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Corporate Hedging Strategy and Firm Value

Article in International Research Journal of Finance and Economics August 2010

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International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 44 (2010)
EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/finance.htm

Corporate Hedging Strategy and Firm Value

Slim Mseddi
Institute of the Higher Business Studies (IHEC), University of Sfax
Route Sidi Mansour, Km 10, Sfax -Tunisia
E-mail: slim_mseddi@yahoo.fr

Fathi Abid
Faculty of Business and Economics (FSEG), University of Sfax
Route de laroport, Km 4.5, Sfax-Tunisia
E-mail: fathi.abid@fsegs.rnu.tn

Abstract

The purpose of this paper is to show the importance of hedging activities in context
of firm theory and information asymmetry. It tries, initially, to measure risk exposures of
interest rate, exchange rates and commodities on a sample of 403 non-financial US firms in
1999. The confrontation of these measures to information published in annual reports will
enable to bring a judgement on the exactitude of exposures. We find that the most common
combination of exposed hedged is of interest rate and currency exchange rates. Second, and
contrary to previous studies, our paper provides a distinctive methodological contribution
according to the determination of hedging variables. More precisely, the recourse to
performance models tested on two sub-samples: those which hedge risks and those which
not hedge, will enable to determine the distinctive and relevant variables for carrying out a
hedging strategy. The results show that the probability of hedging is positively related to
tax loss carry forwards. We find that firms with important research and development
activities are most likely to engage in hedging programs. The results also indicate that
larger firms are more likely to use derivatives to hedge risk exposures.

Keywords: Coordinated risk management, hedging and its determinants and firm value.

1. Introduction
Risk management and hedging are two interesting activities for financial firms as well as non-financial
firms. Companies are exposed to a wide variety of such exchange rate risks, interest risks, commodity
risks, and supply-demand coordinated risks, that affect the firm value. Activity risks are mainly related
on investments and investment opportunities (in fact, with its reel assets) whereas financial risks are
strongly dependent on the financing mode of these investments (such as a high level of debts increase
financial risk of shareholders). Risk management is the process which makes possible to influence
these exposures to risks on firm value (i.e. hedging of an exposure reduce dependence of firm value to
this exposure, whereas speculation means the increase in dependence to this exposure).
The main objective of corporate risk management programs, such actions taken by the
management to control risk exposures through hedging, is to increase firm value and so shareholder
wealth. According to Modigliani and Miller (1958), under the same assumptions (perfect and complete
markets) that guarantee independence between the value of the firm and its capital structure, firm value
International Research Journal of Finance and Economics - Issue 44 (2010) 106

is also independent of corporate risk management programs. Hedging cannot reduce cost of capital,
since shareholders have access to same capital markets, to same information and risk management
tools as firms. Shareholder can manage all risks by themselves and so there is no value creation
through hedging. However, financial economics offers several motivations to explain why corporate
hedging can be rational or value enhancing, each of which relies on some form of market imperfection.
Smith and Stulz (1985) show that hedge can reduce the likelihood of default by increasing the income
it gets in the downside. Smith and Stulz state that hedging leads to lower expected bankruptcy cots and
higher firm value.
Stulz (1984), Smith and Stulz (1985), Francis and Stephan (1990), Froot, Scharfstein and Stein
(1993), Nance, Smith and Smithson (1993), Goldberg, Godwin, Kim and Tritschler (1993), DeMarzo
and Duffie (1995), Tufano (1996) and Geczy, Minton and Schrand (1997) provide useful information
on numerous valid reasons why firms should use a risk-management programs to maximize
shareholder wealth.
Our study has two primary advantages over previous studies. First, using the studies of French,
Ruback and Schwert (1983), Flannery and Jamest (1984), Scott and Peterson (1986), Sweeney and
Warga (1986) and Smith and Smithson (1998), we estimate a firm sensitivity to interest rates,
exchange rate, and the price of oil. Our main contribution consists to the confrontation of the outputs
(degrees of significant of coefficient sensitivities) of time serial regressions to the information
published in the annual reports according to the risk management activity during 1999. Second,
contrary to the same methodology used in studies conducted by Nance, Smith and Smithson (1993),
Tufano (1996), Mian (1996) Berkman and Bradbury (1996), Fok, Carrol and Chiou (1997) Gczy,
Minton and Schrand (1997), Guay (1999), Haushalter (2000), Graham and Rogers (2002) and Guay
and Kothari (2003), our paper provides a distinctive methodological contribution to the level of the
determination of the variables of hedging. More precisely, the recourse to performance models tested
on two sub-samples: those which hedge the risks and those which not hedge, will enable to determine
the distinctive and relevant variables for carrying out a well strategy of hedging.
The remaining of the paper is organized as follows. We review the theoretical motivations for
corporate hedging with derivatives in section 2. We describe the sample procedure, data characteristics
and sources in section 3, while section 4 presents the empirical results on the determinants of return of
the firm and corporate hedging strategy. We conclude with Section 5.

2. Theoretical Motivations for Corporate Hedging Strategy with Derivatives and

Hypothesis
The classic paper of Modigliani and Miller (1958) suggests that, in the absence of market
imperfections, hedging should not add to firm value. If capital markets are perfect, shareholders have
access to the basic information about a firms risk exposures, and the necessary tools, to create their
desired diversified portfolio; therefore, there is no reason for a firm to hedge. When the financial
market is imperfect, corporate hedging can directly affect the cash flow of the firm. Exposures to
volatile interest rate, exchange rate and commodity prices are costly for corporations. Smith and Stulz
(1985), Bessembinder (1991), Nance, Smith and Smithson (1993) and Guay and Kothari (2003),
among others, show why market imperfections lead to an increase in firm value through risk
management activities.
Smith and Stulz (1985) argue that volatility is costly for firms with convex tax functions.
Hedging pre-tax income can increase firm value. This will only happen when the firm faces a
progressive effective marginal tax rate. More convex the effective tax schedule it, the greater is the
reduction in expected taxes. Stulz (1996) and Leland (1998) demonstrate that a decrease in cash flow
volatility through hedging activities can increase debt capacity, raise funds at a lower cost and generate
greater tax benefits. Using a sample of US firms in the period 1994-1995, Graham and Rogers (2002)
provide significant insights that tax convexity does not seem to be a factor in the hedging decision but
107 International Research Journal of Finance and Economics - Issue 44 (2010)

