Corporate Hedging Theories and Foreign Currency Debt:
A review of the evidence
ABSTRACT: A variety of theories have been developed regarding optimal hedging
which attempt to explain the reasons firms may be interested in hedging. The study of
hedging for exchange rate risk has usually focused on the use of derivatives and to a
lesser extent on the use of other types of financial and operational hedging. Debt
denominated in foreign currency acts as a natural hedge to the firm's exposure in that
currency. This paper has reviewed the main arguments from these theories and several
studies which have attempted to determine if firms behave according to the principles
established in the theories of optimal hedging when companies use foreign currency
debt as currency hedging instrument.
KEY WORDS: foreign currency debt, risk management, currency rate risk.
Electronic copy available at: http://ssrn.com/abstract=1523125
The continuous movement in foreign exchange rates means that firms that
operate internationally have exposure to exchange rate risk. Poor management of this
exposure can have a significant influence on the value of the company and on its very
Although Modiglianni and Miller (1958) showed that the value of a company
and financial decisions were not related in the absence of imperfect conditions, more
recently a variety of studies have shown that hedging can increase the value of the firm,
if imperfections exist in capital markets. For this reason, a variety of theories have been
developed regarding optimal hedging which attempt to explain the reasons firms may be
interested in hedging. The hedging decision may be the result of managers’ aversion to
risk as Stulz (1984) explains. Nevertheless, other reasons may drive firms to hedging
such as tax structure or the transaction costs associated to bankruptcy (Smith and Stulz,
1985). In addition, in so far as hedging reduces the likelihood of bankruptcy, the firm
may increase its level of debt (Stulz, 1996 and Leland,1998) and it is possible to
mitigate problems of underinvestment, due to the fact that hedging reduces cash flow
volatility leading to better rates for financing (Froot, Scharfstein and Stein, 1993).
Finally, DeMarzo and Duffie (1995) indicate that hedging is optimal – even if
shareholders can hedge for themselves – when the managers have insider information
about the firms’ future cash flows which is not available to the shareholders. For this
reason, some firms choose to hedge by using derivatives or other internal means such as
foreign currency debt, leads & lags, netting or “own currency”.
The study of hedging for exchange rate risk has usually focused on the use of
derivatives and to a lesser extent on the use of other types of financial and operational
hedging. Debt denominated in foreign currency acts as a natural hedge to the firm's
Electronic copy available at: http://ssrn.com/abstract=1523125
exposure in that currency, since companies with income in foreign currency can borrow
in that currency to perform cash flow matching and, therefore, eliminate or reduce
exchange rate risk.
2. CORPORATE HEDGING THEORIES AND FOREIGN CURRENCY
Now, we will summarize the main theoretical approaches regarding the currency
hedging with foreign currency debt according to hedging theories.
Companies with larger risk exposure through foreign sales benefit more from
using hedging instruments. However, Aabo (2006) clarifies the interpretation of this
proxy (foreign sales) by indicating that the time horizon of the exposure affects the
preference for hedging with derivatives or with foreign debt. Thus, when the exposure is
more direct and short term, which is usually associated to higher levels of exports,
companies tend to opt for derivatives instead of foreign debt. Aabo (2006) clarifies that
due to the fact that it is not possible to know the proportion of foreign sales made up of
direct sales in foreign currency, which are clearly a source of exchange rate risk, and
which are sales from foreign subsidiaries quoted in the local currency, which are not a
source of currency risk for the subsidiary but are for the business group, there may be a
weak relation between exchange rate exposure approximated by percentage of foreign
sales and the foreign debt issue. In fact, Allayannis and Ofek (2001) found evidence that
American exporters preferred derivatives for hedging their exposure.
Respect to foreign currency exposure, the existence of subsidiaries in foreign
countries can also be considered a greater commitment to international activity. For this
reason, Aabo (2006) show that foreign subsidiaries should also be considered as a proxy
for level of foreign currency exposure.
The access to external financing is more difficult and costly for companies with
greater information asymmetry (Froot et al. 1993). Since that hedging represents a
greater guarantee of future cash flow, it may be favourable for obtaining external
financing at better rates, and, as a result, may mitigate potential underinvestment
problems. As Bessimber (1991) indicates, an adequate hedging strategy over time
allows creditors to require a lower remuneration from the company. On the other hand,
the existence of information asymmetries will make it more difficult and/or expensive
to use foreign debt as a hedging instrument. Information asymmetry is more likely in
startups, smaller companies, those with a greater proportion of intangible assets, and
those that invests more heavily in R&D. Moreover, an elevated ownership by
institutions implies less likelihood of hedging because there is less information
asymmetry as a result of the greater control that the management of the firm is subject
Moreover, if a firm is presented with profitable investment opportunities,
underinvestment problems may arise when funding is limited or conditions are
unfavourable. This situation is more likely to occur when the firm has significant
growth opportunities so companies with more growth opportunities are more likely to
adopt a hedging program in order to reduce variability in expected-cash flow. In
contrast, Aabo (2006) proposes a negative relation between growth opportunities and
use of foreign debt. According to this author, a company having less growth
opportunities can better estimate its long term exchange rate exposure, since its value
depends more on tangible or present assets. Since companies tend to use foreign debt to
hedge their long term exposure, companies with less growth opportunities will be more
prone to use this hedging instrument because they will be able to better forecast future
exchange rate risk with which to match cash outflow generated by repaying the debt.
