An Examination of European Firms’ Derivatives Usage: The Importance of Model Selection

Date01 September 2017
AuthorJames Ryan,Fergal O'Brien,Anthony Carroll
Published date01 September 2017
An Examination of European Firms
Derivatives Usage: The Importance of
Model Selection
Anthony Carroll, Fergal OBrien and James Ryan
Kemmy Business School, University of Limerick, Limerick, Ireland
This paper investigates the determinants of foreign currency (FX) and interest rate
(IR) derivatives usage for European non-nancial rms. We employ a Tobit model
and a two-part model which allows the determinants of the usage decision to differ
from the extent of usage decision. We nd FX derivatives usage is motivated by
economies of scale and FX exposure, while IR derivatives usage is motivated by the
magnitude and nature of rmsdebt. We also nd that for IR derivatives the
determinants of the usage decision differ from the determinants of the extent of
usage decision.
Keywords: foreign exchange exposure, interest rate exposure, hedging policies
JEL classification: G32
1. Introduction
The 20072008 crisis in the capital markets, which wreaked havoc in the nancial sector,
caused relatively few problems in the non-nancial sector. Bartram et al. (2015) contend
that the reason for this is that economic risk (e.g., competition, price hikes in the factors
of production, etc.) accounts for the vast majority of non-nancial rmsstock volatility
whereas their exposure to capital markets, i.e., market-based nancial risks such as those
pertaining to interests rates and foreign currencies, accounts for only a fraction. This is
consistent with such rms managing their nancial risk, which they can do by means of
adjustments to leverage, dividend and liquidity policies but also by hedging this risk
using nancial derivatives. Moreover, the established theory suggests that corporate risk
The authors are grateful to the anonymous referees and John Doukas (the Editor) for their
very helpful comments, suggestions and support throughout the review process. We are
further grateful to the Kemmy Business School for its funding throughout this research
project. Anthony Carroll acknowledges the financial support received from the Irish
Research Council.
European Financial Management, Vol. 23, No. 4, 2017, 648690
doi: 10.1111/eufm.12115
© 2017 John Wiley & Sons, Ltd.
management can not only mitigate risk but also increase rm value (Froot et al., 1993;
Leland, 1998). However, conclusive empirical evidence that corporate risk management,
and hedging with nancial derivatives in particular, matters for rm value is mixed, with
some studies nding a positive relationship (Carter and Sinkey Jr, 1998; Disatnik et al.,
2014; MacKay and Moeller, 2007) but others nding no signicant relationship (Bartram
et al., 2011; Guay and Kothari, 2003; Jin and Jorion, 2006). Chang et al. (2016) suggest
one reason for this inconsistency is that even sell-side analysts, despite their apparent
nancial expertise, routinely misjudge the earnings implications of rmsderivatives
activities. What hope then for the average shareholder? All of the above therefore
necessitates a more granular investigation into what motivates rms to use derivatives,
the types of derivatives they use, and the level of that usage.
Previous studies have attempted to do so but many suffer from externally imposed
restrictions such as availability of suitable data. Many therefore limit the scope of their
investigations to certain categories of derivatives, or to particular industries and
geographic locations. Furthermore, a large variety of econometric models and
explanatory variables have been employed across these studies, making comparisons
between each difcult. Table 1 breaks down a selection of these studies by geographic
location of the samples selected, the scope of their investigations, and the models
With respect to scope, the third column illustrates how much of the previous research
focuses on the determinants of certain classications of derivatives usage foreign
currency (FX), interest rate (IR) or commodity price (CP) whereas others examine
general, or aggregate, derivatives usage. Examining general derivatives usage
presupposes that the different categories of derivatives share common determinants.
However, if the determinants of FX, IR and CP derivatives usage differ from one another,
then they should be disaggregated and examined separately. Furthermore, comparisons
between different studies should be restricted to only those that examine the same
classication of derivatives.
