Openness, hedging incentives and foreign exchange exposure: A firm-level multi-country study

Abstract

The benefits of openness to trade are well established, but the disadvantages of openness are less well understood. At the firm level trade is the principal source of exposure to exchange rate movements, and exchange exposure can be moderated by a range of hedging techniques. In this paper we ask two questions. First, do firms in open economies bear higher levels of exchange exposure than those in more closed economies? Second, is a strong corporate governance environment – one in which managers are incentivised to maximise shareholder value by hedging – associated with reduced firm-level exchange exposure? Using a sample of 3788 firms from 23 developed countries for the period 1984–2003, we show that the more open the economy, the more exposed are its firms to exchange rate movements, and this relation holds after controlling for firm size, industry and several financial variables. We also find a strong inverse relation between a firm's exchange exposure and the extent of creditor protection in the country in which it is based. This is consistent with managers acting to reduce the likelihood of financial distress in countries where bankruptcy costs are high, and it underlines the importance of institutional incentives in encouraging value-enhancing risk management activities.

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Notes

  1. 1.

    See Calderon et al. (2004) for a recent review.

  2. 2.

    The period is shorter than 20 years for a few countries, owing to data constraints; the data periods for each country are detailed in Table 1.

  3. 3.

    Although Smith and Stulz (1985) and others use the terms “bankruptcy” and “bankruptcy costs”, it is well established that a firm can bear substantial costs – financial distress costs – before it formally declares bankruptcy. These costs can be categorised as direct and indirect (Haugen & Senbet, 1978). Direct costs – such as the legal and trustee fees associated with bankruptcy – are small, particularly relative to indirect costs such as disruptions to production and lost sales. Andrade and Kaplan (1998) estimate the indirect costs of financial distress at up to 23% of firm value, and most of these are borne prior to bankruptcy. Other potential costs of financial distress arise via agency conflicts between debtholders and shareholders. The incentive for shareholders to engage in asset substitution (Jensen & Meckling, 1976) and underinvestment (Myers, 1977) can be particularly acute if the likelihood of bankruptcy becomes significant.

  4. 4.

    Berkman et al. (1997) found that firms in New Zealand are greater users of derivatives than their US counterparts. Fifty-three per cent of their survey respondents use derivatives, compared with the 35–41% found by Bodnar et al. (1995, 1996) for US firms, and all large New Zealand firms (those with greater than US$250 market value) use derivatives compared with 65% of large firms in the US. Batten et al. (1993) found that 61% of Australian firms routinely manage transaction exposure. The lower rates of derivatives usage among US firms may, however, arise because trade tends to be denominated in US dollars. US firms with international receipts and payments denominated in dollars would not be subject to transaction exposure, but they would bear indirect exposure effects.

  5. 5.

    Our work differs substantially from Allayannis and Ihrig (2001) and Bodnar et al. (2002) in the following ways. First, the former look at US industry sectors and the latter at Japanese industry sectors, whereas we examine firm-level data from 23 countries. Second, while Allayannis and Ihrig's (2001) and Bodnar et al. (2002) models explicitly include export and import intensity, these are measured at the industry level. Our aim is different: we want to examine the extent to which trade intensity generally (i.e., for the country overall) affects firm-level exposure. Third, neither of these studies uses our cross-sectional approach to examine the factors that affect exchange exposure.

  6. 6.

    A less popular approach measures the impact of exchange rate changes on cash flows or earnings (Martin & Mauer, 2003; Walsh, 1994).

  7. 7.

    This includes Greece, Mexico, Portugal and Turkey, which according to Bekaert and Harvey (1997, 2000) deregulated their equity markets before the start date in our data set: respectively December 1987, May 1989, July 1986 and August 1989.

  8. 8.

    This long data period is comparable to the 20-year period used by Dominguez and Tesar (2001a, 2001b, 2006), whose firm-level data set for eight countries covered the period 1980–1999.

  9. 9.

    Alan Heston, Robert Summers and Bettina Aten, Penn World Table Version 6.2, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, September 2006 (http://pwt.econ.upenn.edu/php_site/pwt62/pwt62_form.php).

  10. 10.

    In all of the cross-section analysis in this paper, openness is the log of the average trade openness for the period.

  11. 11.

    The start date for the restricted sample – January 1993 – is a compromise between the length (in time) and the breadth (number of firms) of the data set. The further back in time from which we attempted to collect financial statement variables, the less likely they were to be available. Further, we removed from the sample firms with negative book value of equity.

  12. 12.

    Most studies of exchange exposure and hedging use relatively small US data sets. Pantzalis et al.'s (2001) data, for example, comprise 220 US firms. In their firm-specific analysis Griffin and Stulz (2001) include only US firms “because of data limitations” (235). In his cross-country analysis of currency hedging in firms from 34 countries, Lel (2006) gets around the problem of data availability by examining firms with ADRs. (Firms issuing level 2 and level 3 ADRs are required to report to US authorities, using the same accounting and other standards as US firms.) Lel's (2006) data set is about one-tenth the size of ours, comprising 364 firms.

  13. 13.

    Long-term debt and total assets are from Datastream (wc03251 and wc03501).

  14. 14.

    Market-to-book is Datastream code MTBV.

  15. 15.

    The quick ratio is Datastream code wc08101.

  16. 16.

    The skewness figures for MV, MTB and QR for the 1993–2003 period are respectively 10.3, 7.7 and 13.1. DA, with a skewness statistic of 0.5, would not be expected to be substantially skewed because, by construction, it falls between 0 and 1.

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Acknowledgements

The authors thank the three anonymous reviewers for their helpful and insightful comments, and the Finance Editor Lemma Senbet for his wisdom and patience in guiding the paper through the review process. Thanks also to Zheng Yin and Yan Ping Zhong for excellent research assistance.

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Correspondence to Elaine Hutson.

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Accepted by Lemma Senbet, Area Editor, 1 February 2009. This paper has been with the authors for four revisions.

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Hutson, E., Stevenson, S. Openness, hedging incentives and foreign exchange exposure: A firm-level multi-country study. J Int Bus Stud 41, 105–122 (2010). https://doi.org/10.1057/jibs.2009.32

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Keywords

  • exchange risk pricing
  • firm exposure
  • foreign exchange management and risk
  • economic openness
  • openness to trade
  • corporate governance