do find that firm hedge to increase debt capacity; the resultant tax benefits add about 1.1% to firm
value. Nance, Smith, and Smithson (1993) use three variables to measure a firms effective tax
function: investment tax credits, net operating loss carry forwards, and a binary variable that indicates
whether income is in progressive region.
Another motivation for hedging is related to situations in which there are expected costs of
financial distress. Firms engage in hedging activities to avoid the costs of financial distress. Financial
distress may affect the firms ability to retain its relationships with stockholders. Mayers and Smith
(1990), Smith and Stulz (1985), Froot, Scharfstein, and Stein (1993), and Nance, Smith, and Smithson
(1993) show that hedging via derivatives can increase firm value by reducing the expected costs of
financial distress. As a consequence, we expect that firms with low liquidity and high leverage should
have more incentives to hedge their risky positions.
Conflicts of interest between shareholders and bondholders give rise to underinvestment
problems. Myers (1977) and Myers and Majluf (1984) describe circumstances of information
asymmetries between existing shareholders and new investors in which a firm might reject positive net
present value projects. Bessembinder (1991) and Froot, Scharfstein, and Stein (1993) propose hedging
activities as a solution to avoid the underinvestment problem. Froot, Scharfstein and Stein (1993) show
that the greater a firms growth potential, the greater are the expected costs associated with variation in
cash flows. The ratio of book value of assets to market value of assets, research and development
expenditure and fixed assets deflated by total assets are used to proxy for the level of growth options.
Even in the absence of stockholder and bondholder conflicts, managers have incentives to use
derivatives for purposes based on managerial utility maximisation. Stulz (1984), and Smith and Stulz
(1985) show that, since the value of employee stock options is increasing in stock price volatility,
options provide incentives for managers to engage in activities that increase risk. Tufano (1996) argues
that managers whose human capital and wealth are poorly diversified engage strongly in risk
management and may hedge to protect their reputation (DeMarso and Duffie, 1995). Corporate risk
management will change the distribution of future cash flow or firm value and, thus, managements
expected utility.
Theoretical literature provides substitutes for hedging. Nance, Smith, and Smithson (1993)
show that hedging substitutes can reduce the need for hedging programs. Dividend restrictions and
holding liquid assets might allow a firm to retain sufficient liquidity and, thus, may reduce incentives
to hedge. Firms can avoid bankruptcy and maintain tax benefits by issuing convertible debt. Thus,
convertible debt reduces the need to hedge.
Table 1 presents Summary of variables in previous empirical papers

Table 1: Hypothesis relations between Hedgers and Non-Hedgers for variables used as incentives to hedge

Variables Prediction NSS T M BB FCC GMS G H A0

EBIT/ Interest Expense -
Long-Term Debt/ Market +
Value of Firm
Cost of Total Debt/ Ln total Assets +
financia Total Debt/ Book Value of +
l Equity
distress Expense Charges +
Ln Sales -
Market value of Equity -
Total Assets +/-
Simulated marginal tax rate -
Average Tax rate +
Expecte Tax Incentives dummy (1= +
d Taxes income in progressive
region (>34%), 0=
otherwise)
International Research Journal of Finance and Economics - Issue 44 (2010) 108
Loss Carry Forwards/ total +
Assets
Dummy (1= Loss Carry +
Forwards, 0= otherwise)
Investment Tax Credit/ total +
Assets
Dummy (1= Investment Tax +
Credit, 0= otherwise)
Market Value/Book Value +
of the Firm
Dummy (1= listed firm, 0= -
otherwise)
Dummy (1= if Debt +
ratio.>average and Working
Investm
Capital Ratio <average, 0=
ent and
otherwise)
Financi
Operational Expenses/ +
al
Market Value of firm
Decisio
Acquisition Activities/ +
ns
Market Value of Firm
Ratio of Distribution of -
Dividend
Share Return -
Working Capital ratio -
Market Value of firm +/-
Market-to-Book Value +
R&D/ book value of Firm +
Growth
R&D/ Sales +
opportu
Price-Earning ratio -
nities
Fixed Assets/ Market Value +
of Firm
Dividen Dividend yield +
d Ratio of distribution +
distribu
tion
Working Capital ratio -
Liquidit Current Ratio -
y Current Assets/ Market -
Value of Firm
Convertible Debt/ Total +/-
Assets
Substitu
Preferred Stock / Total +/-
tes for
Assets
Hedgin
(Convertible Debt + +/-
g
Preferred Stock)/ Total
Assets
Risk Coefficient beta +
NSS: Empirical evidence by Nance, Smith and Smithson (1993) for 169 US corporations (Study year 1986).
T: Empirical evidence by Tufano (1996) for 48 US gold mining industry corporations (Study period 1991-1993).
M: Empirical evidence by Mian (1996) for 3 022 US corporations (Study year 1992)
BB: Empirical evidence by Berkman and Bradbury (1996) for 116 New Zealand corporations (Study year 1994).
FCC: Empirical evidence by Fok, Carrol and Chiou (1997) for 369 US corporations (Study period 1990-1992)
GMS: Empirical evidence by Gczy, Minton and Schrand (1997) for 372 US corporations (Study year 1996)
Guay: Empirical evidence by Guay (1999) for 353 US corporations (Study period 1990-1994).
H: Empirical evidence by Haushalter (2000) for 100 US gas and oil producers (Study period 1992-1994).
AO: Empirical evidence by Allayannis and Ofeck (2001) for 724 US corporations (Study period 1992-1993).
109 International Research Journal of Finance and Economics - Issue 44 (2010)

3. Data Description
The analysis is conducted on a sample of 403 non-financial US corporations (SIC Code 2000 through
3999) for the period from 1995 to 1999. Financial statement data is from Zack Investment Research
Inc., and Edgar Scan and stock return from Market Guide Inc. To be included in the analysis sample,
firms are required to have a proxy statement for all years between 1995 and 1999. The initial sample
contains 542 firms; only 403 firms satisfy our sampling criteria every year. In our study firms are
classified hedgers and non-hedgers using disclosures in annual reports for the year 1999. Information
about price of oil, treasury bills and currency exchange rates such as Pound, Yen, Euro, Canadian
Dollar are collected for the year 1999. Table 2 summarizes the number of firms by industry.

Table 2: Summary of firms and industries in the sample

Industry name Two-digit SIC Number of Percent of

code sample firms sample firms
Food and kindred products 20 24 5.96%
Textile mill products 22 4 0.99%
Apparel and other finished products 23 5 1.24%
Lumber and wood products, expect furniture 24 10 2.48%
Furniture and fixtures 25 11 2.73%
Paper and allied products 26 13 3.23%
Printing, publishing and allied 27 24 5.96%
Chemicals and allied products 28 72 17.87%
Petroleum refining and related industries 29 12 2.98%
Rubber and miscellaneous plastic products 30 15 3.72%
Leather 31 2 0.50%
Stone, clay, glass, and concrete products 32 7 1.74%
Primary metal industries 33 15 3.72%
Fabricated metal, expected machinery, transportation equipment 34 8 1.99%
Machinery, expect electrical 35 69 17.12%
Electrical, electrical machinery, equipment, supplies 36 60 14.89%
Transportation equipment 37 20 4.96%
Measuring instruments; photographic goods; watches 38 28 6.95%
Miscellaneous manufacturing industries 39 4 0.99%
Total 403 100%

4. Empirical Results
Initially, we try to highlight the idea of coordinated risk management. We compare exposures to risks
of interest rate, currency exchange rates, and oil prices (as measured by estimated coefficients in
regressions of return of firm on several risks), with information on hedging activities published in
annual reports in 1999.
Second, we have a methodological contribution according to variables selection of hedging.
This approach differs from previous papers since it makes possible to take only distinctive variables
that increase firm value. Such variables are obtained from regressions on performances models.

4.1. Measures of Strategic Exposures

Annual reports published in 1999 show that firms are exposed at various risks such as interest rate, raw
material prices, and some currencies. We retained rate of return of US treasury bills for three months
period as measure of interest risk, price of barrel of oil (since it constitutes the most used raw material)
as measure of commodity risk and rates of return of exchange rates. Annual reports provide list of
International Research Journal of Finance and Economics - Issue 44 (2010) 110

countries or currencies for US corporations that have import-export business with the world. Table 3,
presents the main destination of goods with US corporations (import or export):

Table 3: Classification of number of US firms that import or export by destination

Destination Numbers of corporations

Euro area 2511
England 219
Canada 210
Japan 137
Mexico 108
Australia 104
China 83
Taiwan 52
India 41

We have limited the present study at the companies which import from or export at the euro
area, and Japan, Canada and England, since they constitute the principal destinations of import-export
for US Corporations. The figures below show the evolution of the main currencies, treasury bills, and
oil price in 1999.

