MNC.21

					        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.




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               Electronic copy available at: http://ssrn.com/abstract=1523125
1. INTRODUCTION
       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

survival.

       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



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               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.




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       2. CORPORATE HEDGING THEORIES AND FOREIGN CURRENCY

DEBT:

       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

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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

to.

       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


                                                                                       5
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).


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       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.




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       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.


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       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



                                                                                         9
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.

       Finally, Clark and Judge (2005, 2008) delve deeper into the analysis of currency

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


                                                                                         10
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

foreign currency or this instrument and derivatives.




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