0.1498 0.0000 0.8533 366 3.5812 3.5200 1.6277 0.0000 8.6533 412 34.8536 28.6500 32.0087 0.0000 96.0000 412 0.2816 0.0000 0.4503 0.0000 1.0000 412 0.8043 0.0000 1.7358 0.0000 10.0000 347 15.2185 12.0400 19.6481 -42.2133 228.9367 412 0.3641 0.0000 0.4818 0.0000 1.0000 400 16.8745 6.8876 26.3970 -20.6322 100.0000 400 0.4796 0.3083 0.6685 0.0000 6.8767 370 0.3176 0.3300 0.1079 -0.5300 1.2130 365 4.1548 2.3600 11.0746 -9.4467 164.3333 340 0.4848 0.4633 0.2215 0.0100 0.9800
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The value effects of foreign currency and interest rate hedging
Table 4 Pearson Correlation Coefficients
Table 4 reports Pearson correlation coefficients for variables used in the multivariate analysis. Total assets is the book value of total assets less current liabilities. Market value (MV) of equity is the share price multiplied by the number of ordinary shares in issue. Tobin‟s Q is the book value of total assets minus the book value of equity plus the market value of equity divided by the book value of total assets. Totals assets, MV of equity and Tobin‟s Q are transformed into natural logs. Leverage is the book value of total debt and preference capital as a proportion of the book value of total debt plus the market value of equity. Dividend yield is the gross dividend divided by share price. Foreign sales ratio is the foreign sales by destination divided by total sales. Industry diversification dummy takes on the value of one if the firm operates in more than one business segment. R&D ratio is research and development expenditure divided by total sales. Return on capital employed is the pre-tax profit plus total interest charges divided by total capital employed plus borrowings repayable within 1 year less total intangibles. Tax loss carry forwards is a dummy variable equal to 1 if the firm has tax loss carry forwards. Interest cover ratio is the profit before interest and tax divided by interest payments. Cash ratio is total cash and cash equivalents divided by total current liabilities. Average tax rate is the firms published tax divided by published pretax profit. Market-to-book value ratio is the market value of equity divided by book value of equity, where the book value of equity is measured as equity capital and reserves (excluding preference capital) less goodwill and other intangibles. Asset tangibility is total assets minus current assets divided by total assets. Correlations with an absolute value greater than 0.1 are significantly different from zero at the 5% level.
Industry Tax loss Nat. log Nat. log diversifica Return on carry total MV value Nat. log Dividend Foreign tion capital forwards Interest Average Market-toassets of equity Tobin‟s Q Leverage yield sales ratio dummy R&D ratio employed dummy cover Cash ratio tax rate book ratio Nat. log total assets 1.0000 Nat. log MV of equity 0.8274 1.0000 Nat. log Tobin‟s Q -0.5273 -0.0677 1.0000 Leverage 0.4626 0.0905 -0.6191 1.0000 Dividend yield 0.3034 0.0772 -0.3816 0.2491 1.0000 Foreign sales ratio 0.1327 0.1576 0.0751 0.0551 0.0100 1.0000 Industry diversification dummy 0.1898 0.2012 -0.0422 0.0662 0.0864 0.2327 1.0000 R&D ratio -0.0128 0.1552 0.2490 -0.1781 -0.1690 0.4667 0.0823 1.0000 Return on capital employed -0.3028 -0.0740 0.5061 -0.3736 -0.1071 -0.0211 -0.0622 0.1221 1.0000 Tax loss carry forwards dummy 0.0200 -0.0525 -0.1280 0.1603 0.0351 0.0962 -0.0138 -0.0437 -0.1845 1.0000 Interest