Figure 1: Oil price change in 1999 Figure 2: EUR/USD change in 1999

30 1,2
25 1,15
EURO/USD
Price in $

20 1,1
15 1,05
10 CRUDE OIL 1
EURO/ USD
5 0,95
0 0,9
04/01/1999

04/02/1999

04/03/1999

04/04/1999

04/05/1999

04/06/1999

04/07/1999

04/08/1999

04/09/1999

04/10/1999

04/11/1999

04/12/1999

Time Tim e

Figure 3: CAD/USD change in 1999 Figure 4: YEN/USD change in 1999

1,54 140
1,52 120
YEN /U SD

1,5 100
1,48 80
1,46 60 YEN/USD
1,44 CAD/ USD 40
1,42 20
1,4 0
04/01/99
04/02/99
04/03/99
04/04/99
04/05/99
04/06/99
04/07/99
04/08/99
04/09/99
04/10/99
04/11/99
04/12/99

Time Time

1
mostly France: 144, Germany: 141, Italy: 80, Spain: 67 and Belgium: 47
111 International Research Journal of Finance and Economics - Issue 44 (2010)
Figure 5: USD/Pound change in 1999 Figure 6: Treasury bills rate change in 1999

1,7
1,68 6
1,66 5

treasury bills rate

1,64
USD/Pound

1,62 4
1,6
1,58 3
1,56 USD/ Pound BT
1,54 2
1,52
1,5 1
1,48
0
04/01/99
04/02/99
04/03/99
04/04/99
04/05/99
04/06/99
04/07/99
04/08/99
04/09/99
04/10/99
04/11/99
04/12/99
Time Time

Table 4: Descriptive statistics of risk exposures

Parameters (annual) T.B. Oil EUR/USD CAD/USD YEN/USD USD/POUND

low price 4.18% 11.38 1.0016 1.444 101.53 1.5515
high price 5.42% 28.03 1.1812 1.5302 124.45 1.6765
Mean 4.642% 19.37 1.0653 1.4857 113.6883 1.6174
Standard deviation 0.28% 4.55 0.0396 0.0201 7.0008 0.0240

Figures (from 6 to 11) and table 4 show significant volatilities of treasury bills, crude oil prices
and principal currencies, which stimulate corporations to hedge risks.
We have preceded to 403 regressions on time series daily data for year 1999. Indeed, to
estimate a firms sensitivity to interest rates, exchanges rates, and the price of oil, we would estimate
the following equation:
P P P P P P
Rt = a + b1 TB + b2
P
+ b3 Eur
P
+ b4 YEN
P
+ b5 CAD
P
+ b6 oil
P
+ t

PTB t t Eur t YEN t CAD t Oil t
where

Rt : rate of return of firm i.

a : intercept
PTB PTB : percentage change in three month treasury bills;

P P : percentage change in dollar prices of pounds, euro, yen, and Canadian dollar;

Poil POil : percentage change in crude oil price.

Coefficients b1, b2, b3, b4, b5, b6 provide measures of sensitivity of firm value to percentage
change in three month treasury bills, exchange rates, and crude oil, respectively.
Results show that, for significant level lower or equal to 10%, rates of return of US
corporations are sensitive to changes of:
treasury bills for 59 cases (39 of whom are negatively correlated);
crude oil price for 63 cases (10 of whom negatively correlated);
euro price for 72 cases (67 of whom negatively correlated);
Canadian dollar price for 88 cases (79 of whom negatively correlated);
Japanese yen price for 43 cases (14 of whom negatively correlated);
and pounds price for 57 cases (51 of whom negatively correlated).
International Research Journal of Finance and Economics - Issue 44 (2010) 112

It should be noted that risk exposures can take different signs depending on positions of firm:
net exporter or net importing (Muller and Verschoor, 2006).
Various risk exposures of US firms can be summarized in the following table:

Table 5: Risk Exposures of 403 non-financial US firms (according to the above regressions)

Exposures Number Percentage

Interest rate only 29 7.20%
Exchange rate only 131 32.51%
Crude oil only 24 5.96%
Interest rate and exchange rate 24 5.96%
Interest rate and crude oil 2 0.50%
Exchange rate and crude oil 33 8.19%
Interest rate, exchange rate, and crude oil 4 0.99%
Any risk 156 38.71%
Total 403 100%

Table 5 shows that among 403 firms, 247 firms (61.29%) are exposed at one or more risks.
Currency rate exchange constitutes most significant source of risk, in fact, 192 companies are exposed
to the exchange risk.

4.2. Measure of Hedging Activities

An endogenous variable has been created in the form of dummy measure and was coded 1 for those
firm that indicate they engage in hedging activities and 0 for those firms that disclosure they do not
hedge. Firms with no disclosure on hedging are not considered in our sample. Nance, Smith and
Smithson (1993), Mian (1996), Geczy, Minton and Schrand (1997), Cummins, Phillips and Smith
(2001) and Allayannis and Weston (2001) have defined the same measure of hedging activities.
Table 6 shows that 53.35% of sample firm use hedging programs (according to information
published in annual reports). 33.5% do not use any derivatives to hedge financial price exposures.
Firms that provide no disclosure on hedging represent 13.5%.

Table 6: Hedging programs disclosures by non-financial US firms

Number Percentage
Hedgers 215 53.35%
Not hedgers 135 33.5%
No disclosure on hedging 53 13.15%
Total 403 100%

Table 7 reports frequency of hedging by industry. It shows that firms in Sic code 34
(Fabricated metal, expected machinery, transportation equipment) hedge more financial risk exposures
than others. Lumber and wood products, expect furniture and Printing, publishing and allied industries
show less incentives to hedge activities. The same result is confirmed by the studies conducted by
Geczy, MintonandSchrand (1997) and Dolde (1993).
113 International Research Journal of Finance and Economics - Issue 44 (2010)
Table 7: Frequency of hedging by industry

