Foreign Debt Usage in Non‐Financial Firms: a Horse Race between Operating and Accounting Exposure Hedging

• Author: Yaz Gulnur Muradoglu,Tom Aabo,Marianna Andryeyeva Hansen
• Published date: 01 June 2015
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12032.x

Foreign Debt Usage in Non‐Financial

Firms: a Horse Race between

Operating and Accounting

Exposure Hedging

Tom Aabo

Aarhus University, Fuglesangs Allé 4, DK 8210, Aarhus V, Denmark

E-mail: taa@asb.dk

Marianna Andryeyeva Hansen

Novozymes A/S, Krogshoejvej 36, DK 2880, Bagsvaerd, Denmark

E-mail: mayv@novozymes.com

Yaz Gulnur Muradoglu

Queen Mary, University of London, School of Business and Management, Mile End, Francis Bancroft

Building, Room 4.01, E1 4NS, UK

E-mail: y.g.muradoglu@qmul.ac.uk

Abstract

Previous studies show that foreign exchange exposure from international sales can

be hedged by foreign debt. We go beyond the foreign sales measure by using a

unique database with detailed exposure information on Danish non‐financial firms

with international operations. Our results indicate that foreign debt is used to hedge

foreign assets and subsidiaries (accounting exposure) as opposed to foreign sales

(operating exposure). The paper adds to the literature on corporate hedging by

highlighting the importance of accounting exposure in the hedging behavior of

corporate managers and the perceived need to reduce risks due to currency

mismatches between assets and liabilities.

Keywords: exchange rate exposure management, foreign debt, foreign assets,

foreign subsidiaries, accounting exposure

JEL classification: F23, G32

The authors would like to thank an anonymous referee, John Doukas (the editor), Kim

H. Frederiksen, Jonatan Groba, Alain Krapl, Thomas O’Brien, Berkay Ozcan, Christos

Pantzalis, Frank Thingaard, and participants at the 2010 Behavioral Finance Working Group

Conference, the 2011 European Financial Management Association Annual Meeting, and the

2012 Financial Management Association European Conference for helpful comments and

suggestions to earlier versions of this paper. Tom Aabo acknowledges financial support from

the Danish Council for Independent Research | SocialSciences. Correspondence: Tom Aabo.

European Financial Management, Vol. 21, No. 3, 2015, 590–611

doi: 10.1111/j.1468-036X.2013.12032.x

© 2013 John Wiley & Sons Ltd

1. Introduction

Shapiro (1975) shows that one of the major factors affecting a multinational firm’s

exchange rate risk is sales in export markets. The foreign sales ratio is the standard proxy

for openness. It has been used in a number of studies on the management of exchange rate

exposure by non‐financial firms. A firm that receives revenue in foreign currency has two

ways of eliminating such positive (long) foreign exchange exposure by financial means.

The first is the use of financial derivatives, such as forward contracts, futures, swaps, and

options. The second is the use of debt denominated in foreign currency (‘foreign debt’);

this can involve either raising new debt or changing the currency denomination of existing

debt.

1

The use of the foreign sales ratio as the sole proxy for openness assumes the

firm to be a simple exporter. However, many firms are also multinational producers.

Proxies for openness for such firms also include foreign costs,

2

foreign assets, and foreign

subsidiaries.

We use a unique database with detailed exchange rate exposure information on Danish

non‐financial firms to determine whether foreign debt hedges against exposure from

foreign revenues or against exposure from physical presence abroad (foreign assets and

subsidiaries). Our database enables us to investigate the issue by differentiating the effects

of not only revenues and operating costs, but also foreign operating assets and foreign

subsidiaries. We find that foreign debt usage among internationally involved, medium‐

sized firms is primarily related to foreign operating assets and foreign subsidiaries. Thus,

the results of our study indicate that, in its practical hedging application, foreign debt is

used predominantly to hedge accounting exposure, as opposed to operating exposure.

Yet, it is also possible that foreign debt is used to hedge the flow of expected future

revenues and that foreign assets and foreign subsidiaries provide better proxies for the

present value of future foreign revenues than the annual foreign revenue reported in last

year’s annual report. The foreign debt measure we use ignores domestic debt swapped

into foreign currency but we address this issue and show that the results are robust.

In spite of the academic focus on operating exposure over accounting exposure

3

–for

example, the focus on cash flows in terms of reducing the risk of financial distress (Smith

and Stulz, 1985) or improving the ability to make value‐adding investments (Froot et al.,

1993) –empirical studies show that accounting concerns do matter in actual managerial

decision making (e.g., Lins et al., 2011). A firm that has foreign assets (e.g., in the form of

1

In exposure terms it makes no difference whether, say, a German firm chooses to hedge a

positive cash flow of US$1 million that it expects to receive in three months based on a sales

contract by 1) selling forward today with a settlement of US$1 million against the euro (EUR)

in three months or 2) borrowing an amount in US dollars (instead of borrowing in EUR) today

that, together with accrued interest, is settled by paying back exactly US$1 million in three

months. Géczy et al. (1997) note that foreign debt can displace the need to hedge with

derivatives by acting as a hedge of foreign revenues.

2

Foreign debt cannot be used as a hedge against costs in foreign currency because this would

create two negative –and thus non‐offsetting –cash flows in that particular currency. Thus,

foreign costs cannot explain foreign debt usage but are generally correlated with openness.

3

Foreign exchange exposure is traditionally grouped in three categories: transaction exposure,

translation exposure –also called accounting exposure –and economic exposure –also called

operating exposure, strategic exposure, or competitive exposure (e.g., Eiteman et al., 2010).

© 2013 John Wiley & Sons Ltd

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