See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/293329100

The determinants of exchange rate risk management in developing countries:

Evidence from Indonesia

Article  in  Afro-Asian J of Finance and Accounting · January 2016

DOI: 10.1504/AAJFA.2016.074552

CITATIONS READS

4 963

2 authors:

Nevi Danila Huang Chia-Hsing

Prince Sultan University 25 PUBLICATIONS   87 CITATIONS   
6 PUBLICATIONS   7 CITATIONS   
SEE PROFILE
SEE PROFILE

Some of the authors of this publication are also working on these related projects:

Financial literacy in Indonesia View project

All content following this page was uploaded by Nevi Danila on 19 July 2017.

The user has requested enhancement of the downloaded file.

Afro-Asian J. Finance and Accounting, Vol. 6, No. 1, 2016 53

The determinants of exchange rate risk management

in developing countries: evidence from Indonesia

Nevi Danila*
Malangkucecwara School of Economics,
Jl. Terusan Kalasan – Blimbing, Malang,
Jawa Timur 65142, Indonesia
Email : nevida@staff.stie-mce.ac.id
*Corresponding author

Chia-Hsing Huang
SolBridge International School of Business,
Woosong University,
151-13 Samsung 1-Dong, Dong-gu,
Daejeon 34613, South Korea
Email: koreasing@solbridge.ac.kr

Abstract: Studies on exchange-rate risk management in developing countries

are still very rarely addressed. This study investigates determinants of exchange
rate risk management (hedging) in Indonesian firms. Using 276 samples of
listed firms in the Indonesia Stock Exchange and employing a Logit regression
model, we found that only firm size is associated with a hedging in the listed
companies. The findings are not consistent with the study proposed in the
developed countries. It suggests that most of the large Indonesian companies
are conglomerates with controlling shareholders who have the authority for
hedging and making financing decisions. The finding also suggests that the
hedging market in Indonesia is not yet mature. Furthermore, firms are either not
familiar with the hedging instruments or may not be big enough to hire
professionals to deal with the complicated and costly hedging instruments.

Keywords: derivatives; firm size; market to book asset ratio; risk management;
hedging; exchange rate; dividend yield; leverage; profitability; Indonesia.

Reference to this paper should be made as follows: Danila, N. and

Huang, C-H. (2016) ‘The determinants of exchange rate risk management in
developing countries: evidence from Indonesia’, Afro-Asian J. Finance and
Accounting, Vol. 6, No. 1, pp.53–67.

Biographical notes: Nevi Danila is an Associate Professor at

Malangkucecwara School of Economics, Malang, Indonesia. Currently, she is a
Lecturer and a Director of postgraduate degree program at Malangkucecwara
School of Economics. She obtained her PhD degree from the University of
Sydney, Australia in 2001. She has 15 years teaching experience in the
Undergraduate and MBA level. Her research interest is in the areas of
investment, risk management and Islamic finance.

Copyright © 2016 Inderscience Enterprises Ltd.

54 N. Danila and C-H. Huang

Chia-Hsing Huang is a Professor and Vice Dean at SolBridge International

School of Business, Daejeon, South Korea. He earned his PhD degree from the
University of Pennsylvania. He has taught and worked in the USA, Taiwan and
Thailand. He has published extensively in many leading international journals.

This paper is a revised and expanded version of a paper entitled ‘The

determinants of corporate hedging: evidence from Indonesia’, presented at the
International Conference on Business and Social Science, Tokyo, Japan, 2014.

1 Introduction

For the multinational companies, hedging is used to reduce their foreign exchange rate
risk from the foreign currency denominated operations and transactions (Bartram, 2008);
and hedging increases the value of companies if it brings more benefit than cost (Stulz,
1984). Many empirical studies have attempted to explain the motives of firms using
derivative instruments. Gay and Nam (1998) found that the hedging driver was due to an
underinvestment problem. Nance et al. (1993) suggested that value of firm was increased
due to hedging through decreasing expected taxes, expected costs of financial distress
and other agency costs. Klimczak (2008) divided corporate hedging into four different
theories, namely; financial theory, agency theory, stakeholder theory, and new
institutional economics.
Other researchers investigated motivations for hedging, such as cost of usage,
incentive to use it, and exposure to foreign exchange (Guay, 1997; Guay and Khotary,
2003); firms’ tax liabilities (Graham and Rogers, 2002); accounting earnings volatility,
and volatility of cash flow (Allayannis and Mozumdar, 2000). Moreover, from the
accounting perspective, Panaretou et al. (2013) argued that the impact of derivative
hedging was an increase of transparency, a decrease of earnings’ volatility, and a
decrease of asymmetry information.
Other studies examined the impact of derivative usage on firms. They found that
hedging increased a firm’s market value however, it depended on the firm’s level of
corporate governance, a country level of corporate governance and an interaction
between the two of them (Allayannis and Weston, 2001; Allayannis et al., 2011; Bodnar
and Gebhardt, 1999). Most of the studies of the above theories and the empirical studies
were conducted in developed countries and did not address developing countries.
In the 1940s, most of the large companies in Indonesia were state controlled
enterprises. Some privately owned companies emerged after the 1983 deregulation.
However, most of the 307 companies listed in the Indonesian Stock Exchange
(previously Jakarta Stock Exchange) are still controlled by the largest shareholders
(Simanjuntak, 2001; Darmadi, 2011). With 878 billion US dollars of GDP, Indonesia is
one of the 16 largest countries in the world in terms of GDP, and is the largest economy
in Southeast Asia (World Bank, 2012). In Indonesia, the largest shareholders are the
original owners. Most of the high level managers and board members of the companies
are either the owners or relatives of owners. Under the hierarchical and top down
decision process, the professional managers are required to be loyal and trustworthy to
the large shareholders. Most of the large Indonesian companies are conglomerates with
many business units from banking, finance, forestry, insurance, manufacturing, real estate
 The determinants of exchange rate risk management in developing countries 55

