An examination of US dollar risk management by Canadian non-financial firms
The Authors
Alex Faseruk, Faculty of Business Administration, Memorial University of Newfoundland, St Johns, Newfoundland and Labrador, Canada
Dev R. Mishra, Edward School of Business, University of Saskatchewan, Saskatoon, Canada
Acknowledgements
The authors are grateful to the discussant and seminar participants at ASAC 2005, EFA 2006, especially discussant Gautam Goswami at EFA 2006, and seminar participants at FMA 2006, especially David Carter for helpful comments.
Abstract
Purpose – The purpose of this paper is to examine the impact of US dollar exchange rate risk on the value of Canadian non-financial firms.
Design/methodology/approach – The sample, from the Compustat database, includes all non-financial Canadian firms with sales over $100 million. The study segregates firms into hedging and non-hedging groups and applies statistical techniques to test if hedging enhances value.
Findings – The results demonstrate that Canadian firms that have higher levels of US$ sales tend to use derivatives more frequently through higher levels of US$ exposure. Firms that have both US sales and assets appear less likely to use hedging. Firms with an American subsidiary and use financial instruments to hedge have higher values. When operational hedging is used with financial hedging, it is a value enhancing activity increasing their market-to-book by 14 per cent and market value-to-sales by 40 per cent. Incremental impact of these two hedging strategies is to enhance value by 7 per cent.
Research limitations/implications – The sample from Compustat captures large capitalization Canadian firms but ignores about 75 per cent of Canadian firms. There is a bias towards larger firms. Some hedging items are not disclosed on financial statements. A survey would enhance and complement these results.
Practical implications – The paper finds that it is important for Canadian firms that have exports denominated in US dollars to hedge their exposure. The full value of hedging is reaped by using both operational and financial hedges.
Originality/value – This study is the first that examines US dollar risk management by Canadian firms.
Article Type:
Research paper
Keyword(s):
Hedging; Financial risk; Currency options; Canada; United States of America; Exchange rates.
Journal:
Management Research News
Volume:
31
Number:
8
Year:
2008
pp:
570-582
Copyright ©
Emerald Group Publishing Limited
ISSN:
0140-9174
1. Introduction
In this study, the value implications of financial and operational hedging of United States (US) dollar exposure by Canadian non-financial firms are examined. The financial hedging of US dollar risk refers to the use of financial instruments to reduce foreign exchange exposure by Canadian firms through various means, such as US dollar derivative contracts. Operational hedging refers to a Canadian firm possessing American denominated assets, operations or subsidiaries doing business in the USA.
In an efficient capital market, or under the restrictive assumptions of Modigliani and Miller, hedging by itself would not be expected to enhance the value of the firm. However, when one considers various market frictions, endemic to the financial environment, the inclination is to develop models designed to capture the effect of hedging on financial performance in order to justify the usage of hedging strategies.
Financial hedging is viewed as value-maximizing by management if combined with operational hedging (Allayannis et al., 2001). An operational hedge is also viewed as a significant means to reduce foreign exchange rate risk (Pantzalis et al., 2001). Firms should take into account not only the breadth, but also the depth dimensions of a multi-national corporation's (MNC) foreign subsidiaries. It is important to examine the impact of operational hedges on exposure separately that can influence value in MNCs either negatively or positively.
A more basic question is whether firms are indeed exposed to foreign exchange risk. During the past decade, several attempts were undertaken to measure the extent of the exposure (Jorion, 1990; Bodnar and Gentry, 1993; Bartov and Bodnar, 1994; Chow et al., 1997). These studies have documented only a weak relationship between share performance and exchange rate fluctuations. Notwithstanding the weakness of these results, case studies (Pringle, 1991), survey results (Bodnar et al., 1998), as well as anecdotal evidence from financial practitioners, all contend that foreign exchange exposure is an important consideration for most firms and MNCs in particular. Thus, many corporations actively undertake hedging techniques designed to lessen foreign exchange exposure, despite the paucity of evidence documenting a strong relationship to its performance in the financial markets. Some have questioned whether or not hedging through derivatives reduces foreign exchange risk while other studies have found that firms which employ foreign exchange risk management have recorded higher values (Allayannis and Weston, 2001; Copeland and Copeland, 1999; Copeland and Joshi, 1996).