cover -0.3505 -0.0957 0.4863 -0.5139 -0.2114 -0.1583 -0.1415 0.0902 0.4782 -0.1899 1.0000 Cash ratio -0.0632 -0.0138 0.0853 -0.0343 -0.2224 0.0228 -0.1068 0.2740 -0.0633 0.0237 0.1000 1.0000 Average tax rate 0.0633 0.1269 -0.0055 -0.0675 0.0936 0.1059 0.1081 -0.0286 0.1090 -0.2429 0.0521 -0.2160 1.0000 Market-to-book ratio -0.2162 -0.0351 0.3978 -0.1903 -0.1200 -0.0233 -0.0171 0.1248 0.5328 -0.0386 0.2752 0.1144 -0.0400 1.0000 Asset tangibility 0.4130 0.2821 -0.3382 0.2650 0.0205 -0.2749 -0.0254 -0.1967 -0.1575 -0.0890 -0.2061 -0.1029 -0.0454 -0.0881
30
The value effects of foreign currency and interest rate hedging
Table 5 Multivariate Analysis of Value Effects of Foreign Currency and Interest Rate Hedging
Table 5 presents the results for OLS regressions on the effect of FC (IR) hedging on a firm‟s market value. The dependent variable is the natural log of Tobin‟s Q, which is measured as the natural log of the book value of assets minus the book value of equity plus the market value of equity divided by the book value of assets. The numerator approximates the market value of the firm and the denominator approximates the replacement cost of assets. The regressions include control variables for size, leverage, profitability, dividend yield, foreign sales, R&D expenditure and industry diversification. Log of total assets is the natural log of book value of total assets less current liabilities. Leverage is the book value of total debt and preference capital as a proportion of the book value of total debt plus the market value of equity. Return on capital employed (ROCE) is the pre-tax profit plus total interest charges divided by total capital employed plus borrowings repayable within 1 year less total intangibles. Dividend yield is the gross dividend divided by share price. Foreign sales ratio is the foreign sales by destination divided by total sales. R&D ratio is research and development expenditure divided by total sales. Industry diversification dummy takes on the value of one if the firm operates in more than one business segment. White (1980) corrected standard errors are reported in parentheses. ***, **, * denote significance at the 1%, 5%, and 10% levels, respectively.
Independent Variables
FC derivative hedging All FC hedging IR derivative hedging All IR hedging Log of total assets Leverage ROCE Dividend yield Foreign sales ratio R&D ratio Diversification dummy -0.0866*** (0.0188) -1.4098*** (0.1829) 0.0078*** (0.0030) -0.0534*** (0.0126) 0.0010 (0.0008) 0.0281* (0.0172) 0.0236 (0.0422) 336 52.21 0.5764 -0.0863*** (0.0183) -1.4473*** (0.1865) 0.0079*** (0.0030) -0.0566*** (0.0126) 0.0007 (0.0008) 0.0307* (0.0173) 0.0195 (0.0427) 336 55.40 0.5800 Model 1 0.0850** (0.0429) Model 2
FC Hedging
Model 3 0.1468** (0.0644) Model 4 Model 5 Model 6 Model 7
IR Hedging
Model 8 Model 9 Model 10
0.1310** (0.0537)
0.1315** (0.0627)
0.1525** (0.0701) 0.1219*** (0.0421) 0.1139*** (0.0427) -0.0973*** (0.0200) -1.5054*** (0.1893) 0.0076** (0.0029) -0.0538*** (0.0125) 0.0015** (0.0007) 0.0280* (0.0168) 0.0209 (0.0423) 336 53.28 0.5788 0.1857** (0.0719) 0.1560** (0.0691) -0.1091*** (0.0234) -1.4999*** (0.2196) 0.0063* (0.0033) -0.0665** (0.0164) 0.0020** (0.0009) 0.0345* (0.0211) 0.0192 (0.0591) 226 38.26 0.5670 -0.0237 (0.1059) -0.2255*** (0.0510) -1.1933*** (0.3070) 0.0041 (0.0027) -0.0817*** (0.0298) 0.0039 (0.0026) 0.0724** (0.0315) 0.0760 (0.1321) 90 13.74 0.5893