and retailing (Simanjuntak, 2001). The ten largest Indonesian companies together
represent 44% of Indonesia’s total market capitalisation. Among these ten companies,
five companies are state owned and five companies are family owned (Sutayanto, 2013).
About 58% of the companies listed in the Indonesian Stock exchange are family owned
(Darmadi, 2011).
It is difficult for the companies to negotiate with their creditors owing to the free rider
and asymmetric information problems. Therefore, companies may have difficulties
obtaining financing and may suffer greater financial distress costs. However, companies
that belong to a group of particular industries, including the banking industry, tend to
have better access to financing and have lower financial distress costs (Hoshi et al.,
1990). Under this industry structure, external funding can be easily obtained from the
same conglomerate with relatively low cost. Therefore, it might not be necessary to use
derivatives hedging for the company. Then, one important question is whether the
hedging behaviour in developed countries is the same as in the developing countries,
specifically in Indonesia. This paper will examine whether a firm’s size, growth,
profitability, dividend yield (a substitute of hedging) and agency cost are the
determinants of derivative hedging in Indonesia. The results of this empirical study will
enrich the existing theory of corporate hedging in developing countries.

2 Literature review

Stulz (2004) investigated whether derivative hedging in a foreign exchange market was
the most usage market measure by a majority of non-financial firms from 48 countries.
They found that it was around 43.6%. Swaps and forwards were used more than options.
In an efficient capital market, the cost of capital is the shareholder’s minimum required
rate of return. Shareholders have a fully diversified portfolio and only bear the systematic
risk. A company’s value is maximised by rational stakeholders (Modigliani and Miller,
1958). Nevertheless, a company, which engages in hedging in order to reduce the
unsystematic risk, will only incur extra trading cost without bringing any benefit of a risk
reduction to the shareholders.
Different from the perfect world of the Modigliani and Miller, Stulz (1984) stated that
a company’s value could be increased by hedging in an imperfect capital market. An
increased of the value comes from reductions of tax (Mayers and Smith, 1987; Smith and
Stulz, 1985), financial distress cost (Smith and Stulz, 1985), agency cost (Smith and
Stulz, 1985; Campbell and Kracaw, 1987), and an inefficient investment (Froot et al.,
1989, 1993; Stulz, 1990). If a managerial compensation scheme is perfectly aligned with
a shareholder’s value optimisation, hedging will increase the value of both managers and
shareholders. However, since hedging is not free, if the benefit is greater than the cost,
then the value of both managers and shareholders are increased.
According to Smith and Stulz (1985), a manager will not prefer to hedge if a
compensation plan is a convex function of accounting earnings. However, the manager
will have incentives to hedge if they own a large number of the firm’s shares, then his
wealth is a linear function of the firm’s value. Thus, there is a positive relation between
managerial wealth invested in the firm and the use of derivatives. Further, a hedging can
reduce the manager’s exposure to risk and increase the company’s value (Campbell and
Kracaw, 1987).
56 N. Danila and C-H. Huang