Hedging reduces variations in company value because it reduces the likelihood
of financial distress and the related costs (Smith and Stulz, 1985). Thus, the likelihood
of hedging increases along with the likelihood of bankruptcy (Smith and Stulz, 1985;
Stulz, 1996, Leland, 1998) and Nance et al. (1993) established the hypothesis that this
likelihood of bankruptcy increases along with leverage. Therefore, Keloharju and
Niskanen (2001) established a positive relation between debt level and the volume of
foreign debt used by the company. Similarly, Aabo (2006) indicated that if the company
has a predisposition to use debt, it can be assumed that they will also have a
predisposition to use foreign debt. Nevertheless, Clark and Judge (2008) questioned the
use of leverage as a proxy for the likelihood of financial distress when companies use
foreign debt, indicating that leverage is not as important as the ability to repay the debt.
For this reason, they proposed the joint use of other variables such as credit rating, the
interest coverage ratio, the payback capacity and the tax loss carry forwards.
Moreover, if a company has a high volume of resources generated internally
there may be less bankruptcy problems. Then, the reputation of highly profitable
companies gives them better access to external financing and, therefore, they may be
interested in raising foreign debt to hedge exchange rate risk. In these cases, debt
emission does not represent a high financial risk and, nevertheless, means a reduction in
exchange rate risk.
Smith and Stulz (1985) showed that hedging could reduce expected tax
payments when firms are subject to a progressive tax system, that is, a tax system which
is progressive and/or subject to possible tax deductions or compensation for losses in
future accounting periods. This is because hedging generates greater performance
stability and entails a reduction in the quantity of taxes to be paid.
When managers assume high risk in a business -- by dedicating all their human
capital and often a significant portion of their financial capital as well-- those managers
may be interested in hedging the firm’s profitability because possible losses or
variations in value will directly affect the managers’ own assets, and perhaps their job
as well (Smith y Stulz, 1985).
Empirical research supports the claim that setting up and managing a hedging
program is subject to significant economies of scale. These economies of scale are
associated to the high fixed costs of training employees (experience), the need for
technical resources, and the development of a hedging strategy. Thus, the size variable
constitutes a key factor in the analysis because the foreign debt issue can be an
inflexible and expensive hedging option for smaller companies (Aabo, 2006).
Larger companies have greater resources, and their financial reputation and
experience can give them easier and cheaper access to foreign debt markets. However,
Nandy (2002) indicates that the size effect could be ambiguous. According to this
author, smaller companies tend to find themselves in progressive tax brackets and are
more affected by the costs of financial distress; therefore, they will be more prone to
hedge with foreign debt. Furthermore, larger companies tend to be more diversified
which acts as an operational hedging system, and means that they may not use foreign
debt as a hedging instrument. In light of this, the relation between size and debt usage
would be negative.
Finally, the company’s economic sector also constitutes a key variable in the
choice of foreign debt as a hedging mechanism, although it has only been included in
the study by Aabo (2006). Economic sectors characterized by long-term investments
and projects should be more likely to have a time-horizon that corresponds to the uses
of foreign debt than firms in sectors characterized by short-term investments.
3. RELATED LITERATURE
Several studies have shown that hedging can increase company value (Shapiro,
2003; Froot et al., 1993; Bessembinder, 1991; Shapiro y Titman, 1986; Smith y Stulz,
1985) so authors such as Stulz (1984), Smith and Stulz (1985), Bessembinder (1991),
Froot et al. (1993), DeMarzo and Duffie (1995) and Leland (1998) developed the
optimal hedging theories to explain the reasons why companies may be interested in
hedging their risks. Most of these arguments are based on value creation and refer to
factors like information asymmetries, under-investment problems, costs of financial
distress, managerial risk aversion, and the existence of a convex tax system.
