Simultaneous Equations Tests of Established and New Theories of FX Derivatives Use

Abstract

We have two main interests in this research: to suggest and test a new theory of corporate FX derivatives use; and to test it against six established theories using simultaneous equations methods common in other disciplines but dormant in finance since Titman and Wessels (1988). Theoretical papers by DeMarzo and Duffy (1991, 1995) suggest a relation between the complexity of a firm and hedging with FX derivatives. We find clear evidence for complexity, managerial options, financial distress, and primitive risk theories relating to two measures of hedging behavior. Our estimates do not support underinvestment, managerial interests related to undiversified wealth, nor scale economies theories of hedging. Our data set comprises all US firms with sales exceeding $1 billion.

Keywords: Hedging, foreign exchange, derivatives, complexity, underinvestment, managerial interests, financial distress, structural equation modeling information

JEL Classification: F31, G14, G32