Under the condition of a convex tax schedule, where expected tax is higher in a
greater volatility of earnings, the tax schedule will have a negative impact on the
company’s cash flow. This cash flow may lead to a company’s financial distress.
Consequently, it will increase the shareholders’ required rate of returns. Then, a company
may opt to hedge to reduce the risk of their cash flow fluctuation. Thus, a corporate
hedging is utilised to reduce the probability of financial distress through reducing the
volatility of its cash flow (Mayers and Smith, 1982; Smith and Stulz, 1985). Furthermore,
if a company cannot hedge the risk surrounding its tax shields, it may choose to under
invest in risky assets (Green and Talmor, 1985). On the other hand, if a company can
hedge the uncertain tax shields, it will not have the underinvestment behaviour
(MacMinn, 1985). However, if the tax loss can be carried forward and backward, then
there is no incentive for the company to hedge and to smooth its cash flow.
A firm size has several explanations associated with hedging (Nance et al., 1993;
Panaretou et al., 2013). First, when a firm faces a financial distress which leads to
bankruptcy, the firm has direct legal costs. Small firms are more likely to hedge since the
legal costs are less than proportional to a firm size. Second, small firms are likely to
hedge since they are taxed more. Third, large firms are more likely to hedge since they
possess informational economies of scale. In other words, the large firms are able to hire
managers to manage hedging activities (Block and Gallagher, 1986; Booth et al., 1984).
Furthermore, Geczy et al. (1997) defined cost into two components: costs associated with
initiating and maintaining risk management programs in general, which showed
economies of scale related to the amount of risk managed, and costs associated with
choosing a particular currency derivative instrument. Accordingly, large firms are more
likely to hedge since the economies of scale cover costs of hedging transactions for
forward, swap, and OTC options. So, the size of the firm is indeterminate.
Debt holders have fixed claims on companies, while shareholders have residual
claims on companies. Investing in positive NPV projects will reduce shareholders value
if the benefits belong to the debt holders. Issuing debts could reduce the firm value by
inducing an underinvestment strategy. Hence, shareholders will prefer not to invest in
some positive NPV projects (Myers, 1977). Moreover, companies may choose not to
invest in positive NPV projects when the appropriate internal funds are not available and
the external funds are too expensive. Then, companies will hedge the positive NPV
projects (Froot et al., 1993). Companies with higher debt ratios will have
underinvestment problems. Consequently, they are more likely to hedge in order to
reduce their underinvestment problems (Nance et al., 1993). Therefore, companies can
use either derivatives hedging or lower levels of debt to avoid their financial risk.
However, reducing the debt level will reduce the tax shield benefit (Nance et al., 1993;
Berkman et al., 2002; Graham and Rogers, 2002).
Froot et al. (1993) argued that firms with high R&D were more likely to hedge
because of their difficulty in raising external finance since either their assets were not
good collateral or there were asymmetric information on the quality of their new projects.
Thus, high growth firms were more likely to hedge (Berkman et al., 2002; Gay and Nam,
1998; Geczy et al., 1997).
 The determinants of exchange rate risk management in developing countries 57

3 Hypotheses

Both small and large firms have incentives to hedge for different reasons. Normally, the
start-up fixed cost of hedging is high. Because of the economies of scale in information
and transaction costs, large firms are more capable of bearing the high fixed cost of using
derivatives (Mian, 1996; Fok et al., 1997; Schiozer and Saito, 2009). In other words, the
influence of economies of scale in hedging activities is stronger than that of the costs of
financial distress or the costs of raising external capital. Large firms use derivative
instruments for hedging to reduce the cash flow fluctuation, which might render the
investment of growth opportunity (Nance et al., 1993; Geczy et al., 1997; Allayannis and
Ofek, 1997; Klimczak, 2008). In addition, larger firms tend to use derivatives to hedge
than medium and smaller firms (El Masry, 2006). It is expected that there is a positive
relationship between the propensity for a firm to use derivatives hedging and the size of
the firm. The log of total sales, log of total assets, and the log of the sum of debt book
value and equity market value are used to represent the firm size.
Hypothesis 1a A positive relationship exists between the propensity for a firm to use
derivatives hedging and the log of total sales.
Hypothesis 1b A positive relationship exists between the propensity for a firm to use
derivatives hedging and the log of total asset.
Hypothesis 1c A positive relationship exists between the propensity for a firm to use
derivatives hedging and the log of the sum of debt book value and equity
market value.
Companies with more growth opportunities have a tendency to hedge more in order to
reduce the volatility of firm’s value. Nance et al. (1993) and Fok et al. (1997) suggested
that high growth companies were likely to acquire the external funding to finance their
investments. However, the external funds are not cheap. Therefore, companies use
derivatives hedging to reduce the fluctuations of cash flows or risks (Froot et al., 1993).
With a different reason, Bessembinder (1991) showed that high growth companies were
more likely to hedge since the companies have more internal funding for future
investments. It is expected that there is a positive relationship between the propensity for
a firm to use derivatives hedging and the growth opportunities. The market to book asset
ratio and the market to book equity ratio are used to represent the growth.
Hypothesis 2a A positive relationship exists between the propensity for a firm to use
derivatives hedging and the market to book asset ratio.
Hypothesis 2b A positive relationship exists between the propensity for a firm to use
derivatives hedging and market to book equity ratio.
Profitability is important for the company’s life. Firms with high profits are likely to
experience the growth; and have enough internally generated funds to obtain attractive
investments (Jang and Park, 2011; Kouser et al., 2012). Accordingly, they are more likely
to hedge (Shaari et al., 2013). Return on equity is used to represent profitability.
Hypothesis 3 A positive relationship exists between the propensity for a firm to use
derivatives hedging and return on equity.
58 N. Danila and C-H. Huang