All Disclosure
SIC Industry name hedgers Interest rate Exchange rate Crude oil
firms information
N N % N % N % N % N %
20 Food and kindred 24 19 79.2 16 84.2 15 78.9 13 68.4 12 63.2
products
22-23 Textile mill products, 9 7 77.8 3 42.9 3 42.9 2 28.6 2 28.6
and Apparel and other
finished products
24 Lumber and wood 10 9 90.0 1 11.1 1 11.1 1 11.1
products, expect
furniture
25 Furniture and fixtures 11 10 90.9 6 60.0 5 50.0 3 30.0 1 10.0
26 Paper and allied 13 11 84.6 6 54.5 6 54.5 3 27.3 2 18.2
products
27 Printing, publishing 24 20 83.3 4 20.0 4 20.0 2 10.0 0.0
and allied
28 Chemicals and allied 72 55 76.4 33 60.0 26 47.3 24 43.6 9 16.4
products
29 Petroleum refining and 12 7 58.3 6 85.7 3 42.9 6 85.7 6 85.7
related industries
30-31 Rubber and 17 15 88.2 13 86.7 9 60.0 8 53.3 1 6.7
miscellaneous plastic
products, and Leather
32 Stone, clay, glass, and 7 5 71.4 2 40.0 1 20.0 2 40.0
concrete products
33 Primary metal 15 15 100 9 60.0 5 33.3 5 33.3 8 53.3
industries
34 Fabricated metal, 8 6 75.0 6 100 5 83.3 4 66.7 3 50.0
expected machinery,
transportation
equipment
35 Machinery, expect 69 66 95.7 43 65.2 23 34.8 33 50.0 7 10.6
electrical
36 Electrical, electrical 60 56 93.3 29 51.8 15 26.8 21 37.5 8 14.3
machinery, equipment,
supplies
37 Transportation 20 18 90.0 12 66.7 10 55.6 6 33.3 2 11.1
equipment
38-39 Measuring 32 31 96.9 26 83.9 10 32.3 12 38.7 2 6.5
instruments;
photographic goods;
watches and
Miscellaneous
manufacturing
industries
Total of the sample 403 350 86.8 215 61.4 141 40.3 145 41.4 63 18.0

The next table provides combinations of exposures hedged by non-financial US firms.

Table 8: Combination of exposures hedged by hedging firms

Exposures Number Percentage

Interest rate only 18 8.37%
Exchange rate only 57 26.51%
Crude oil only 5 2.33%
Interest rate and exchange rate 77 35.81%
Interest rate and crude oil 3 1.40%
Exchange rate and crude oil 12 5.58%
Interest rate, exchange rate, and crude oil 43 20 %
Total 215 100%
International Research Journal of Finance and Economics - Issue 44 (2010) 114

Table 8 shows that the most hedged exposures is the exchange rate and the most combination of
exposed hedged is currency exchange and interest rate hedging. Only five firms among the sample that
hedge the position in crude oil. Our results seem to be confirmed by the recent study conducted by
Bartram, Brown and Fehle (2007). They provide evidence from international data (7292 non-financial
firms) by investigating derivative usage across 48 countries. The results show that 59.8% of companies
use derivatives. The companies use currency derivatives for 43.6%, interest rate for 32.5%, and only
10% that hedge raw materials exposures.

4.3. Estimated Coefficients Versus Information Published in Annual Reports: A Comparison

By referring to information on hedging activities published in annual reports, we assume that estimated
coefficients obtained by regressions of rate of returns of firms on several risks are insensitive to
changes of hedged exposures (estimated coefficients are not significant)
The following table compares information published in annual reports of firms sample with the
results obtained by regressions.

Table 9: Comparison between data provided by annual reports and the coefficients estimated by the
regressions of rate of returns on interest rate, exchange rate and crude oil.

Interest rate Exchange rates Crude oil

Exposures hedged (information in annual reports) 141 145 63
Number of estimated coefficient non significant 120 68 52
Percentage of similarity 85.11% 46.9% 82.54%
Number of estimated coefficient significant (negative) 16 1
77
Number of estimated coefficient significant (positive) 5 10
Exposures not hedged (according to annual reports) 209 205 287
Number of estimated coefficient non significant 166 112 235
Number of estimated coefficient significant (negative) 28 9
Percentage of firms exposed to risks 13.4% 93 3.83%
Number of estimated coefficient significant (positive) 15 43

With regard to interest rate, annual reports (tables 7 and 9) specify that the number of
corporations which hedge interest rate volatility is 141. Not significant coefficients number is about
120 confirming 85.11% the hypothesis that equity return rate is insensitive to hedged interest rate
exposure. We note that 5 firms profited from hedging (positive relation between return rate and
treasury bills exposure). The number of significant negative coefficient is 16 meaning interest rate
positions is weakly hedged, therefore the degree of assumed risk is rather high. Not hedged exposures
rise to 209 cases, according to published annual reports. 166 coefficients estimated are not significant;
these firms do not assume interest rate risk. We find that 15 firms profited from treasury bills return
changes (positive relation). Finally, 28 companies assume really interest rate risk (coefficients
estimated are significant and negative).
According to exchange rates, the number of firms which showed intention to hedge currency
exchanges exposures rises to 145. Firms return rates are insensitive to euro, yen, pounds and Canadian
dollar changes for 68 cases (46.9%) of hedged positions. We note that 77 hedged firms still incur
exchange rate risks (the majority of coefficients estimated are negative), which can be explained by a
partial hedging exposures. Annual reports indicate that 205 firms do not hedge currency exchange
exposures. We find that 112 cases havent significant coefficients. The results can be justified by
invoicing in national currency (US dollars) or weak exposures. An interesting number among firm
sample (93 cases) is exposed to currency exchange risk.
115 International Research Journal of Finance and Economics - Issue 44 (2010)

The data provided by annual reports show less hedging activities for raw material risks. The
main raw material risk for US corporations is oil barrel price changes. Firms that hedge the type of this
risk are 63. Results show 82.54% (52 among 63) of hedged firms havent significant coefficient.
Regression outputs show also 235 cases among 287 non-hedgers havent significant estimated
coefficients. Only 9 firms incur oil price risk; 3.83% of sample firms do not hedge oil price exposure.

4.4. Derivatives use and Performance

We have collect information about hedging variables from EDGARSAN and COMPUSTAT databases.
53 sample firms among 403 are eliminated given we havent information according to hedging
programs. We calculated the average for each explanatory variable during the period 1995 to 1999
(except variables relating to search and development and tax function: tax rate and tax loss carry
forwards). The endogenous dummy variable (hedge or not hedge) relates to the year 1999. The same
methodology is used by Dolde (1995) during the period 1989-1991 for US firms sample and Amrit
(2005) during the period 1990-1995 for Britannic firms sample.
In order to determine variables of hedging policy, we follow a new methodology different from
previous studies (Stulz, 1996; Dolde, 1995; Berkman and Bradbury, 1996; Sinkey and Carter, 1994;
Dolde, 1996; Geczy, Minton and Schrand, 1997; Gay and Nam, 1999; Howton and Perfect, 1999;
Haushalter, 2000; Graham and Rogers, 1999, 2002, Judge, 2004 and Albuquerque, 2007). It consists in
dividing initial sample into two sub-samples: the first includes hedgers, whereas the second includes
non-hedgers regarding information published in annual reports.
To highlight such approach, we consider in a first stage a performance accounting measurement
like Return on Asset (ROA) as dependent variable that can be explained by hedging variables. Two
regressions are used, the first one for sub-sample of hedgers and the second for sub-sample of non-
hedgers. In a second stage, a comparison between the two regressions results makes it possible to
determine the distinctive variables of performance. We assume that: hedgers have greater incentives
to control hedging variables likely to improve investments profitability.