While the existing literature in foreign exchange risk management by non-financial firms is diverse, comparatively few studies explore this issue in relation to Canadian non-financial firms. Jalilvand (1999) used corporate hedging explanations to examine observed differences in the use of derivatives by Canadian non-financial firms. His study demonstrated that the scale, operational efficiency and level of integration of treasury activities are important determinants for identifying Canadian and international users of derivatives. The current study examines the US dollar risk management practices of Canadian firms. Specifically, the issue of whether CA$/US$ risk management by Canadian firms is both risk reducing and value enhancing is examined.
Most studies focus on the foreign exchange risk management using a sample of US firms. The larger American sample provides the most robust test of firm value implications of hedging. There are specific advantages in studying foreign exchange risk management of Canadian firms. The primary advantage is that US foreign trade is highly diversified around the globe, while that of Canadian is highly concentrated with the USA. For example, the highest US export/import to a single country is about 23 per cent, whereas Canada's average exports to the US are about 85 per cent and imports are about 60 per cent[1]. This uniquely concentrated Canadian foreign trade allows for generation of a substantially large sample of firms with transaction exposure to only one currency – the US dollar. Therefore, the sample provides a unique test of the effect of foreign exchange risk management as the firms in this study have exposure to a single foreign currency.
The results of the current study demonstrate that Canadian firms with higher levels of US sales tend to use derivatives more frequently and encounter higher levels of US$ exposure. However, firms that have higher levels of both US$ sales and assets appear less likely to use financial hedging. Arguably, US assets held in conjunction with sales provide a natural operational hedge for these US sales made by Canadian firms. Firms that have a US subsidiary and use financial instruments to hedge US dollar risk have higher values than other firms in this sample. Overall, this paper finds that the Canadian non-financial firms that use operational hedging in conjunction with financial hedging of US dollar risk have higher relative values on average. For example, such firms have higher market-to-book ratios by about 14 per cent with the market value-to-sales ratios being over 40 per cent higher.
This remainder of the paper is divided into four sections. Section 2 reviews the relevant literature. Section 3 describes the data. Section 4 presents the methodology, analysis and results. The paper is concluded in section 5.
2. Literature review
Many firms have transactions and assets denominated in a currency other than their own domestic currency. This fact provides a source of risk for that firm. Recent studies have examined foreign exchange risk management (Bodnar et al., 1998; Dolde and Mishra, 2007; Géczy et al., 1997; Jorion, 1991). Some studies relate hedging to firm value (Allayainnis and Weston, 2001). Recent studies have also combined operational and financial hedging together into a single risk management paradigm (Allayannis et al., 2001). Few studies involving Canadian firms exist, with some notable exceptions (Jalilvand, 1999; Booth and Rotenberg, 1990).
Early literature found evidence that the exchange rate exposure does not matter in integrated or efficient markets (Jorion, 1990; 1991). In recent years, exchange rate risk and exposure was found to be significant and a matter for concern for US corporations (Allayannis and Ihrig, 2001; Chow et al., 1997; Dominguez and Tesar, 2001; Griffin and Stulz, 2001). Foreign exchange risk was the most widely hedged risk using derivatives (Bodnar et al., 1998). The impact change in exposure was found to vary in changing value from very small fractions (Allayannis and Ihrig, 2001) to a significant exchange rate exposure across countries at firm and industry levels (Dominguez and Tesar, 2001). The current study documents that exchange rate exposure matters even across integrated financial markets, such as Canada and the USA.
Other studies found that foreign exchange exposure related to both operational and financial hedging (Allayannis et al., 2001). Results have also shown that operational hedging is value maximizing if it is combined with financial hedging, and that the hedging successfully reduced foreign exchange exposure. Accordingly, exposure was related to the use of operational hedging (Pantzalis et al., 2001). It was also found that firms with greater operations network breadth exhibited less exchange rate risk, while firms in highly concentrated networks were more exposed to such risk (Pantzalis et al., 2001).
Canadian firms may be in greater need of foreign exchange risk management, particularly with respect to the US dollar. The large majority of Canadian trade is conducted in US dollars either through direct trade with the USA or by dealing in international trade wherein the trade is denominated in American dollars. The Canadian economy is not only export-driven, but also deals in many raw materials where the unit of account is American currency, such as oil, precious and base metals, and lumber. Accordingly, the rate of exposure by Canadian non-financial firms is very high. The US dollar exchange rate is arguably the single most important foreign factor affecting the Canadian economy in short-term transaction and long-term economic exposure. Exporting and importing firms follow the appreciation and depreciation of the US dollar very closely as often their level of profitability and their share price are directly tied to movements in that currency.