-0.1041*** (0.0212) -1.4019*** (0.2480) 0.0072** (0.0028) -0.0689*** (0.0162) 0.0006 (0.0009) 0.0299* (0.0178) 0.0514 (0.0509) 259 40.51 0.5718
-0.0863*** (0.0189) -1.5346*** (0.2156) 0.0077*** (0.0029) -0.0557*** (0.0139) 0.0007 (0.0008) 0.0295* (0.0173) 0.0297 (0.0440) 318 51.24 0.5678
-0.1508*** (0.0309) -1.7489*** (0.3541) 0.0077** (0.0027) -0.0434** (0.0204) -0.0016 (0.0013) 0.0437* (0.0243) 0.0643 (0.0695) 176 24.57 0.5420
-0.0979*** (0.0) -1.5113*** (0.) 0.0076** (0.0029) -0.0529*** (0.0) 0.0015** (0.00) 0.0288* (0.0) 0.0230 (0.0) 336 53.28 0.5799
-0.1148*** (0.0243) -1.5973*** (0.2418) 0.0060* (0.0032) -0.0621*** (0.0181) 0.0020** (0.0010) 0.0359* (0.0213) 0.0223 (0.0631) 211 35.47 0.5692
No. of observations F-statistic Adj R2
31
The value effects of foreign currency and interest rate hedging
Table 6 Quantifying the Debt Tax Benefit of Foreign Currency and Interest Rate Hedging
Table 6 summarises the contribution of the debt tax benefit associated with FC (IR) hedging to a firm‟s market value. The value estimates are calculated for each firm that hedges FC (IR) exposure by taking the product of the estimated influence of the FC (IR) hedging on the leverage ratio (i.e., the estimated coefficient on the FC (IR) variable in the second-stage leverage regression), the firm‟s average tax rate, and the value of total debt. This value is divided by the market value of equity (including preferred stock) plus the book value of debt. Since average tax rates are most likely lower than marginal tax rates these calculations may understate the increase in the value of the firm due to FC (IR) hedging.
Col. 1 All FC Hedgers (NH include other hedgers) 0.0494 (0.110) 2 All FC Hedgers (NH exclude other hedgers) 0.1867 (0.000) 1.2937% 1.0462% 1.0528% 5.5097% 3.1034% 2.3272% 1.6356% 0.6081% 0.2688% 0.1643% 0.0796% 319 254 0.3837 3 FC Derivative users (NH include other hedgers) -0.0922 (0.000) 4 FC Derivative users (NH exclude other hedgers) 0.0938 (0.000) 0.6304% 0.4972% 0.5546% 2.9461% 1.5473% 1.1419% 0.7849% 0.2926% 0.1294% 0.0781% 0.0314% 260 190 0.3694 5 FC Only Hedgers (NH exclude other hedgers) 0.1388 (0.000) 0.7784% 0.6277% 0.7256% 4.0973% 1.7300% 1.5963% 0.9754% 0.3631% 0.1222% 0.0764% 0.0465% 176 107 0.3597 6 All IR Hedgers (NH exclude other hedgers) 0.5067 (0.000) 3.9982% 3.4936% 2.7712% 14.1859% 8.3921% 7.0970% 5.0727% 2.1663% 1.4489% 0.6953% 0.4221% 227 160 0.5231 7 IR Derivative users (NH exclude other hedgers) 0.7469 (0.000) 5.9846% 5.2847% 4.0352% 20.9136% 12.3316% 10.5024% 7.8065% 3.2665% 2.1713% 1.0248% 0.6222% 212 144 0.5586 8 FC & IR Hedgers (NH exclude other hedgers) 0.2365 (0.000) 1.8670% 1.5745% 1.3601% 6.6224% 4.3531% 3.2989% 2.1986% 0.0987% 0.6876% 0.3280% 0.1970% 215 147 0.4158 9 IR Only Hedgers (NH exclude other hedgers) 0.6289 (0.000) 5.0889% 5.1883% 2.9303% 10.4459% 10.4459% 8.9581% 7.4712% 2.8105% 0.6708% 0.5534% 0.5534% 91 19 0.8734
Estimated coefficient on FC (IR) hedging in 2nd stage leverage regression Mean Median Std. Dev. 99th percentile 95th percentile 90th percentile 75th percentile 25th percentile 10th percentile 5th percentile 1st percentile Number of observations Number of hedgers Adj R-Sq
32
The value effects of foreign currency and interest rate hedging
Middlesex University Business School Economics Discussion Paper Series
(Copies of papers listed below are available on request from The Research Office, Middlesex University Business School, The Burroughs, Hendon, NW4 4BT.)