The fourth column shows the range of models employed to examine rmsderivatives
usage. Studies that exclusively examine the usage decision employ either a logit or a
probit model. Generally, the requirement is that a rm that discloses derivatives usage,
even qualitatively, be classied as a derivatives user. Hence, rms with widely varying
magnitudes of derivatives usage are broadly categorised as users, which can introduce a
large amount of measurement error. Studies that examine the extent of rmsderivatives
usage, most commonly measured with gross notional amounts, use either a Tobit or a
two-part model, which differ in their assumptions of rmsdecision processes: those that
assume that the binary derivatives usage and extent of usage are jointly decided in one
step employ the Tobit model, whereas those that assume rms decide on the extent of
usage only after they have decided to use derivatives employ a two-part or hurdle model.
Perhaps a reason for the apparent disparity in empirical ndings is the lack of consensus
on which model is the most representative of rmsactual decision processes.
In addition to scope and model employment, studies also vary in their selection of
explanatory variables. Of the ten studies that examine the determinants of FX derivatives
usage in Table 1, only ve control for FX exposure with some measure for foreign sales
(Allayannis and Ofek, 2001; Bartram et al., 2009; Elliott et al., 2003; G
eczy et al., 1997;
Muller and Verschoor, 2005). Of the six studies that examine the determinants of IR
derivatives usage, only one attempts to directly control for IR exposure by measuring
variable rate debt (Chernenko and Faulkender, 2012). Graham and Rogers (2002), who
© 2017 John Wiley & Sons, Ltd.
An Examination of European FirmsDerivatives Usage 649
examine the determinants of general derivatives usage, include a proxy for interest rate
exposure in the sum of short-term and oating rate debt (as a percentage of total debt).
The majority of these studies have been motivated by the theories of optimal hedging,
which argue that a range of rm attributes, such as its growth opportunities (Froot et al.,
1993) or the probability that it will get into nancial distress (Smith and Stulz, 1985),
determines derivatives usage. Consequently, many studies share a common subset of
explanatory variables. However, even within this subset, empirical ndings have been
Table 1
Overview of derivatives literature
This table provides an overview of the literature that uses annual report disclosures to examine the
determinants of rmsderivatives usage. The column entitled Scoperefers to what categories of
derivatives are examined. For example, FX and IRmeans that study examines the determinants of FX
and IR derivatives separately. Generalrefers to the determinants of aggregate derivatives usage, or
FX, IR and CP derivatives usage, combined. The last column, entitled Model, refers to the model
employed to examine rmsderivatives usage.
Author(s) Sample Scope Model
eczy et al. (1997) US FX Logit
Allayannis and Ofek (2001) US FX Two-part
Elliott et al. (2003) US FX OLS
Visvanathan (1998) US IR Logit
Borokhovich et al. (2004) US IR Tobit
Chernenko and Faulkender (2012) US IR OLS
Tufano (1996) US CP Tobit
Haushalter (2000) US CP Two-part and Tobit
Dionne and Garand (2003) US CP Tobit
Adam and Fernando (2006) US CP Two-part
Mian (1996) US FX, IR and CP Logit
Howton and Perfect (1998) US FX and IR Tobit
Gay and Nam (1998) US General Tobit
Fok et al. (1997) US General Logit
Graham and Rogers (2002) US General Tobit
Knopf et al. (2002) US General Tobit
Rogers (2002) US General Tobit
Lin and Smith (2007) US General Probit
Nguyen and Faff (2002) Australia General Tobit
Nguyen and Faff (2003) Australia FX and IR Tobit
Marsden and Prevost (2005) New Zealand General Two-part
Bartram et al. (2009) International (incl.
FX, IR and CP Probit
uck and Schmid (2014) International (incl.
FX, IRand CP Probit and Tobit
Lel (2012) International (incl.
FX Tobit
Judge (2006) UK General Logit
Muller and Verschoor (2005) Belgian, Dutch, German, UK FX Two-part
© 2017 John Wiley & Sons, Ltd.
650 Anthony Carroll, Fergal OBrien and James Ryan

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