Thus, the primary hypothesis for this study is that the hedging (operational and financial) of US dollar exchange rate risk would be a value maximizing activity by Canadian non-financial firms.
3. Data description
The data sample initially included all Canadian non-financial firms with sales exceeding $100 million in 2001 represented in Compustat's Canadian stock file[2]. This search from Compustat returned a total of 447 firms. The firms cross-listed in the US exchanges are required to file their annual reports to the Securities and Exchange Commission (SEC) according to American general accepted accounting principles (GAAP), as well as SEC requirements. Therefore, the amount of foreign sales and assets reported may already be fully in US dollars, thereby accounting for transactions and translations risk. In addition, the pricing of the stocks on the American Stock Exchanges, notably the New York Stock Exchange and National Association of Security Deeler Automatic Quotations (NASDAQ), may already have incorporated the exchange rate effect of US sales/assets in a different fashion than the stocks that traded solely on Canadian exchanges. For example, the Potash corporation (primarily a Saskatchewan corporation) normally declares and pays its dividends in US dollars, but the corporation encounters sales in both Canadian and America dollars. However, the different amounts of sales and location of the shareholders are not disclosed. Accordingly, one does not know the extent to which hedging of the dividend payment has already taken place, perhaps through a natural hedge. Therefore, all cross-listed firms between Canadian and American Stock Exchanges are excluded, leaving 303 firms that are listed only on Canadian Stock Exchanges. Often it is not clear in cross-listed firms as to what is being hedged. Canadian firms that are cross-listed on American exchanges often have a substantial part of the business operations in the USA. For example, Nortel Network's volume of business on both sides of the border, it is hard to distinguish whether it is optimal form the firm to manage risk from the perspective of US dollar investors or Canadian dollar investors. Similarly, Potash corporation a Saskatchewan-based mining company pays its dividends in US dollars. Hence, it is difficult to determine whether these cross-listed firms are maximizing the value of US dollar or Canadian dollar investors. Therefore, cross-listed firms are excluded from the sample.
For the remaining 303 firms, a manual search of annual report footnotes available from www.sedar.com was conducted for information on use of foreign exchange derivatives, e.g. futures, forwards, options and swaps, or at least a statement about some instruments that reflected hedging of US dollar exchange risk in 2000 and 2001. From the hedging data, the existence of US and non-US subsidiaries, the amount foreign dollar denominated sales and foreign assets were extracted. Excluded were all stocks that contained ambiguous information on the currency hedged, as the intent of this study was to examine US$ hedging by Canadian non-financial corporations. In addition, some firms whose names could not be clearly matched in sedar were excluded. For the firms remaining in the sample, the price-to-book ratio, market value, total debt, total assets and total sales data were all extracted from Compustat. The firms that did not have complete data on all the selected variables for these years were also excluded. The final sample included 316 useable observations involving 194 Canadian firms over 2000 and 2001. Three of these firms traded on the Canadian Venture Exchange with the rest from Canada's major exchange, the Toronto Stock Exchange.
4. Analyses and discussion
4.1 Proxies of value, hedging and exposure
Four proxies of value were created: first, closing stock price per share divided by book value per share (PriceBook), as available in Compustat annual files; second, total capital divided by total assets (TCTA), where total capital refers to the total of long-term debt, preferred stock and market value of equity. The third proxy is total market value of equity divided by sales (PriceSales) with the fourth being total capital divided by sales (TCSales).
The proxy of US dollar hedging is created under two types of observations in the annual reports. The first proxy of hedging is a binary variable. Firms are classified as “HEDGERS”, if annual report footnotes contained at least one statement that the firm hedged US$ risk, or a statement that the firm used US$ derivatives or reported explicit amount for US$ denominated derivatives (options, futures, swaps, forwards or US$ denominated loan). “HEDGERS” are assigned a value of “1”. The firms that do not qualify as HEDGERS are denoted as “NON-HEDGERS” and are assigned a value of “0”. There are total of 130 firm/years of data for HEDGERS and 186 firm/years for NON-HEDGERS.