1. "Energy Transition in Western Europe, 1970-1990", Sylvanus Madujibeya, April 1992. 2. "On the US-Japan Trade Imbalance", Jitendralal Borkakoti, April 1992. 3. "Europe and World Trade", Klaus Heidensohn, April 1992. 4. "The Mixed Economies of the West and the Peripheral Countries of Europe: The Case of Greece", Eleni Paliginis, June 1992. 5. "The Labour Market and Employment", Maria Moschandreas, January 1993. 6. "Regional Policies in the EC", Eleni Paliginis, September 1992. 7. "Economic Contributions to Personnel Management", Maria Moschandreas January 1993. 8. "Trade Aspects of '1992'", Klaus Heidensohn, July 1993. 9. "A Non-inflation Tax Rebate", Michael Connock, April 1994. 10. "Gender and Sectarianism: The Northern Ireland Labour Market 1971-1991", Rosemary Sales, May 1994. 11. "Trade Policy of the European Communities", Klaus Heidensohn, September 1994. 12. "Transaction Cost Economics: An Evaluation of the Role of Opportunism" Maria Moschandreas, October 1994. 13. "Macroeconomic Convergence in Europe: The Retreat from Maastricht", Michael Connock, Alan G Gully and Harry J Hillier, February 1995. 14. "Tariff Policy, the Terms of Trade and the Foreign Asset Position: A Dynamic Two-Country Analysis", Dirk Willenbockel, December, 1995. 15. "Technological Progress and Capital Accumulation Together in a Dynamic Model of International Trade", Jitendral Borkakoti, December, 1995. 16. "Contracts, Competition and Performance in the UK Defence Industry", Paul Dunne and Steve Schofield, December, 1995. 17. "East-West Trade", Klaus Heidensohn, December, 1995.
1
The value effects of foreign currency and interest rate hedging
18. "Eden, the European Defence Community and Dulles' 'agonising reappraisal', 1953-54", Martin Dedman and Clive Fleay, February, 1996. 19. "France, the Indo-China War and the European Defence Community", Martin Dedman and Clive Fleay, February, 1996. 20. "Modelling Exchange Rates: Monetary and Currency Substitution Models Under the European Monetary System", Yonghao Pu and Wen Zhang, February, 1996. 21. "The Interwar French Franc, 1919-1936: Crisis, Stabilisation and Devaluation", Leonard Gomes, February, 1996. 22. "Globalisation of Production and Industrialisation in the Periphery: The Case of the EU and NAFTA", Philip Arestis and Eleni Paliginis, February, 1996. 23. "An Analysis of the X-using Technological Progress in the X-intensive Sector", Jiten Borkakoti, March, 1996. 24. "When Do Firms Go In For Growth By Acquisitions?", Donald A. Hay and Guy S. Liu, March, 1996. 25. "A Critique of the Feminist Response to Adam Smith", Ken Jackson, March, 1996. 26. "The Economics of Interest Rate Swaps: A Survey", Amrit Judge, July, 1996. 27. “Restricted Market Participation and the Market Provision of Basic Knowledge with Long Gestation Periods”, Alvin Birdi and Paul Madden, October, 1996. 28. “Keynes, the Transfer Problem and German Reparations” Dr Leonard Gomes, June 1997. 29. Economic Integration and the Future of the Welfare State in the European Union”, Eleni Paliginis, July, 1997. 30. “Cost Behaviour of Chinese State-owned Manufacturing Enterprises in the 1980s”, Donald A Hay, Guy S Liu, July 1997. 31. “Minimum Wages versus In-Work Income Transfer Programmes: A Theoretical Appraisal”, Duncan Watson, July 1997. 32. “On Measurable Dynamic Effects of Integration” Dirk Willenbockel, July 1997. 33. “The Economics of the Arms Trade in the UK” Paul Dunne, Ron Smith, August 1997. 34. “The Economics of War and Peace” Paul Dunne, September 1997. 35. “The Relationship Between Stock Returns, Systematic Risk, and Market Value: The Case of the Athens Stock Exchange” Spyros I. Spyrou, October 1997.