A company can reduce the conflict between shareholders and bondholders with some
financial instruments other than derivatives hedging, such as convertible bonds and
preferred stock. The demand for derivatives hedging can also be affected by dividend
policy. A company with a lower dividend payment is likely to have more funds to pay for
the bond holders. Using low dividend payment policy as a substitute for hedging will
help the company to have sufficient funds for the fixed claim of their debt. In other
words, a company with a low dividend yield may reduce the agency conflict (Nance
et al., 1993). It is expected that there is a positive relationship between the propensity for
a firm to use derivatives hedging and the dividend yield.
Hypothesis 4 A positive relationship exists between the propensity for a firm to use
derivatives hedging and the dividend yield.
The residual claim belongs to the shareholders who have a tendency to invest in the high
risk and sub-optimal investment projects. The risk from the risky investment project will
be transferred to the bondholders. Derivative hedging can be used to reduce the
bondholders’ risk (Mayers and Smith, 1987; Bessembinder, 1991). On the other hand,
being the fixed claimers of the company, bondholders have more benefits if shareholders
pursue positive net present value (NPV) projects. Therefore, shareholders are more likely
to have underinvestment behaviour if the investment benefits only go to the bondholders
(Myers, 1977). Subsequently, the company tends to have a higher debt ratio. Thus, a
company has a tendency to have more derivatives hedging if the debt ratio is high (Nance
et al., 1993). Then, it is expected that there is a positive relationship between the
propensity for a firm to use derivatives hedging and the agency cost.
Thus, the debt to equity ratio and leverage are used to represent the agency cost.
Hypothesis 5a A positive relationship exists between the propensity for a firm to use
derivatives hedging and the debt to equity ratio.
Hypothesis 5b A positive relationship exists between the propensity for a firm to use
derivatives hedging and the leverage.
The hypotheses described above are based on the theories and empirical studies in the
developed countries where the shareholders are widely dispersed and most of the
companies are not owned by the government or families. While in the case of Indonesia,
most of the companies listed in the Indonesian Stock Exchange are either state owned or
family owned. Will the derivatives hedging behaviours from the studies of the companies
in the developed countries remain the same as in Indonesia?

4 Data and methodology

A sample of 276 non-financial firms listed in the Indonesian Stock Exchange is taken
from the annual reports of the year 2012. Table 1 reports the industry distribution for the
sample firms. The sample comprises eight different industries. Basic industry and
chemicals have the highest representation comprising 17.75% of the sample, while trade,
services and investment; and property, real estate and building construction place in the
second (16.67%) and third (15.94%) highest respectively. About 24% of the sample firms
are hedge users (almost all of them use ‘forward’ to hedge). The rest of the companies
 The determinants of exchange rate risk management in developing countries 59

either employs a natural hedge or do not hedge at all. Among the hedgers, an
Infrastructure, utilities and transportation industry has the largest hedge users.
Table 1 Industry classification of the sample

Number % of total % of % of
Industry Hedgers Non-hedgers
of firms hedgers hedgers non-hedger
Agriculture 12 4.35% 4 33.33% 8 66.67%
Mining 31 11.23% 9 29.03% 22 70.97%
Basic industry and 49 17.75% 10 20.41% 39 79.59%
chemicals
Miscellaneous industry 33 11.96% 11 33.33% 22 66.67%
Consumer goods industry 28 10.14% 5 17.86% 23 82.14
Property, real estate and 44 15.94% 3 6.82% 41 93.18%
building construction
Infrastructure, utilities and 33 11.96% 12 36.36% 21 63.64%
transportation
Trade, services and 46 16.67% 13 28.26% 33 71.74%
investment
Total 276 100% 67 24.28% 209 75.72%

Table 2 provides the descriptive statistics. The firm size proxies have positive average,
minimum and maximum value; for example, the average of total sales of Rp. 2,726,000
million, ranging from Rp. 728 million to Rp. 95,919,000 million. One of the growth
proxies (MBE) has a negative average value and a negative skewness. The negative
skewness means a long tail to the left (to the negative value). ROE also shows the same
characteristics, i.e., a negative average value and a negative skewness.
Table 2 Descriptive Statistics of the Sample

Variables Mean Min Max Skewness

TS (million Rp) 2.7260e+06 728.00 9.5919e+07 8.7542
TA (million Rp) 6.6388e+06 14.800 1.7148e+08 6.5032
BM (million Rp) 1.1846e+07 47,805 3.5390e+08 7.2834
MBV (x) 87.382 0.26561 23609 16.523
MBE (x) –971.03 –2.6876e+05 71.525 –16.523
DY (%) 1.4894 0.0000 407.00 16.523
DME (x) 2.5941 4.6366e-05 230.57 13.935
L (x) 0.99917 –14.500 19.200 1.1185
ROE (%) 0.081823 –8.1138 6.8758 –2.5112

Next, a non-parametric univariate test is used to investigate the mean difference between
each variable of hedging users and non-users. While a logistic regression model is
employed to study the determinants of corporate hedging. A dummy variable of value ‘1’
represents hedge users, and ‘0’ represents non-hedge users. The model below shows that
derivative hedging is a function of firm size, growth, profitability, substitute of hedging,
and agency cost.
60 N. Danila and C-H. Huang

Y = α + β1TS + β 2TA + β3 BM + β 4 MBV + β5 MBE

+ β 6 ROE + β 7 DY + β8 DME + β9 L + ε
where
Y dummy variable; 1 = hedge user, 0 = non-user
TS log of total sales, representing firm size
TA log of total asset, representing firm size
BM log (debt book value + equity market value), representing firm size
MBV market to book asset value ratio, representing growth
MBE equity market value to equity book value ratio, representing growth
ROE return on equity, representing profitability
DY dividend yield, representing substitute of hedging
DME debt to equity ratio = debt book value to equity market value ratio, representing
agency cost
L leverage, representing agency cost
ε error term.

