TECHNICAL EXCELLENCE

DERIVATIVES IN FOREIGN EXCHANGE RISK MANAGEMENT AND FIRM VALUATION

DON’S COLUMN: USAGE OF DERIVATIVES IN FOREIGN EXCHANGE RISK MANAGEMENT AND FIRM VALUATION

LEE KIN WAI

REDUCE COST OF CAPITAL, INCREASE ECONOMIC PROFITABILITY

Firms with substantial foreign currency transactions expose themselves to the risk of loss in net income and cash flows arising from adverse changes in the foreign currency exchange rate. To mitigate this risk, firms often hedge their foreign currency exposure using derivative instruments such as forward contracts and currency options.

This paper examines the usage of financial derivatives by listed firms in Asia as a corporate risk management strategy to mitigate their foreign exchange risk exposure. First, we examine the firm-level characteristics that affect the intensity of derivatives usage (that is, what are key drivers that lead firms to use more financial derivatives to hedge their foreign exchange risk?). Second, we examine whether derivatives usage and hedging affect firm valuation.

The sample consists of 520 listed industrial firms in Hong Kong, Indonesia, Korea, Philippines, Taiwan, Thailand, Malaysia and Singapore for the period 2007 to 2014. The sample comprises firms in various industries such as electronics and electrical equipment, shipping, petrochemicals, manufacturing industrial products, transportation, consumer products and business services. We classify firms as users or non-users of derivatives based on their annual report disclosures on corporate financial risk management and derivatives usage. On average, for the whole sample, 43% of the firms hedge foreign exchange risk. In general, the firms typically use forward contracts, futures contracts, currency swaps and options to manage foreign exchange risk.

DETERMINANTS OF DERIVATIVES USAGE

First, we find that derivative users tend to have higher foreign exchange exposure such as high foreign sales as a percentage of total sales and foreign assets as a percentage of total assets. For example, derivative users have about 27% to 64% of their total sales from foreign operations. Similarly, derivative users also have a substantial portion of their total assets (ranging from 11% to 73%) located in various countries outside their home country. Sensitivity analysis indicates that a 10% adverse movement in foreign exchange rates can potentially reduce the net profit of these firms by 4% to 18% if these firms do not hedge their foreign exchange risk exposures.

Second, we find that firms that use derivatives (users) are significantly larger in size than non-users. This result suggests that larger firms, with higher organisational complexity (such as many business segments) and higher geographic spread (such as operating in many countries) have greater exposure to financial risk. Furthermore, large firms are more likely to have formal financial risk management programmes that define risk management objectives, risk tolerance, specific policies to mitigate financial risk and responsibilities to monitor the risk exposures. For example, some firms disclose that they hedge about 40% to 65% of their foreign currency exposures under their financial risk management programmes.

Third, we find that the intensity of derivatives usage is positively associated with operating profitability. This result is intuitive as profitable firms are more likely to have greater resources to implement financial risk management programmes.

Fourth, our results indicate that hedging intensity is positively associated with the firm’s growth options and investment opportunities. Using various measures of growth such as sales growth, the ratio of capital expenditure to sales and the proportion of intangible assets to total assets, we find that derivative users usually have more investment opportunities. This result is consistent with the notion that by reducing the variation of cash flow realisations, hedging facilitates high-growth firms to maintain sufficient funds to finance profitable future investments. In addition, we also find that the beneficial role of financial hedging to lower cash flow variability is especially important for those firms with weak short-term liquidity.

Fifth, we find that derivative users have higher debt-to-assets ratio than non-users. In general, the probability of financial distress increases with corporate debt (leverage). Thus, firms with higher expected costs of financial distress are more likely to use derivatives for hedging purposes. In these cases, hedging helps the firms (borrowers) to reduce the likelihood of violating debt covenants in their loan contracts with their lenders. Collectively, our results suggest that firms are more likely to hedge in response to financial distress costs, growth options, investment opportunities, and future cash flow needs.

Finally, country-level institutional features also affect derivatives usage. In general, we find a positive association between hedging with financial derivatives and country-level investors protection. The intensity of derivatives usage is higher in countries with stronger enforcement of shareholder rights and stronger protection of creditor rights.

DERIVATIVES USAGE AND FIRM VALUATION

An important issue is whether derivatives usage affect firm valuation. Using market-to-book equity as a measure of firm valuation, we provide evidence that firm valuation is positively associated with the intensity of derivatives usage. In terms of economic significance, we find that derivatives usage increases shareholder value, by between US$21 million and US$70 million, representing about 2% to 5% of equity valuation. Hence, derivatives usage has substantial economic effect on shareholder value. Moreover, we find that the positive association between firm valuation and derivatives usage is stronger in firms with stronger corporate governance structures such as those with higher proportion of independent directors on their Board, firms that separate their CEO and Chairman positions, firms with Boards with stronger financial expertise and firms that have larger proportion of equity held by institutional shareholders. In well-governed firms, managers are more effectively monitored and this increases the likelihood of usage of derivatives for hedging purposes, instead of value-destroying speculative activities. Thus, firms with stronger corporate governance structures benefit more from risk management with derivatives.

During 2008–2009 Global Financial Crisis, many countries experienced economic downturn. The global equity market declined sharply in this period. The economic recession and global financial crisis led to an increase in corporate bankruptcies and a decrease in new and seasoned equity issuances. Thus, if the main objective of financial risk management is to reduce the probability of financial distress, then firms that employ derivatives to manage risk are likely to have experienced significant benefits during this period of economic downturn.

In general, relative to non-crisis years, firm valuation is lower in the years of economic downturn. However, we find that the negative association between firm valuation and economic downturn is mitigated by derivative usage. In other words, relative to non-users of derivatives, firms that use derivatives have higher valuation during the period of economic downturn. Furthermore, among the users of financial derivatives, the sub-sample of firms with stronger corporate governance structures exhibited higher firm valuation during the years of economic downturn. In addition, derivative users report higher operating profitability, higher cash flow from operations and higher sales per dollar of assets than non-users during the 2008–2009 Global Financial Crisis.

One of the channels in which derivatives can reduce financial distress cost is firm risk reduction. Using various measures for firm risk, we provide evidence on the effectiveness of derivatives to reduce firm risk. We find that derivatives usage is negatively associated with cash flow volatility, earnings volatility and stock return risk. In other words, derivative users have less volatile cash flow, less volatile earnings and less volatile stock returns than non-users. Thus, smoothness and predictability of cash flows and earnings are important benefits that are experienced by firms that hedge their foreign exchange exposure with derivatives. More generally, these results are consistent with the notion that hedging with financial derivatives reduces a firm’s cost of capital and thus increases the economic profitability of the firm.


Lee Kin Wai is Associate Professor, Nanyang Business School, Nanyang Technological University. This article is based on his research paper, “The Usage of Derivatives in Corporate Financial Risk Management and Firm Performance”, first published in International Journal of Business, Volume 24(2), 2019, 113-131. Reproduced with permission.