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The value effects of foreign currency and interest rate hedging
36. “Volatility Spillovers in Spot and Forward Foreign Exchange Markets” Peijie Wang, Ping Wang, October 1997. 37. “Decisions Not to Devalue Sterling - 1964-67: The Role of The Civil Service” Mark McGann, November 1997. 38. “Common Trends in Emerging Equity Markets” Ian Garrett, Spyros I. Spyrou, December 1997. 39. “Initial Conditions for a Random Walk” Dimitrios V. Vougas, January 1998. 40. “The Tariff Reform Debate (1903)” Dr Leonard Gomes, February 1998. 41. “UK Wage Underpayment: Implications for the Minimum Wage”* Duncan Watson, March 1998. 42. “Cognitive Dissonance, Job Search and Persistent Low Wages” Alvin Birdi & Duncan Watson, May 1998. 43. “Military Spending and Economic Growth in South Africa: A Causal Analysis*” Paul Dunne & Dimitrios Vougas, June 1998. 44. “The Demand for Military Spending in South Africa” Peter Batchelor, Paul Dunne & Guy Lamb, July 1998. 45. “Recent Developments in the Predictive Assessment of Dynamic Integration Effects: A Critical Appraisal Dirk Willenbockel, August 1998. 46. “The Restructuring of South Africa‟s Defence Industry” Peter Batchelor & Paul Dunne, August 1998. 47. “Testing PPP For Asian Economies During the Recent Floating Period” Ping Wang, August 1998. 48. “Intervention in the Economy: Trade offs Between Output and Volatility” Ephraim Clark & Octave Jokung, September 1998. 49. “A Dual-Price Demand Function for Economic Transition in China” Guy Shaojia Liu, September 1998. 50. “Is “Patience” a Desirable Virtue for Evolving Oligopoly Markets? A Theoretical and Empirical Analysis of Pricing Behaviour in the UK Contract Gas Market” Joshy Z Easaw & David J Smyth, October 1998. 51. “Public Debt, Welfare and Perpetual Yough: The Ghosh Paradox Revisited” Dirk Willenbockel, November 1998. 52. “Racial Wage Discrimination and the End of Apartheid in South Africa: A NonDiscriminatory Approach” Timothy Hinks, November 1998.
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The value effects of foreign currency and interest rate hedging
53. “In Search of the Poor” Duncan Watson, November 1998. 54. “Dynamic Applied General Equilibrium Trade Policy Analysis in the Presence of Foreign Asset Crown-Ownership” Dirk Willenbockel, November 1998. 55. “The Effect of Barter on the Demand for Money: An Empirical Analysis” Akbar Marvasti & David Smyth, November 1998. 56. “Defence Spending and Economic Growth: A Causal Analysis for Greece and Turkey” Paul Dunne, Eftychia Nikolaidou & Dimitrios Vougas, December 1998. 57. “The Allocation of UK Government Expenditure: A Forward Looking Dynamic Model” Paul Dunne & John Hunter, January 1999. 58. “Military Industrial Cooperation: Saab, BAe and the JAS 39 Gripen Joint Venture” Bjorn Hagelin, January 1999. 59. “Interest Rate Liberalisation and Equity Market Volatility: The Case of Malaysia and Thailand” Spyros Spyrou & Dimitrios Vougas, January 1999. 60. “Sources of Movements in Real Exchange Rates - Evidence from Pacific Basin Economies” Ping Wang, January 1999. 61. “Corporate Performance and Military Production in South Africa” Peter Batchelor, Paul Dunne and Sepideh Parsa, February 1999. 62. “Military Spending and Economic Growth in South Africa” Peter Batchelor, Paul Dunne and David Saal, February 1999. 63. “The Determinants of the Reputations of U.S. Economics Departments: Pages Published, Citations and the Andy Rooney Effect” David J Smyth, February 1999. 64. “Military Expenditure and Economic Growth: A Demand and Supply Model for Greece, 1960-1996” Paul Dunne & Eftychia Nikolaidou, March 1999. 65. “Identifying South Africa‟s Defence Industrial Base” Peter Batchelor, Paul Dunne and David Saal, March 1999. 66. “Developing Realistic Methodology: How New Dialectics Surpasses the Critical Realist Method for Social Science” Andrew Brown, March 1999. 67. “A Multinomial Logit Non-Discriminatory Approach to Estimating Racial Wage and Occupational Discrimination” Timothy Hinks and Duncan Watson, March 1999. 68. “A Test of the Cost and Benefits of Policy Intervention” Ephraim Clark & Octave Jokung, April 1999. 69. “Strategic Parameters for Capital Budgeting When Abandonment Value is Stochastic” Ephraim Clark & Patrick Rousseau, April 1999.