5 Empirical results

5.1 Univariate analysis

Table 3 reports the mean of each variable and Wilcoxon signed-rank test for the median
difference between hedgers and non-hedgers of each variable.
Table 3 Univariate analysis

Mean Wilcoxon signed-rank test

Variables
Non-hedgers Hedgers p-value
TS 5.6737 6.2240 0.001***
TA 6.1771 6.6049 0.005**
BM 6.3244 6.7746 0.005**
MBV 1.8223 1.7088 0.356
MBE 2.7953 2.5313 0.373
ROE 0.0696 0.0898 0.915
DY 1.9602 0.0209 0.551
DME 2.7198 2.3558 0.615
L 1.0619 0.7943 0.749
Note: Significant at *10%, **5%, and ***1%.
 The determinants of exchange rate risk management in developing countries 61

The means of non-hedged firm size variables, i.e., total sales, total asset, debt plus equity
value, are all smaller than the means of hedgers. It implies the firm size of non-hedged is
smaller than that of the hedger. The Wilcoxon signed rank test shows that non-hedgers
are significantly smaller than the hedgers. Theory suggests both small and large firms
have incentives to do hedging with different reasons. The result here is consistent with
the theory that the larger firms use derivative instruments for hedging to reduce a cash
flow fluctuation which might render the investment of growth opportunity; it is also
consistent with a literature of existence of large fixed start-up costs of hedging
(Allayannis and Ofek, 1997; Nance et al., 1993; Klimczak, 2008; Geczy et al., 1997).
Furthermore, El Masry (2006) indicated that larger firms tended to use derivatives to
hedge than medium and smaller firms. Schiozer and Saito (2009) argued that it was due
to the effect of economies of scale and the cost of financial distress, only the large firms
have a capability to bear the high fixed cost of using derivatives. Mian (1996) and Fok
et al. (1997) suggested that the economies of scales in terms of information and
transactions was a determinant of hedging. In other words, the influence of economies of
scale in hedging activities is stronger than financial distress costs or costs of raising
external capital.
The non-hedged firms have higher growth than the hedged firms. However, the
Wilcoxon signed rank test shows that there is insignificant difference between the
non-hedgers and hedgers. It is inconsistent with the theory, which suggests that firms
with high growth opportunities are more likely to acquire the external funding to finance
their investments; and use derivatives hedging for reducing the risk from cash flow
fluctuations (Froot et al., 1993) and reducing the agency costs (Bessembinder, 1991).
The non-hedger firms have a lower return on equity than the hedgers. It indicates that
non-hedger firms have a less profitability than the hedgers. It is consistent with the
research finding, which suggests that firms with a high profitability are likely to hedge
(Shaari et al., 2013). However, the Wilcoxon signed rank test shows that there is
insignificant difference between the non-hedgers and hedgers.
Next, the non-hedgers firms have a higher dividend yield. It is inconsistent with the
theory that firms with high dividend yield are more likely to hedge (Nance et al., 1993).
However, the Wilcoxon signed rank test shows that the difference between the
non-hedgers and hedgers is insignificant.
The non-hedgers firms have higher a level of leverage and a level of debt to equity
ratio. This result supports the argument of Nance et al. (1993) who suggested that higher
leverage firms were less likely to hedge. However, the Wilcoxon signed test rank shows
that the difference between non-hedgers and hedgers is insignificant.

5.2 Multivariate analysis

A logistic regression is employed with using binary dependent variable, where ‘1’ is used
for the firms with derivatives hedging and ‘0’ for the firms without derivatives hedging.
A multi-collinearity test is conducted before running the regression. Table 4 shows
collinearity statistics. Only two variables, i.e., TA and BM, show a tolerance value less
than 0.1; and a VIF value more than 10. It indicates a serious collinearity problem. Thus,
we drop the variables from the model.
62 N. Danila and C-H. Huang

Table 4 Collinearity statistics

Variable Tolerance VIF

TS .296 3.376
TA .024 41.112
BM .022 45.618
MBV .167 5.977
MBE .622 1.609
ROE .799 1.251
DY .994 1.006
DME .920 1.087
L .977 1.024

Next, we examine the model using logistic regression. Table 5 shows that only one
variable, total sales (the proxy for firm size), has a significant and positive association
with derivative hedging. The McFadden R-squared value indicates that all of the
explanatory variables explain about 8% of the derivative hedging. It suggests that there
are some other variables not included in this model. The likelihood ratio test shows that
all the explanatory variables together have a significant impact on derivative hedging.
Table 5 Estimates of logistic regression

Independent
Predicted relations Coefficient p-value
variables
Constant –6.982 0.000
TS –/+ 0.980 0.000**
MBV + –0.117 0.424
MBE + 0.005 0.897
ROE + 0.081 0.746
DY + –0.016 0.889
DME + 0.003 0.823
L + –0.018 0.201
Notes: Significant at *10%, **5%, and ***1% level. A forward stepwise logistic
regression method is also conducted. The result is consistent with a logistic
regression method.