The second proxy of hedging is based on the explicit amounts of US$ hedging instruments available in the annual report footnotes. The firms that have explicit amount for one or more hedging instruments (options, futures, swaps, forwards or dollar denominated loan) in US$ are classified as “E-HEDGERS”, and the firms that do not qualify as E-HEDGERS are classified as “E-NON-HEDGERS”. There are 102 firm/years of data for E-HEDGERS and 214 firm/years of data for E-NON-HEDGERS.
The proxy of foreign exchange exposure is created using the two-factor market model as previously done in Jorion (1990, 1991). See equation (1). In this equation, R it is the time series of stock returns; Rm it is the time series of contemporaneous market returns, Δ(ExchangeRate) it is the time series of change in the CA$/US$ exchange rate. The symbol π i is the coefficient of exchange rate exposure and u it is the error term. An exposure for 2000 is measured by using time series of monthly data from June 1998 to May 2001. For 2001, it is measured using data from June 1999 to May 2002, similar to the approach used in Allayannis et al. (2001). The paper records the absolute value of π i as exposure. Note that some firms have a negative value for π i . A firm with a negative π i cannot be regarded as being an exposure less than that of a firm with zero exposure. Therefore, the absolute value of the coefficient is employed instead of the actual value[3].(see equation 1)
4.2 Descriptive analysis
Table I provides the cross-sectional descriptive statistics of the sample. The sample is divided into four categories, based both on hedging tendencies and control variables. Panel 1 of Table I shows the value impact of hedging for the Canadian firms “with a US subsidiary” vs “without a US subsidiary”.
From the table, it is observed that HEDGERS are more highly valued by the market than NON-HEDGERS, as all four value-measures clearly demonstrate that HEDGERS with a US subsidiary are the most valuable firms, while the HEDGERS without a US subsidiary are the least valuable firms. In line with Allayannis et al. (2001), one may make following interpretation of this result. Assuming the existence of a US subsidiary as operational hedging and the use of US$ derivatives as financial hedging, the use of both operational and financial hedging is value enhancing while the use of only one is not. For example, the average for the value proxies for HEDGERS with US subsidiary is the highest; that for the NON-HEDGERS with no US subsidiary is the second highest, followed by other two sub-categories. This result may also imply that the market penalizes Canadian firms that use financial hedging and do not have a US subsidiary. Moreover, HEDGERS with at least one US subsidiary have a 14 to 54 per cent larger average for value proxies than an average firm, and about 28 to 97 per cent larger than that of HEDGERS with no US subsidiary. Results in Panel 5 of Table I, which measures firms hedging tendency as E-HEDGERS and E-NON-HEDGERS, are consistent with those of Panel 1.
Panel 2 of Table I groups firms on US sales volume available in annual reports, i.e. firms reporting an amount for US sales vs firms not reporting an amount for US sales. As the table indicates, firms with US sales have higher average price-to-book values than those without US sales. The existence of US Sales is equivalent to having transaction exposure in a Canadian firm to the US dollar. Results in this table show that the HEDGERS with US sales have the highest values, whereas NON-HEDGERS with US sales have the lowest values implying that the market penalizes firms that do not hedge the US dollar risk associated with US sales.
Note the difference between Panel 1 and Panel 3, that the market penalizes two groups of firms, which are HEDGERS with no US subsidiary, and NON-HEDGERS with US Sales. As expected NON-HEDGERS without US sales have higher values than the HEDGERS without US sales. Overall, the results in this table imply that it is important for Canadian firms to hedge transaction exposure related to US sales. All exporting Canadian firms are markedly better off hedging their US dollar risk. Moreover, transaction exposure may also be related to imports. However, as the import data are not available, no inferences could be made about total transaction exposure. This area can prove fruitful for further research.
Panel 3 of Table I divides firms based on explicit amounts of US assets available in annual reports, i.e. firms reporting an amount of US assets vs firms not reporting an amount of US assets. In line with Allayannis et al., (2001), the existence of US assets, such as the existence of a US subsidiary, can be regarded as being equivalent to operational hedging. Consistent with the operational hedging argument, the results in this table show that the HEDGERS that have US assets exhibit the highest average values, while NON-HEDGERS without an explicit amount of US assets have the lowest average values[4].