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The value effects of foreign currency and interest rate hedging
70. “Partial Shirking Within Efficiency Wage Theory: The Possibility of Long-Run Racial Discrimination” Timothy Hinks, April 1999. 71. “The Impact of Defense Procurement on U.S. Manufacturing Productivity Growth” David S Saal, April 1999. 72. “Military Spending and Economic Growth in Greece, A Multi-Sector Analysis, 19611996” Eftychia Nikolaidou, May 1999. 73. “UK Government Expenditure Cycles and Elections: An Analysis of the Conservative Government, 1979-1997” Joshy Easaw, Dean Garratt & David Smyth, May 1999. 74. “Arms Race Models and Econometric Applications” Paul Dunne, Eftychia Nikolaidou and Ron Smith, July 1999. 75. “Financial Liberalisation and Stock Market Volatility in Selected Developing Countries” Konstantinos Kassimatis, October 1999. 76. “Stock and Credit Market Expansion and Economic Development in Emerging Markets: Further Evidence Utilising Cointegration Analysis” Konstantinos Kassimatis, Spyros I Spyrou, October 1999. 77. “Racial Wage Discrimination and the End of Apartheid in South Africa: A Multilateral Approach” Timothy Hinks, October 1999. 78. “Real Exchange Rate Fluctuation Analysis: Empirical Evidence from Six East Asian Countries” Ping Wang, Paul Dunne, January 2000. 79. “Industrial Participation, Investment and Growth: The Case of South Africa‟s Defence Related Industry” Peter Batchelor, Paul Dunne, February 2000. 80. “Greece: Military Expenditure, Economic Growth and the Opportunity Cost of Defence” Emmanuel Athanassiou, Christos Kollias, Eftychia Nikolaidou, Stavros Zografakis, March 2000. 81. “Defence Spending and Economic Growth in South Africa: A Supply and Demand Model” Paul Dunne, Eftychia Nikolaidou & Andre Roux, March 2000. 82. “The Impact of Arms Production on the South African Manufacturing Industry” Alvin Birdi, J Paul Dunne & David S Saal, April 2000. 83. “Military Expenditure and Employment in South Africa” Paul Dunne & Duncan Watson, April 2000. 84. “Are Hodrick-Prescott „Forecasts‟ Rational?" J.C.K. Ash, J.Z. Easaw, S.M. Heravi & D.J. Smyth, May 2000. 85. "The Post-war Productivity Failure: Insights from Oxford (Cowley)" Sue Bowden, James Foreman-Peck & Tom Richardson, June 2000.