The firm size has a significant and positive relationship with the derivatives usage. It
means that the larger firms are more likely to hedge. The theory suggests that both large
and small firms have an incentive to hedge for different reasons. However, our finding
only supports one side, the larger firms tend to hedge due to the effects of economies of
scales and high fixed costs of derivative instruments (Mian, 1996; Fok et al., 1997; Nance
et al., 1993; Geczy et al., 1997; El Masry, 2006; Klimczak, 2008; Schiozer and Saito,
2009).
Both of the growth proxies have insignificant values. This means that firms with
higher growth opportunities are not having incentives to hedge. This result is inconsistent
with the argument that high growth companies tend to hedge to avoid an expensive
 The determinants of exchange rate risk management in developing countries 63

external funding cost (Nance et al., 1993; Froot et al., 1993, 1997). However, the external
fund is not cheap. Therefore, the companies use derivatives hedging to reduce the
fluctuations of the cash flows or risk. Moreover, one of the proxies has a negative sign.
The negative relationship between growth and derivatives usage is consistent with the
empirical study result of Mian (1996). It is possible that most of the Indonesian large
companies are conglomerates with many business units from banking, finance, forestry,
insurance, manufacturing, real estate to retailing with a focus on domestic market. Under
this industry structure, an external funding can be easily obtained with a relatively low
cost. Therefore, it is not necessary to use derivatives to hedge if a company has high
growth rate.
The ROE has a negative and insignificant relationship with the derivatives usage.
This result is similar to other research finding. Gounopoulos et al. (2012) argued that
there was a negative correlation and insignificant relationship between derivatives usage
and ROE. Belghitar et al. (2013) also showed that the derivatives usage had no significant
relationship with the company value. However, Shaari et al. (2013) showed that
profitability had a positive and a significant impact on derivative hedging.
The dividend yield has a negative and insignificant relationship with the derivatives
usage. This result is different from the argument of Nance et al. (1993). They stated that
there was a positive association between hedgers and dividend payout ratios. The
companies reduced the probability of default by having more liquid assets or imposing
dividend restrictions. Therefore, the bondholders were assured to get their claims.
Consequently, the financial distress costs and agency costs were lower. It implied that a
company with a lower dividend payout ratio was less likely to use hedging instruments
(Nance et al., 1993). Nevertheless, this result is the same as the findings of Fok et al.
(1997). Most of the Indonesia companies are families owned or state owned. They tend to
have lower dividends. It is because the controlling shareholders have power over
companies by the management participation (La Porta et al., 1999). In addition, high
insider ownership companies are likely to have a lower level of dividend policy (Jensen
et al., 1992). In contrast, a individualistic and self-serving managerial behaviour states
that high level managers are loyal and trustworthy to the companies (Davis et al., 1997;
Vallejo, 2009); and they are likely to have a dividend policy in favour of the controlling
shareholders.
Both of the proxies used for agency cost (debt to equity ratio and leverage), are not
significantly associated with derivative hedging. Further, the leverage has a negative sign.
This result is different from the theory that was argued by Lin et al. (2008) that hedging
was positively related to leverage. To avoid debt holder opportunistic behaviour and the
underinvestment problem due to a high debt ratio, the higher leverage firms are more
likely to hedge (Myers, 1977). Hedging can reduce the financial distress and the
underinvestment problems by reducing the cash flow fluctuation (Gay and Nam, 1998;
Afza and Alam, 2011; Wang and Fan, 2011). However, a negative relationship between
leverage and hedging is supported by Nance et al. (1993), Getzy et al. (1997), Fok et al.
(1997), Purnanandam (2008), Afza and Alam (2011), and Shaari et al. (2013). They
suggested that firms with high leverage had more financial distress and higher cost of
hedging. These companies had a difficulty to bear higher risk management costs. Hence,
it was better for the company to cut the high hedging cost. Therefore, companies with
high leverage levels were less likely to hedge. Further, Nance et al. (1993) also found that
firms with more investment options had both lower leverage and more hedging. Smith
64 N. Danila and C-H. Huang

and Watts (1992) argued that firms with more investment options employed lower
leverage hence they had a greater incentive to hedge.
With regards to the ownership structure, high insider ownership companies which
have the managers’ wealth highly tied to the companies, tended to have a lower level of
debt (Jensen et al., 1992; Moh’d et al., 1998). With a family owned or a state owned
corporate structure, most of the Indonesian companies tend to have a lower level of debt.
The conglomerate can rely more on debt financing from its own financial institutions and
does not need to give up controlling rights to raise funds (La Porta et al., 1999). This
corporate structure becomes a natural anti-takeover mechanism (Morck and Nakamura,
1998; Bolton and von Thadden, 1998). Therefore, the state owned and family owned
companies will have a lower level of derivatives hedging. A combination of growth and a
high level of insider ownership will cause the Indonesian companies to have a lower level
of debt to equity ratio.