4.4.1. Performance Models

The following models are estimated:

Model I: performance model for hedgers firms

ROAi = + 1 EBIT / IE + 2 Equity / TA + 3 LnMVE + 4 LossB + 5 CAF / FixedAssets +
H =1

6 M / B + 7 RDB + 8 EPS / Share Pr ice + 9 FixedAssets / TA + 10 LnDiv + 11WKR +

12 ConDebt / TA + 13 Pr efCap / TA + 14 Beta + 15 Pr ofitM arg in / Sales + 16 Pr oductivity + i

Model II: performance model for non-hedgers firms

ROAi = + 1 EBIT / IE + 2 Equity / TA + 3 LnMVE + 4 LossB + 5 CAF / FixedAssets +
H =0

6 M / B + 7 RDB + 8 EPS / Share Pr ice + 9 FixedAssets / TA + 10 LnDiv + 11WKR +

12 ConDebt / TA + 13 Pr efCap / TA + 14 Beta + 15 Pr ofitM arg in / Sales + 16 Pr oductivity + i
International Research Journal of Finance and Economics - Issue 44 (2010) 116

Where:

EBIT/IE : Interest cover

Equity/TA : Market value of equities/ Total Assets
LnMVE : Firm seize : natural logarithm of firm market value
Lossb : Tax function: dummy (1= tax loss carry forwards, 0= otherwise)
CAF/Fixed Assets : Funds from operations / Fixed Assets
M/B : Market-to-Book
RDB : Dummy (1= research and development activities, 0= otherwise)
EPS/Share Price : Share return
Fixed Assets /TA : Fixed Assets/ Total Assets
LnDiv : natural logarithm of distrbuted dividend
WCR : Working Capital Ratio (Short Terme Debt/Current Assets)
ConDebt/TA : Convertible Debt/Total Assets
PreCap/TA : Prefered Capital/Total Assets
Beta : Volatitlity coefficient
Profit Margin/Sales : Profit Margin/ Total Sales
Productivity : Value Added/ employees number

Table 10 presents correlations between exogenous variables. At a level equal or less to 5%, 66
correlations are significant. 33 correlations have a coefficient less than 0.2, and only eight correlations
have an absolute value more than 0.4. There is a problem of multicollinearity but not severe.
117 International Research Journal of Finance and Economics - Issue 44 (2010)

Table 10: Pearson Correlation Coefficients

Pearson correlation coefficients for 16 variables used in performance models and logit regressions. Table 10 include correlation
coefficient, observation number and the two-tailed significance level.

Variables EBIT/IE Equity/TA LnMVE Lossb CAF/Fix M/B RDB EPS/Share Fixed LnDiv WCR ConDebt/T PreCap/TA Beta Prof Productivit
As Price Assets /TA A Mar/Sales y
EBIT/IE 1
N 371
Equity/TA 0.258* 1
N 371 403
LNMVE -0.029 -0.256* 1
N 366 398 398
LOSSB -0.118** -0.079 0.00 1
N 320 349 347 349
CAF/Fixed Assets 0.472* 0.054 0.157* -0.218* 1
N 371 403 398 349 403
M/B -0.054 0.059 0.121** 0.062 -0.131* 1
N 367 399 397 348 399 399
RDB 0.012 0.09 0.087 0.141* -0.025 0.096 1
N 318 347 345 347 347 346 347
EPS/Share Price 0.055 -0.168* 0.118** -0.203* 0.331* -0.125** -0.045 1
N 365 397 397 346 397 396 344 397
Fixed Assets /TA -0.145* -0.482* 0.294* -0.031 0.057 -0.184* -0.242* 0.221* 1
N 371 403 398 349 403 399 347 397 403
LnDiv -0.134* -0.394* 0.721* -0.05 0.081 -0.041 -0.06 0.294* 0.462* 1
N 371 403 398 349 403 399 347 397 403 403
WCR -0.191* -0.629* 0.388* 0.002 0.065 -0.027 -0.219* 0.228* 0.875* 0.564* 1
N 371 403 398 349 403 399 347 397 403 403 403
ConDebt/TA -0.024 -0.133* -0.063 0.101 -0.203* 0.108** 0.09 -0.222* -0.064 -0.183* -0.099** 1
N 371 403 398 349 403 399 347 397 403 403 403 403
PreCap/TA 0.001 -0.113** 0.073 0.054 0.02 -0.008 0.023 -0.051 0.067 0.09 0.074 0.074 1
N 371 403 398 349 403 399 347 397 403 403 403 403 403
BETA 0.114** 0.217* 0.343* 0.059 0.036 0.205* 0.295* -0.140* -0.361* -0.075 -0.321* 0.137* 0.012 1
N 367 399 397 349 399 398 347 396 399 399 399 399 399 399
Profit 0.200* -0.092 0.144* -0.122** 0.613* -0.130* -0.057 0.239* 0.236* 0.143* 0.242* -0.308* -0.007 -0.025 1
Margin/Sales
N 371 403 398 349 403 399 347 397 403 403 403 403 403 399 403
Productivity 0.012 -0.104 0.153* 0.043 0.154* -0.067 -0.113** 0.164* 0.129** 0.176* 0.137** -0.043 0.004 -0.022 0.175* 1
N 313 342 340 342 342 341 340 339 342 342 342 342 342 342 342 342
* Significant at the 1% level
** Significant at the 5% level
International Research Journal of Finance and Economics - Issue 44 (2010) 118

Table 11 reports results of performance model regressions. Coefficients estimated by

performance models are in bold. The statistic below coefficients estimated is t-student value.
According to multicolliniearity test, we use VIF statistic (or variance inflation factor) and we find
that all variables included in models have a value less than 10 (thus, there is no problem of
multicollinearity).

Table 11: Results of linear regression of performance on hedging variables

Variables Hedgers Non-Hedgers

Intercept -0.042** -0.082**
-2.315 -2.185
EBIT/IE 0.016 0.018
0.433 0.433
Equity/TA 0.132* 0.163*
3.013 3.69
LNMVE -0.003 0.112**
-0.047 2.204
LOSSB -0.019 -0.055***
-0.586 -1.707
CAF/Fixed Assets 0.465* 0.506*
8.261 8.58
M/B 0.412* -0.207*
10.51 -5.267
RDB 0.07** -0.071**
2.153 -2.164
EPS/Share Price 0.313* 0.113***
8.755 1.656
Fixed Assets /TA 0.19* 0.065
3.122 0.658
LnDiv 0.071 -0.043
1.191 -0.833
WCR -0.139** -0.028
-2.076 -0.257
ConDebt/TA -0.075** -0.199*
-2.317 -5.502
PreCap/TA 0.038 -0.027
1.2 -0.83
BETA -0.144* -0.041
-3.141 -0.997
Profit Margin/Sales 0.225* 0.202*
4.487 3.266
Productivity 0.002 -0.011
0.078 -0.182
R Square 83.50% 92.56%
Adjusted R Square 82.00% 91.26%
Fischer 57.108* 71.516*
Observations Number 197 108
* Significant at the 1% level
** Significant at the 5% level
*** Significant at the 10% level.
119 International Research Journal of Finance and Economics - Issue 44 (2010)

Table 11 shows that independent variables explain more than 83% performance variation.
Fisher statistic is important and significant at the 1% level.
The performance of hedger firms can be explained by low debt level, recourse at self-financing
to finance fixed assets, positive growth opportunities, research and development activities, important
margin profits, low systematic risk, and less incentive to use hedging substitutes.
The financial performance of non-hedgers seems to be explained by low debt level, negative
impact of loss carry forwards, recourse at self-financing to financed fixed assets, worse use of research
and development activities and growth opportunities, and less incentives to recourse at convertible debt
(hedging substitute)
A comparison of these two regressions enables us to detect hedging determinant variables and
their importance in improvement of corporations performance. This comparison makes it possible to
release seven variables:

1. The variable natural logarithm of firm market value (LnMVE) which measures the size is
significant only for non-hedgers;
2. The dummy variable tax loss carry forwards (LossB) which indicate tax function convexity is
significant only for non-hedgers;
3. The variable M/B as measurement of the growth opportunities is significant for hedgers and
non-hedgers but with different sings;
4. The binary variable research and development (RDB) as a second determinant of growth
opportunities also presents different signs;
5. The variable Fixed Assets /Total Assets (Fixed Assets /TA), a measurement of the investment,
is significant only for hedgers;
6. The variable working capital ratio (WCR), measurement of equilibrium and liquidity, is
significant only for hedgers corporations;
7. The variable Beta which is a measurement of risk is significant only for hedgers.
These seven variables will be introduced into logit regression models to show their influence on
the decisions to hedge or not risks.
It should be noted that financial distress costs variables do not reveal too much importance.
Indeed, the variable interest cover does not explain the performance of hedgers and non-hedgers, since
this variable is not significant in the two regression models. In the same way, the variable relating to
the debt level is significant for the two sub-samples. These variables are excluded in the logit
regression models since they do not represent a distinction between hedgers and non-hedgers. The
same result is obtained in the empirical study of Nance, Smith and Smithson (1993) which shows that
there is not a significant difference for the variable debt level between hedgers and non-hedgers.

4.4.2. Logit Models

Before proceeding to the logit regressions allowing determining hedging variables, we propose
univariate tests which confront theoretical assumptions with sample firms real data.

A. Univariate Analysis
The univariate tests verify endogenous variables heterogeneity or homogeneity between hedged firms
and non-hedged firms. Table 12 reports means and variances of our explanatory variables for
derivative users and non-users.
International Research Journal of Finance and Economics - Issue 44 (2010) 120
Table 12: Univariate tests of Derivatives Use
Univariate tests concern a sample of 350 US non-financial firms including 215 derivative
users and 135 non-users in 1999. The Fisher and t-student statistics are given for tests of
variance equality and means equality between hedgers and non-hedgers respectively.
Observations number is given in parentheses. We use the real values of loss carry forwards
and research and development expenditures (more significant) and not dummy variable
values. H0 and H1 indicate the assumption of equal variances and the assumption of
unequal variances, respectively.
Group Statistic Levene test for equality of Test-t for equality of means
means variances
Variables Prediction Actual Hedgers Non- Hyp. F Sig. t Sig Mean diff. Stand. 95% Conf. mean
Hedgers Dev. Dif lower upper
Tax convexity function
LossCarFor 85.558 21.895 H0 3.08 0 63.66 20.64 23.06 104.26
H>NH H>NH 19.43 0
(215) (133) H1 3.7 0 63.66 17.21 29.79 97.54
Growth Opportunities
Fixed 0.535 0.468 H0 3.36 0 0.07 0.02 0.03 0.11
Assets/TA H>NH H>NH 7.67 0.01
(215) (133) H1 3.22 0 0.07 0.02 0.03 0.11
M/B 2.793 3.264 H0 -1.13 0.26 -0.47 0.42 -1.29 0.35
H>NH H<NH 2.03 0.16
(215) (132) H1 -0.95 0.34 -0.47 0.5 -1.45 0.51
RD 295.102 69.814 H0 1.72 0.09 225.29 130.93 -32.25 482.82
H>NH H>NH 6.25 0.01
(215) (131) H1 2.15 0.03 225.29 104.67 19.13 431.45
Firm seize
LNMVE 7.675 6.441 H0 7.88 0 1.23 0.16 0.93 1.54
H? NH H>NH 6.82 0.01
(215) (131) H1 8.25 0 1.23 0.15 0.94 1.53
Hedging substitutes
WCR 0.732 0.594 H0 5.21 0 0.14 0.03 0.09 0.19
H>NH H>NH 3.88 0.05
(215) (133) H1 5.11 0 0.14 0.03 0.09 0.19
Risk
BETA 0.761 0.756 H0 0.13 0.9 0.01 0.04 -0.07 0.08
H>NH H>NH 6.41 0.01
(215) (133) H1 0.12 0.9 0.01 0.04 -0.08 0.09

Table 12 shows that hedgers are statistically different from non-hedgers with respect of all
variables except market-to-book variable. Consistent with tax function convexity hypotheses,
derivatives users have higher tax loss carry forwards. Both mean and variance tests are significant
supporting the idea that hedgers have more tax loss carry forwards. This evidence is confirmed by
Berkman and Bradbury (1996), Mian (1996) and Amrit (2005).
The univarite results do not generally support the underinvestment hypotheses as suggested by
Myers (1997) and Froot, Scharfstein and Stein (1993). Hedgers have higher fixed assets and more
research and development incentive but have lower market-to-book ratios. Parametric tests are
significant for fixed assets-to- total assets ratios and research and development, and not significant for
market-to-book ratios. Amrit (2005) uses four variables to test underinvestment hypotheses: fixed asset
expenditure, research and development/sales, market-to-book and price-earning-ratio. No one of these
variables explain hedging decision. Geczy, Minton and Schrand (1997) examine the interaction
between financial distress (measured by debt level) and four proxies of growth opportunities
(R&D/sales, fixed asset expenditure/sales, M/B and price-earning-ratio). Only the interaction between
debt level and M/B is significant. Nance, SmithandSmithson (1993) use R&D expenditures and M/B as
proxies of underinvestment, their finding is similar to our results. Mian (1996) finds a significant test
for M/B, but contradictory to the underinvestment theory.
We also examine the seize effect on hedging. Natural logarithm of firm market value is used as
proxy of firm seize. Both tests of mean and variance inequalities are significant. Larger firms have
more incentives to hedge risk exposures. The studies conducted by Nance, Smith and Smithson (1993),
Geczy, Minton and Schrand (1997), Mian (1996) confirm the hypothesis of seize. Dolde (1995) finds
that smaller firms hedge more than larger firms, but the result is not statistically significant.
The evidence regarding substitutes hedging, we use working capital ratio as measured by short
term debt/ current assets and we find evidence supporting the theory. Amrit (2005) and Mian (1996)
121 International Research Journal of Finance and Economics - Issue 44 (2010)

find a significantly relation between working capital ratio and incentives to hedging. Amrit (2005)
shows that univariate tests are not significant for convertible debt and preferred capital as proxies of
hedging substitutes. The same result is shown by Nance, Smith and Smithson (1993). In this study,
these two variables are not considered as real proxies of hedging because they not explain firm
performances.
We have also examined the relation between systematic risk and incentive to hedge. The results
of parametric tests show that hedgers have more systematic risk compared to the non-hedgers, but the
test is not significant.