Panel 4 of Table I divides firms that have reported both US sales and US assets and that have not reported one of the two or both. Consistent with all other tables, HEDGERS reporting both US sales and US assets demonstrate the highest average values. Overall, the results in Table I Panels 1 to 5 indicate that operational hedging (having subsidiary or assets) is beneficial to manage foreign exchange risk only if backed by financial hedging. Similarly, the use of financial hedging by exporting firms is value maximizing, while by non-exporting firms is value deteriorating. The following section further explores these findings further through the use of multivariate statistical analysis.
4.3 Regression tests
Table II provides regression results of foreign exchange exposure measured using an equation utilizing the aforementioned different hedging measures and varying amounts of foreign sales. The first two rows present regression of exposure with the percentage of the firm's sales denominated in US dollars (US_SALES), a dummy variable for financial hedging of US dollar risk (US$_HED) with “1” for HEDGERS and “0” for NON-HEDGERS, and a second dummy variable for the presence of at least one US subsidiary (US_SUB) with a “1” for the firms with US subsidiaries, “0” otherwise. The US dollar exposure of Canadian firms is positively related to the proportion of US sales. This result is consistent with the literature that foreign exchange exposure is a positive function of foreign sales (Allayannis et al., 2001). Further, the coefficient of US$_HED and US_SUB is negative which should indicate that both financial and operational hedging reduce foreign exchange exposure. However, these coefficients are not significant and do not affect value. This result is inconsistent with the findings in the past literature with foreign exchange exposure of US firms[5].
The second set of the next two rows in Table II drop US_SALES from the regression, replacing it instead with the proportion of US assets (US_ASSETS). Interestingly, the coefficient of US_ASSETS is both negative and significant. This result implies that the proportion of US assets substantially reduces US dollar risk exposure incurred by Canadian firms. The sign and significance of the coefficient of US$_HED remain unchanged. One may interpret these results as the existence of explicit assets in the US provides significant operational hedging of US dollar exposure of Canadian firms, rather than simply having an America subsidiary.
The important question now becomes, “What type of Canadian firms hedge US dollar risk?” Table III provides results to this question through the probit test of financial hedging dummy vs US_SALES, US_ASSETS and US_SUB along with interaction variables and the associated tobit test. The first two rows show that the firms with higher proportions of US sales hedge more often. While hedging tendency is negative, it is also insignificant when examining the proportion of firm's assets in the US (US_ASSETS). Consistent with Table II, foreign assets provide some sort of hedging of foreign exchange exposure resulting in the reduced need for financial hedging. However, as seen in the next two rows, after adding an interaction variable for both US_SALES and US_ASSETS, the coefficient for US assets is positive and significant at the 0.10 level. Further, the coefficient for interaction variable is negative and significant at 0.05 level implying that the firms that have both US dollar sales and US assets tend to indulge to a lesser extent in the hedging of US dollar foreign exchange risk. The next two sets of regressions show that the existence of a US subsidiary does not necessarily alleviate the need for financial hedging. However, when examining firms that have both US subsidiary and sales, the relationship is significant at the 0.10 level.
Table IV provides regression tests of different measures of value with different measures of hedging and control variables. In this table, the coefficient of interaction variables provides very cogent argumentation. Table IV has been produced using the price-to-book ratio as the main proxy of firm value. In these regressions, correction is also made within the SE for heteroskedasticity with the interaction variable USHed*US_sales used in selected specifications. Further, as discussed subsequently, this variable USHed*US_Sales is notable not only in Table IV but also in Table II. As well in Table IV the quantitative proxy of hedging, USHed*Derivatives is also included. Derivatives represent the notional value of hedging instruments used by the firms divided through by the firm's sales in order to provide the appropriate percentage of sales hedged. Consistent with Allayannis et al. (2001), operational hedging when combined with financial hedging is significantly value enhancing. The coefficient of 0.07 for the interaction variable US$_HED*US_SUB implies that even after controlling for firm size, the incremental value impact of using both operational and financial hedging strategies by Canadian firms is about 7 per cent.
5. Conclusion
This study analyzed the impact of US dollar exchange rate risk management by Canadian non-financial firms traded exclusively in Canadian markets and that have a sales of $100 million and higher in 2001. Data on financial and operational hedging were hand collected from financial footnotes from 2001 annual reports of the sample firms, which provided hedging, foreign sales and asset information for 2000 and 2001.