6 Conclusions

The empirical study on exchange risk management in Indonesia is not similar to the study
in developed countries. Our findings confirm that only a firm’s size (with total sales as a
proxy) has a significantly positive relationship with the hedging. The rest of variables,
such as growth, profitability, substitute of hedging, and agency cost, do not have any
impact on hedging, which is not consistent with the study proposed in the developed
countries. This study suggests that most of the Indonesian large companies are
conglomerates with a variety of business units from banking, finance, forestry, insurance,
manufacturing, real estate to retailing. The controlling shareholders are also high level
managers with authority for hedging and financing decision makings. Obtaining a
relatively low cost external funding from the banks or financial companies within the
same conglomerate is an easy task (Witt and Redding, 2013). Therefore, the demand for
derivatives hedging is diminished when a high growth company is part of a conglomerate
in Indonesia. The findings also suggest that the hedging market is not mature as yet in
Indonesia. In addition, firms are either not familiar with the hedging instruments or not
big enough to hire professionals who deal with the complicated and costly hedging
instruments. The government should take a part in developing the derivative markets,
such as providing more infrastructure of the market, and introducing the instruments to
the market more rigorously.
However, the study does not incorporate the ownership structure in detail. The data
also is limited in the Indonesian market. Thus, further studies incorporating the
ownership structure and a corporate governance system; and comparing to other ASEAN
market will be challenging.

References
Afza, T. and Alam, A. (2011) ‘Corporate derivatives and foreign exchange risk management: a case
study of non-financial firms of Pakistan’, The Journal of Risk Finance, Vol. 12, No. 5,
pp.409–420.
Allayannis, G and Ofek, E. (1997) ‘Exchange rate exposure, hedging, and the use of foreign
currency derivatives’, Journal of International Money and Finance, Vol. 20, No. 2,
pp.273– 296.
 The determinants of exchange rate risk management in developing countries 65

Allayannis, G. and Mozumdar, A. (2000) ‘Cash flow, investment, and hedging’ [online]
http://ssrn.com/abstract=243639 or doi:10.2139/ssrn.243639 (accessed 26 July 2012).
Allayannis, G. and Weston, J.P. (1998) The Use of Foreign Currency Derivatives and Firm Market
Value, Working paper No. 97-23, Darden School [online] http://ssrn.com/abstract=138498 or
http://dx.doi.org/10.2139/ssrn.138498 (accessed 29 August 2012).
Allayannis, G., Lel, U. and Miller, D.P. (2011) The Use of Foreign Currency Derivatives,
Corporate Governance, and Firm Value Around the World, Working paper No. 03-10, Darden
Business School.
Bartram, S.M. (2008) ‘What lies beneath: foreign exchange rate exposure, hedging and cash flows’,
Journal of Banking and Finance, Vol. 32, No. 8, pp.1508–1521.
Belghitar, Y., Clark, E. and Mefteh, S. (2013) ‘Foreign currency derivative use and shareholder
value’, International Review of Financial Analysis, September, Vol. 29, pp.283–293.
Berkman, H., Bradbury, M.E., Hancock, P. and Innes, C. (2002) ‘Derivative financial instrument
use in Australia’, Accounting and Finance, Vol. 42, No. 2, pp.97–109.
Bessembinder, H. (1991) ‘Forward contracts and firm value: investment incentive and contracting
effects’, The Journal of Financial and Quantitative Analysis, Vol. 26, No. 4, pp.519–532.
Block, S.B. and Gallagher, T.J. (1986) ‘The use of interest rate futures and options by corporate
financial managers’, Financial Management, Vol. 15, No. 3, pp.73–78.
Bodnar, G.M. and Gebhardt, G. (1999) ‘Derivatives usage in risk management by US and German
non-financial firms: a comparative study’, Journal of International Financial Management
and Accounting, Vol. 10, No. 3, pp.153–187.
Bolton, P. and Von Thadden, E-L. (1998) ‘Blocks, liquidity, and corporate control’, The Journal of
Finance, Vol. 53, No. 1, pp.1–25.
Booth, J.R., Smith, R.L. and Stolz, R.W. (1984) ‘The use of interest futures by financial
institutions’, Journal of Bank Research, Spring, Vol. 15, pp.15–20.
Campbell, T.S. and Kracaw, W.A. (1987) ‘Optimal managerial incentive contracts and the value
of corporate insurance’, Journal of Financial and Quantitative Analysis, Vol. 22, No. 3,
pp.315–328.
Darmadi, S. (2011) ‘Board compensation, corporate governance, and firm performance in
Indonesia’ [online] http://ssrn.com/abstract=1907103 or
http://dx.doi.org/10.2139/ssrn.1907103 (accessed 20 January 2014).
Davis, J.H., Schoorman, F.D. and Donaldson, L. (1997) ‘Toward a stewardship theory of
management’, Academy of Management Review, Vol. 22, No. 1, pp.20–47.
El Masry, A.A. (2006) ‘Derivatives use and risk management practices by UK nonfinancial
companies’, Managerial Finance, Vol. 32, No. 2, pp.137–159.
Fok, R.C.W., Carroll, C. and Chiou, M.C. (1997) ‘Determinants of corporate hedging and
derivatives: a revisit’, Journal of Economics and Business, Vol. 49, No. 6, pp.569–585.
Froot, K.A., Scharfstein, D.S. and Stein, J.C. (1989) ‘LDC debt: forgiveness, indexation, and
investment incentives’, Journal of Finance, Vol. 44, No. 5, pp.1335–1350.
Froot, K.A., Scharfstein, D.S. and Stein, J.C. (1993) ‘Risk management: corporate investment and
financing policies’, Journal of Finance, Vol. 48, No. 5, pp.1629–1658.
Gay, G.D. and Nam, J. (1998) ‘The underinvestment problem and corporate derivatives use’,
Financial Management, Vol. 27, No. 4, pp.53–69.
Geczy, C.C., Minton, B.A. and Schrand, C.M. (1997) ‘Why firms use currency derivatives’,
Journal of Finance, Vol. 52, No. 4, pp.1323–1354.
Gounopoulos, D., Molyneux, P., Staikouras, S.K., Wilson, J. and Zhao, G. (2012) ‘Exchange rate
risk and the equity performance of financial intermediaries’, International Review of Financial
Analysis, September 2013, Vol. 29, pp.271–282.
Graham, J.R. and Rogers, D.A. (2002) ‘Do firms hedge in response to tax incentives?’, Journal of
Finance, Vol. 57, No. 2, pp.815–839.
66 N. Danila and C-H. Huang