B. Multivariate Analysis
In this study we use logit regression to determine the impact of exogenous variables on the firms
hedging decision. Nance, Smith and Smithson (1993), Francis and Stephan (1993), Mian (1996),
Colquit and Hoyt (1997), Gczy, Minton and Schrand (1997) and Haushalter (1998) examine the effect
of independent variables on hedging decision by using logit models. The model is following:
ez
Pr ob(Yi = 1) =
1+ ez
Or,
1
Pr ob(Yi = 0) =
1+ ez
With Z a linear combination which arises as follows:
Z = B0 + B1 X 1 + B2 X 2 + ....... + B P X P
Y = 1, firm engage in hedging program, and
Y = 0, firm does not engage in hedging program.
From the Pr ob(Yi = 1) , we can determine the Odds ratio:
Pr ob(Y = 1)
Odds (Y = 1) =
1 Pr ob(Y = 0)
This equation can be transformed as follows:
odds(Y = 1) = e B0 e B1 (var iable1) e B2 (var iable 2) ...
1
Probability of hedging = B0 B1 (var iable1)
1+ e e e B2 (var iable 2) ...
The transformation of odds ratio by natural logarithm is called Logit.
Pr ob(Y = 1)
Logit (Y ) = Log {odds (Y = 1)} = Log
1 Pr ob(Y = 1)
We estimate the following model:
P (Yi = 1)
Z i = Log = Logit HEDGE = 0 + 1 LossB + 2 FixedAssets / TA + 3 M / B +

1 P (Yi = 1)
4 RDB + 5 LnMVE + 6 WCR + 7 Beta + i
The following table shows the results of logit regressions.
International Research Journal of Finance and Economics - Issue 44 (2010) 122
Table 13: Logit regression estimates: determinants of derivative use
The sample includes 350 non-financial firms containing information about disclosure of
hedging activities in year end 1999. Hedgers that disclosure risk management programs to
hedge currency exchange rates, interest rate and oil exposures in their annual reports are
215 firms. The number of non-hedging firms is 135. The number of observations for the
regressions depends upon the variable included for the model.

Variables Pred. M. 1 M. 2 M. 3 M. 4 M. 5 M. 6 M. 7 M. 8 M. 9 M. 10 M. 11 M. 12
Intercept 0.450 0.590 0.251 -0.531 -0.279 -1.084 -1.831 -4.279 -4.570 -4.276 -5.221 -4.951
Wald 3.092 16.052 2.487 2.669 1.238 10.458 13.396 36.617 37.629 31.939 37.992 34.089
Sig. level 0.079 0.000 0.115 0.102 0.266 0.001 0.000 0.000 0.000 0.000 0.000 0.000
Tax convexity function
lossB + 0.434 0.512 0.469 0.390 0.426
Wald 3.819 4.239 3.482 2.284 2.667
Sig. level 0.051 0.040 0.062 0.131 0.102
Growth opportunities
Fixed As./TA + 2.014 2.673 -4.295 -3.663 -5.084
Wald 10.701 15.856 5.477 4.192 6.969
Sig. level 0.001 0.000 0.019 0.041 0.008
M/B + -0.034 -0.024 -0.121
Wald 1.083 0.601 3.166
Sig. level 0.298 0.438 0.075
RDB + 0.966 1.327 1.220 1.215
Wald 11.863 18.703 12.328 11.991
Sig. level 0.001 0.000 0.000 0.001
Firm seize
LNMVE +/- 0.682 0.725 0.732 0.725 0.743
Wald 44.608 33.100 31.726 29.871 29.083
Sig. level 0.000 0.000 0.000 0.000 0.000
Hedging substitutes
WCR + 2.354 0.516 3.471 3.383 4.221
Wald 23.769 0.666 5.429 5.477 7.298
Sig. level 0.000 0.414 0.020 0.019 0.007
Risk
BETA + 0.039 -0.830 -0.963 -1.225 -1.095
Wald 0.017 3.995 5.042 7.724 5.947
Sig. level 0.897 0.046 0.025 0.005 0.015
Statistics
Chi-square 0.017 1.267 3.836 11.050 12.019 25.973 30.058 60.560 72.999 79.387 90.885 95.449
Sig. level 0.897 0.260 0.050 0.001 0.001 0.000 0.000 0.000 0.000 0.000 0.000 0.000
-2log likelihood 231.45 229.87 229.54 225.94 223.52 218.48 213.53 199.25 193.03 189.84 182.14 178.87
R2 of Cox & Snell 0.000 0.004 0.011 0.031 0.034 0.072 0.083 0.161 0.190 0.205 0.232 0.243
R2 of Nagelkerke 0.000 0.005 0.015 0.042 0.046 0.098 0.114 0.219 0.259 0.279 0.316 0.331
Percentage correct 61.782 62.248 61.782 62.644 64.740 67.241 66.957 69.653 72.543 70.231 74.128 73.178
Non-Hedgers 133 132 133 133 131 133 130 131 131 131 129 128
Hedgers 215 215 215 215 215 215 215 215 215 215 215 215
Sample seize 348 347 348 348 346 348 345 346 346 346 344 343

Table 13 shows the results of twelve logit regressions of determinants of hedging use. We
report wald statistic for significance of coefficients and same others statistics such as Chi-square, log
likelihood, R-square of Cox & Snell, R-square of Nagelkerke, and Percentage of good classification for
the significance of the model.
The first group models from 1 to 6 and 8 show the results of the contribution of each variable in
hedging decision process. Model 7 gives the unique importance of growth opportunities for hedging
strategy. The models from 9 to 11 present a combination between the various variables. Finally, model
12 considers all the variables resulting from the linear regressions of the performance on hedging
123 International Research Journal of Finance and Economics - Issue 44 (2010)

determinants. The estimated coefficients of independent variables correspond to natural logarithms of

the Odds.
Chi-square statistics are significant for all models except for the two first. More the Chi-square
value is high, more the model is powerful. According to table 13, Chi-square value tends to improve
from model 1 to 12. The highest statistic (95.5) is observed for the model 12 which include all hedging
variables. Log likelihood, R-square of Cox & Snell, R-square of Nagelkerke, and percentage of good
classification statistics; show that the last regression (model 12) is the best model.
The regression results permit as to identify factors that explain the probability to engage in
hedging programs.
Odds (Y = 1) = e -4.951 e 0.426( LossB ) e -5.084( FixedAs . / TA) e -0.121( M / B ) e1.215( RDB )
e 0.743( LnMVE ) e 4.221(WCR ) e -1.095( BETA )
Pr obability of hedging =
1
4.951 - 0.426 ( LossB ) 5.084 ( FixedAs . / TA ) 0.121( M / B )
1+ e e e e e -1.215 (WCR ) e -0.743( LnMVE ) e -4.221(WCR ) e1.095 ( BETA )
This real example (at random) illustrates the effect of independent variables variations on
hedging probability:

The data relative to non-Hedger firm is follow:

Lossb Fixed Assets/TA M/B RDB LnMVE WCR Beta

0 0.35 1.39 0 3.11 0.46 0.19

Thus, the probability of hedging risks is equal to 5.45% as shown by the following equation:
1
P(Y = 1) = - 0.4260 5.0840.35 0.1211.39
= 5.45%
1+ e 4.951
e e e e -1.2150 e -0.7433.11 e -4.2210.46 e1.0950.19
This probability is conforming to the information published in annual report. We tried to
simulate the rising effect of each variable on the increase or decrease of hedging probability. For
example, if this firm anticipates that will have a tax loss carry forwards (the dummy variable passes
from 0 to 1) keeping other items unchanged, probability will increase at 8.1%.
1
P(Y = 1) = -0.4261 5.0840.35 0.1211.39
= 8.1%
1+ e 4.951
e e e e -1.2150 e -0.7433.11 e -4.2210.46 e 1.0950.19
In order to test the tax convexity function effect on the hedging probability, Mian (1996) used
three independent variables such as tax loss carry forwards, tax credits and the incomes in progressive
area. Positive signs were predicted for these variables. The results show significant estimated
coefficients but only tax credit variable confirms theory. In our study, the variable tax loss carry
forwards is positive and significant. Our finding is conform to previous studies conducted by Berkman
and Bradbury (1996), Fok, Carroll and Chiou (1997), Gczy, Minton and Schrand (1997), and
Allayannis and ofek (2001). Nance, Smith and Smithson (1993) and Tufano (1996) studies does not
confirm the assumption of tax function convexity.
Fixed assets/ total assets, market-to-book and the dummy variable research and development
measure the importance of growth opportunities on hedging decision. According to model 12, the
coefficients associated with these ratios, are negative and significant indicating that sample firms show
less incentives for hedging, which contradicts theory. Whereas the coefficient associated with research
and development activity is significant and positive. Model 7 regresses hedging decision on the
underinvestment variables and shows that the ratio fixed assets/ total assets and R&D are significant
and positive. Amrit (2005) and Gczy, Minton and Schrand (1997) use, respectively, the ratios fixed
asset to sales and fixed assets to total assets as proxies of growth opportunity. They find positive
coefficients but statistically not significant. Nance, Smith and Smithson (1993), Mian (1996), Gczy,
International Research Journal of Finance and Economics - Issue 44 (2010) 124

Minton and Schrand (1997), Fok, Carroll and Chiou (1997) and Allayannis and Ofek (2001) use the
ratio M/B as determinant of growth opportunities. Only the study conducted by Gczy, Minton and
Schrand (1997) confirms the assumption of positive relation. In accordance with prediction, the
positive effect of research and development activity are confirmed by Nance, Smith and Smithson
(1993), Gczy, Minton and Schrand (1997), Fok, Carroll and Chiou (1997), Allayannis and Ofek
(2001) and Knopf, Nam, and Thornton (2002), Nam, Ottoo, and Thornton (2003).
Financial literature shows that firm size is an incentive for hedging. The natural logarithm of
firm value is introduced into the last five models (8 to 12). All estimated coefficients are positive and
significant in accordance with theoretical developments. Our results confirm previous studies of
Nance, Smith and Smithson (1993), Francis and Stephan (1993), Mian (1996), Tufano (1996),
Berkman and Bradbury (1996), Gczy, Minton and Schrand (1997), Fok, Carroll and Chiou (1997) and
Guay (1999).
The ratio of working capital (current liabilities/ current assets) used as a hedging substitute, is
included in five models. The results confirm the assumption of positive relation. The same results are
obtained by Tufano (1996), Nance, Smith and Smithson (1993), Berkman and Bradbury (1996) and
Gczy, Minton and Schrand (1997).
Guay and Kothari (2003) show that companies which have higher risk market should prove
more incentives to purchase derivatives. Guay (1999) justifies the use of beta by the fact that the
interest rates can affect as well numerator (cash-flows) as denominator (discount rate) in equation of
stockholders' equity evaluation, hedging of cash-flows changes to the interest rate should not
necessarily reduce the equity volatility. Model 1 regards only the value of beta as an independent
variable. The estimated coefficient well that it is positive, the statistics of this model are not significant.
This variable is introduced into the last four models; the estimated coefficients are negative and
significant. Guay (1999) find the same results but not significant.
The following table shows the comparison between our results and those of previous studies.

Table 14: Comparison between results of the present study and results of previous studies

Variables Pre NSS T M BB FCC GMS G H A0 RPS

EBIT/ Interest Expense - -NS - -NS - -NS -
Long-Term Debt/ Market Value of
+ -NS +NS + -
Firm
Cost of Total Debt/ Ln total Assets + +
financial Total Debt/ Book Value of Equity + +NS + +NS
distress Expense Charges + NS
Ln Sales - +
Market value of Equity -
Total Assets +/- +NS +
Simulated marginal tax rate - +
Average Tax rate +
Tax Incentives dummy (1= income
in progressive region (>34%), 0= + + - +NS
otherwise)
Expected
Loss Carry Forwards/ total Assets + -NS - +NS
Taxes
Dummy (1= Loss Carry Forwards,
+ - + +
0= otherwise)
Investment Tax Credit/ total Assets + + +NS
Dummy (1= Investment Tax
+ +
Credit, 0= otherwise)
Market Value/Book Value of the
+ - -
Firm
Dummy (1= listed firm, 0=
Investment - -NS
otherwise)
and
Dummy (1= if Debt ratio.>average
Financial
and Working Capital Ratio + -NS
Decisions
<average, 0= otherwise)
Operational Expenses/ Market
+ +
Value of firm
125 International Research Journal of Finance and Economics - Issue 44 (2010)
Acquisition Activities/ Market
+ - + +NS
Value of Firm
Ratio of Distribution of Dividend - -NS
Share Return - - -NS
Working Capital ratio - -
Market Value of firm +/- + +NS + + + + + + +
Market-to-Book Value + -NS -NS + -
R&D/ book value of Firm + + + +
Growth
R&D/ Sales + + +
opportunitie
Price-Earning ratio - +
s
Fixed Assets/ Market Value of
+ + -
Firm
Dividend Dividend yield + +
distribution
Ratio of distribution + +NS
Working Capital ratio (Current
+ + +
Liabilities/Current Assets)
Liquidity Current Ratio - -
Current Assets/ Market Value of
- NS
Firm
Convertible Debt/ Total Assets +/- -NS
Substitutes Preferred Stock / Total Assets +/- -NS
for Hedging (Convertible Debt + Preferred
+/- NS
Stock)/ Total Assets
Risk Coefficient beta + +NS -
-NS: negative coefficient but not significant, +NS: positive coefficient but not significant, (+): positive coefficient and
significant and (-): negative coefficient and significant. NSS: Nance, Smith and Smithson (1993). T: Tufano
(1996). M: Mian (1996). BB: Berkman and Bradbury (1996). FCC: Fok, Carrol and Chiou (1997). GMS: Gczy,
Minton and Schrand (1997). G: Guay (1999). H: Haushalter (2000). AO: Allayannis and Ofeck (2001). RPS:
Results of present study.

5. Conclusion
In this paper, we have given a theoretical and empirical overview of corporate hedging strategies. Data
on hedging activities of 403 non-financial US firms are obtained from annual reports published in
1999. Initially, we have determined firm exposures to risks in 1999 (currency exchange rates, interest
rate, and oil prices). Using time series models, we have regress equity return rate to risk exposure
variables. The results show that the companies are more exposed to currency exchange risk compared
to oil risk. These results are confronted with the hedging information collected from annual report.
This confrontation confirms the regression results at a level of 85.11%.
We focus on the hedging determination variables. The literature of risk management suggests
several variables as relevant indicators for hedging. Nevertheless, the choice of the variables remains
problematic. Our empirical methodology consists in regressing, first stage, return on assets (ROA) as
performance measure on hedging variables for two sub-samples (hedgers and non-hedgers). Seven
variables explain performance differences between hedgers and non-hedgers. These variables are used
in logit regressions to determine hedging strategies of non-financial US firms.
Consistent with previous studies, the results show that the probability of hedging is positively
related to tax loss carry forwards. We find that firms with important research and development
activities but less fixed assets and low current assets are most likely to engage in hedging programs.
The results indicate that larger firms are more likely to use derivatives to hedge risk exposures.
International Research Journal of Finance and Economics - Issue 44 (2010) 126

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