The Use of Foreign Currency Derivatives and Firm Market Value
Darden School Working Paper No. 97-23
48 Pages Posted: 2 Nov 1998
Date Written: October 1998
This paper examines the use of foreign currency derivatives (FCDs) by a sample of 720 large U.S. nonfinancial firms between 1990 and 1995 and its potential impact on firm value. Using Tobin's Q as an approximation of a firm's market valuation, we find a positive relationship between firm value and the use of FCDs. The hedging premium is statistically and economically significant mostly after 1993 and is on average 5.7\% of firm value. This result is robust to a) controls for size, profitability, leverage, growth opportunities, ability to access financial markets, industrial and geographical diversification, credit quality, industry classification (4-digit SIC), year-dummies and firm fixed-effects; b) the use of a weight-adjusted industry Tobin's Q and other measures of value, such as the market to book and the market to sales ratios; and, c) alternative estimation techniques that handle the potential impact of outliers. Using the ratio of foreign currency derivatives to foreign sales as a proxy for the percentage of exposure that a firm hedges, we observe a significant dispersion in our measure of the hedge ratio. In univariate tests we find a nonlinear relationship between Q and our proxy. However, firm-specific factors explain this relationship in multivariate tests and it appears that firms are hedging optimally.
JEL Classification: G15, G30
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