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The value effects of foreign currency and interest rate hedging
86. "Exchange Rate Illusions or, How Not to Pay for the War: The Debt Constraint on British Economic Policy in the 1920s" James Foreman-Peck, July 2000. 87. "Entrepreneurship and Social Transformation" James Foreman-Peck, Julia A Smith, July 2000. 88. “The Path Dependence of Technological Trajectories – The Battery Electric Vehicle” James Foreman-Peck, October 2000. 89. “Germany Wage Underpayment: An Investigation into Labour Market Inefficiency and Discrimination” Peter Dawson, Timothy Hinks, Duncan Watson, November 2000. 90. “The Russian Transition through the Historical Looking-Glass: Gradual versus Abrupt Decontrol of Economic Systems in Britain and Russia” Dr Christopher Davis, Dr James Foreman-Peck, November 2000. 91. “Strategic Responses to Regulatory Policies: What Lessons Can Be Learned from the UK Contract Gas Market?” Hux Dixon & Joshy Easaw, November 2000. 92. “How Accurately Does Consumer Sentiment Forecast Personal Consumption and What Are the Implications for Consumption Behaviour? Joshy Easaw, Dean Garratt & Saeed M Heravi, December 2000. 93. “Technology Accumulation in India‟s Space Programme Ground Systems: The Contribution of Foreign and Indigenous Inputs” A Baskaran, December 2000. 94. “Competence Building in Complex Systems in the Developing Countries: The Case of Satellite Building in India” A Baskaran, December 2000. 95. “Convergence of China‟s Regional Incomes: 1952-97” Z Zhang, A Liu & S Yao, March 2001. 96. “Country Financial Risk and Stock Market Performance: The Case of Latin America” E Clark & K Kassimatis, June 2001. 97. “A Comparison of Relative Mobility in Germany and the UK” Michael Brookes, July 2001. 98. “Defence Procurement and Regional Industrial Development in South Africa: A Case Study of the Eastern Cape” Paul Dunne and Richard Haines, August 2001. 99. “The Demand for Military Spending in Developing Countries” Paul Dunne and Sam Perlo-Freeman, September 2001. 100. “Military Spending and Economic Growth in the Peripheral Economies of Europe: A Causal Analysis for Greece, Spain and Portugal” Paul Dunne and Eftychia Nikolaidou, October 2001. 101. “An Inter-temporal Analysis of Gender Wage Differentials and Discrimination in Germany and the UK” Michael Brookes, January 2002.
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The value effects of foreign currency and interest rate hedging
102. “Efficiency of Large Banks in the Single European Market” Barbara Casu and Claudia Girardone, November 2002. 103. “Hedging and the Use of Derivatives: Evidence From UK Non-Financial Firms” Amrit Judge, November 2002. 104. “The Determinants of Foreign Currency Hedging by UK Non-Financial Firms” Amrit Judge, November 2002. 105. “Specification Choice and Robustness in CGE Trade Policy Analysis with Imperfect Competition.” Dirk Willenbockel, December 2002. 106. “How Firms Hedge Foreign Currency Exposure: Foreign Currency Derivatives versus Foreign Currency Debts” Amrit Judge, September 2003. 107. “Corporate Risk Management: A Theoretical Appraisal” Amrit Judge, November 2003. 108. “Who Do Firms Hedge? A Review of the Evidence” Amrit Judge, November 2003. 109. “The Price Normalisation Problem in General Equilibrium Models with Oligopoly Power: An Attempt at Perspective” Dirk Willenbockel, June 2004. 110. “A Monetary Approach to the Sterling-US Dollar Exchange Rate” Marie Wong, October 2004. 111. “The Asian Financial Crisis and the Integration of Regional Stock Markets” Marie Wong, November 2004. 112. “The Determinants of Interest Rate Hedging Practices of UK Firms” Amrit Judge, November 2004. 113. “Motives for Corporate Hedging: Evidence from the UK” Amrit Judge, July 2005. 114. “The Determinants of Foreign Currency Hedging: Does Foreign Currency Debt Induce a Bias?” Amrit Judge, July 2005. 115. “Economic Growth in the Presence of FDI: The Perspective of Newly Industrialising Economies” Shujie Yao & Kailei Wei, October 2005. 116. “Linking Productivity to Trade in the Structural Estimation of Production within UK Manufacturing Industries” Marian Rizov & Patrick Paul Walsh, June 2006. 117. “Exchange Rate Volatility and Exports: Evidence from the ASEAN-China Free Trade Area” Myint Moe Chit, July 2006. 118. “The Determinants of Corporate Hedging: An Empirical Study of Hong Kong and Chinese Firms” Ephraim Clarka, Amrit Judgeb,, Wing Sang Ngaib Sept 2006
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The value effects of foreign currency and interest rate hedging
119. “The Rise of Obesity in Transition Economies: Theory and Evidence from the Russian Longitudinal Monitoring Survey” Sonya K. Huffman* and Marian Rizov, April 2007 120. “Corporate Capital Structure and How Soft Budget Constraints May Affect It. Marian Rizov, May 2007 121. “The Value Effects of Foreign Currency and Interest Rate Hedging: The UK Evidence” Yacine Belghitar, Ephraim Clark and Amrit Judge , June 2007
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