As expected, Canadian firms that have higher levels of US sales tend to use derivatives more often and tend to have higher levels of US$ exposure. However, firms with both US sales and US assets tend not to use financial hedging as often. The US assets provide some sort of natural operational hedging for US sales of Canadian firms. Firms that have at least one US subsidiary (or reported assets) and that use financial instruments to hedge US$ risk tend to have higher values than other firms. Hence, the use of operational hedging in conjunction with financial hedging of US$ risk by Canadian firms is value enhancing; this result is consistent with existing literature that has studied American firms. On average, the market-to-book ratio of such firms is 14 per cent larger and market value-to-sales ratio is over 40 per cent than those of an average firm. The incremental value impact of using both financial and operational hedging together is about 7 per cent.
The paper has two major contributions. First, this is the first study that examines the US dollar risk management by Canadian firms. Second, it documents that it is important to hedge US dollar risk for the firms that have US exports. Firms are better off by implementing both operational and financial hedging of US dollar risk.
The study is not free of limitations. First, the sample is drawn from the population of firms represented in Compustat, which excludes almost 75 per cent of Canadian firms, which represents a significant proportion of market capitalization. Second, the information disclosed through annual reports may not be fully complete; hence, a survey may provide richer information on derivatives use by Canadian firms which future studies may consider pursuing.
Notes
- Estimates are based on the Canadian export and import data from Statistics Canada for the years 2001 to 2005.
- Sales in 2000 were obviously different from sales in 2001. The lowest sales in 2000 were $45 million, and in 2001 were $100.3million. $ refers to Canadian dollar unless otherwise stated as US$.
- There is a debate in literature regarding the appropriate model for the measurement of foreign exchange exposure. One school of thought, led by Adler and Dumas (1984), argues the use of a single-factor model for measuring exposure, while another school of though led by Jorion (1990) argues for the two-factor model. This paper does not involve itself in this debate but uses the two-factor model as it is used in most of the recent literature, such as Allayannis et al. (2001) and Bodnar and Wong, (2003), among others.
- One may note that the firms explicitly disclosing an amount for US assets are less than the firms that reported a US subsidiary. Although, this information may be somewhat contradictory, however, it is as found in annual reports without further examining this anomaly except to say that this situation may be partially explained by a nature hedge given that a gain in asset value may offset the transactional loss and vice versa for the opposite situation.
- For example, see Allayannis et al. (2001), Allayannis and Weston (2001).
Table I.Descriptive statistics of value impact of hedging grouped by the firms with their characteristics on US exposure through an operation, sales and assets
Table II.US dollar exposure and hedging
Table III.Probit and tobit analysis of US dollar hedging
Table IV.Firm value and hedging
(see equation 1)
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Further reading
Ihrig, J. (2001), "Exchange rate exposure of multinationals: focusing on exchange rate issues", Board of Governors of the Federal Reserve System, International Finance Discussion Papers # 709, .
About the authors
Alex Faseruk graduated from Queen's University, Dalhousie University and the University of Kentucky (DBA). He has been a professor at Memorial University since 1981 and is the Associate Dean (Research). Dr Faseruk has received 21 teaching awards including his President's Award for Distinguished Teaching. Externally, he received the Leaders in Management Education Award from the National Post, a 3M Teaching Fellowship and has been recognized by Beta Gamma Sigma and the Academy of Finance. His research has appeared in Journal of Business Venturing, Journal of Applied Business Research, Finance India, Canadian Treasurer, Management Research News and Journal of Financial Management and Analysis. Alex Faseruk is the corresponding author and can be contacted at: afaseruk@mun.ca
Dev R. Mishra is an Associate Professor of Finance at the Edwards School of Business, University of Saskatchewan. Professor Mishra's research interests are in the area of Corporate Finance, International Corporate Finance with emphasis in Corporate Governance, Cost of Capital, Foreign Exchange, International corporate diversification, emerging markets, and Share Repurchases. He has published papers in the journals like Financial Management, Financial Review, Emerging Markets Finance, and Quarterly Journal of Business and Economics. He teaches International Corporate Finance and Corporate Finance courses at the University of Saskatchewan.