The study of why companies hedge has led to numerous publications that
attempt to determine if corporate behaviour is in line with the principals of these
theories when they use derivatives products. This research ranges from generic analysis
for the non-financial business sector to others focusing on specific sectors or types of
risk, which find that the factors explaining hedging differ according to the type of risk
and the market under analysis. The latter group includes studies that analyze exchange
rate risk (Wysocki, 1995; Mian, 1996; Geczy et al., 1997; Howton and Perfect, 1998;
Allayannis and Ofek, 2001; Graham and Rogers, 2000; Hagelin, 2003; Otero et al.,
2008; among others), interest rate risk (Mian, 1996; Howton and Perfect, 1998; Graham
and Rogers, 2000) and/or commodity price risk (Tuffano, 1996; Hauslhalter, 2000). In
general, these studies showed that market imperfections, associated either the creation
of value or managers’ aversion to risk, are responsible for the existence of incentives to
hedge with derivatives. Nevertheless, while these incentives are necessary to justify
hedging activities, the existence of sufficiently large risk exposures and the costs related
to hedging strategies have as well to be considered when ultimately evaluating the
hedging decision (Gezcy et al., 1997; Muller and Verschoor, 2005) with derivatives.
However, derivatives are not the only hedging option. The issue of foreign debt
can act as a natural hedging instrument for companies with foreign income. In this case,
the flow of liabilities destined to repaying the principal and interest of the foreign debt
would be compensated by income in that currency generated by foreign operations.
Only more recently there are studies focused on the analysis of using foreign
debt itself to hedge exchange rate risk, assuming that the determinants are the same as
for derivatives usage, that is to say, those based on the optimal hedging theories.
Among these group of studies is the work by Allayannis and Ofek (2001) for the
American market. Their results showed that companies with greater size and greater
foreign currency exposure were more likely to use foreign debt, while only the level of
exposure acted was an important determinant for the volume issued.
A study involving Europe was made by Keloharju and Niskanen (2001). Using a
sample of Finnish firms, these authors found that firms raise foreign debt in order to
hedge their foreign currency exposures and to borrow when foreign interest rates are
low. Likewise, they detected that the largest companies had better access to
international financial markets and, therefore, were more likely to use foreign debt.
A multi-country study by Nandy (2002) analyzed U.S. dollar denominated bank
debt by a sample of British and Canadian firms. This author found that a firm's decision
to raise U.S. dollar denominated debt is significantly related to its exposure to the U.S.
market and with the existence of tax loss carry forwards.
For a sample of American companies, Kedia and Mozumdar (2003) examined
the factors determining the emission of debt in the ten most widely-used currencies. The
results showed that foreign debt issue is positively related to foreign activity and
company size. In addition, they found that those companies that reduce their problems
of information asymmetry, by providing more and better information to their foreign
investors, are more likely to issue foreign debt.
Judge (2006, 2007) analyzed the determinants of hedging for British non-
financial companies and his results showed that the hedging decision is related to the
existence of scale economies, the costs of financial distress, the level of foreign
currency exposure and liquidity. In addition, the author evaluated how hedging was
used so he found that companies with greater liquidity and size as well as those with tax
loss carry forwards were more likely to hedge with derivatives. With respect to the type
of exposure, the likelihood of using derivatives had a significant negative relation with
the existence of foreign assets, while this relation was positive for firms that use foreign
debt or both. When exposure stemmed from export and/or import activity, hedging only
with derivatives was more likely. Likewise, companies with greater exposure to interest
rates or with greater likelihood of financial distress were more likely to hedge only with
derivatives, or with a combination of these and other hedging instruments.
Also in the European context, using a sample made up of non-financial Danish
companies listed, Aabo (2006) analyzed the determinants of the relative importance of
foreign debt compared to derivatives for hedging exchange rate risk. This author found
that the importance of foreign debt in currency hedging was positively related to foreign
currency exposure, company size, and the costs of financial distress, while it was
negatively related to information asymmetries.
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hedging practices in the British market using the same study sample as Judge (2006,
2007). Thus, Clark and Judge (2005) obtained that the hedging decision was
significantly and positively related to under-investment problems, the costs of financial
distress, the level of exposure and economies of scale, and that it was negatively related
to liquidity. A second study by Clark and Judge (2008) analyzed the joint use of
derivatives and foreign debt to delve deeper into the hypothesis that hedging aims to
avoid costs of financial distress. They presented two possible reasons for the
inconclusive results obtained in previous studies regarding the influence of this factor: a
classification problem resulting from identifying hedging companies as only those that
use derivatives, as Judge (2006, 2007) had already pointed out, and the fact that debt
level is not a good proxy for costs of financial distress. They propose the simultaneous
use of several indicators as proxies for costs of financial distress (the interest coverage
ratio, if the company has net positive financial income, company credit rating and tax
losses carried forward). Their results show that the leverage variable is a significant
determinant only when hedging companies are considered to be those that use debt in
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