Academic journal article International Journal of Business

The Value Effects of Foreign Currency and Interest Rate Hedging: The UK Evidence

Academic journal article International Journal of Business

The Value Effects of Foreign Currency and Interest Rate Hedging: The UK Evidence

Article excerpt

ABSTRACT

In this paper we use UK data to present empirical evidence on the valuation and debt capacity effects of foreign currency (FC) and interest rate (IR) hedging. We build on recent studies that have presented mixed results on the link between hedging, leverage and firm value. Our results provide evidence of a significant relationship between firm value, measured as Tobin's Q, and foreign currency and interest rate hedging. These findings are much stronger than those found in previous studies that have examined US firms. Our empirical evidence suggests that this is due to the fact the US studies include in their non-hedging sample other hedging firms, such as firms using non-derivative methods for hedging, which can bias the results against finding positive leverage and firm value effects. The larger value effects in our results could also be due to institutional differences in the bankruptcy codes between the UK and the US that cause higher expected financial distress costs for UK firms and therefore greater benefits generated by hedging. When we look at debt capacity and the tax shield effects of hedging, we find that investors reward interest rate hedgers with a larger hedging premium than that rewarded for FC hedging. In fact, our results show that the debt capacity benefits of interest rate only hedging are around six times those generated by FC only hedging. Finally, the debt capacity results in relation to IR hedging and the Tobin's Q results show that derivative hedging generates more value than nonderivative hedging.

JEL Classification: F30, G32, G33

Keywords: Firm value; Foreign currency hedging; Interest rate hedging; Derivatives; Debt capacity; Leverage; Financial distress.

I. INTRODUCTION

The positive theory of corporate hedging developed by Smith and Stulz (1985) is based on the demonstration that imperfect capital markets can create conditions where corporate hedging becomes economically justified because it can add value to the firm. Many studies have examined what these conditions are and why firms might be using derivatives for hedging. The key question for shareholders, however, is whether hedging does, in fact, add value to the firm. Empirical research on this question is relatively recent, generally focused on the US and, since commodity price hedging seems to be generally limited to specific industries, has concentrated on interest rate and foreign currency hedging. In this paper we extend this literature and study the value effects of the interest rate (IR) and foreign currency (FC) hedging practices of a sample taken from the top 500 non-financial firms in the UK ranked by market value as of year-end 1995.

The UK data for this period is well adapted to the value testing we propose for several reasons. At the time the UK had (and still has) a large number of firms with foreign operations. These firms were facing continuous currency risk because the pound had been floating since its withdrawal from the European currency mechanism in 1992. The economy was highly industrialized and open with developed, generally unrestricted capital markets and trading partners that were predominantly in the same conditions. Thus, the financing and hedging decisions by the firms in our sample are likely to reflect economic and financial criteria rather than the result of constraints imposed by shallow domestic capital markets, bureaucratic controls and the like. Furthermore, the year 1995 is at the midpoint of the years included in the studies cited in this paper and, thus, serves as a good point of comparison.

The innovation in this study that makes our results so interesting is that we organize the tests so that the value effects of each type of hedging, both interest rate and foreign currency, and each type of instrument, both derivative and non-derivative, can be isolated and estimated independently in order to eliminate any potential bias. The failure of other studies to do this weakens their results and probably explains why the evidence is so mixed. …

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