Green, R.C. and Talmor, E. (1985) ‘The structure and incentive effects of corporate tax liabilities’,
Journal of Finance, Vol. 40, No. 4, pp.1095–1114.
Guay, W.R. (1997) ‘The impact of derivatives on firm risk: an empirical examination of new
derivative users’, Journal of Accounting & Economics, Vol. 26, Nos. 1–3, pp.319–351.
Guay, W.R. and Kothari, S.P. (2003) ‘How much do firms hedge with derivatives?’, Journal of
Financial Economics, Vol. 70, No. 3, pp.423–461.
Hoshi, T., Kashyap, A. and Scharfstein, D. (1990) ‘The role of banks in reducing the costs of
financial distress in Japan’, Journal of Financial Economics, Vol. 27, No. 1, pp.67–88.
Jang, S. and Park, K. (2011) ‘Inter-relationship between firm growth and profitability’,
International Journal of Hospitality Management, Vol. 30, No. 4, pp.1027–1035.
Jensen, G.R., Solberg, D.P. and Zorn, T.S. (1992) ‘Simultaneous determination of insider
ownership, debt, and dividend policies’, Journal of Financial and Quantitative Analysis,
Vol. 27, No. 2, pp.247–263.
Klimczak, K.M. (2008) ‘Corporate hedging and risk management theory: evidence from Polish
listed companies’, The Journal of Risk Finance, Vol. 9, No. 1, pp.20–39.
Kouser, R., Bano, T., Azee, M. and Hassan, M. (2012) ‘Inter-relationship between profitability,
growth and size: a case of non-financial companies from Pakistan’, Pakistan Journal of
Commerce and Social Science, Vol. 6, No. 2, pp.405–419.
La Porta, R., Lopez-De-Silanes, F. and Shleifer, A. (1999) ‘Corporate ownership around the
world’, Journal of Finance, Vol. 54, No. 2, pp.471–517.
Lin, C.M., Phillips, R.D. and Smith, D.S. (2008) ‘Hedging, financing and investment decisions:
theory and empirical rests’, Journal of Banking & Finance, Vol. 32, No. 8, pp.1566–1582.
MacMinn, R.D. (1985) ‘Forward markets, stock markets, and the theory of the firm’, Journal of
Finance, 1987, Vol. 42, No. 5, pp.1167–1185.
Mayers, D. and Smith, C.W. (1987) ‘Corporate insurance and the underinvestment problem’,
Journal of Risk and Insurance, Vol. 54, No. 1, pp.45–54.
Mian, S.L. (1996) ‘Evidence on corporate hedging policy’, Journal of Financial and Quantitative
Analysis, Vol. 31, No. 3, pp.419–439.
Modigliani, F. and Miller, M.H. (1958) ‘The cost of capital, corporation finance and the theory of
investment’, American Economic Review, June, Vol. 48, No. 3, pp.911–922.
Moh’d, M., Perry, L.G. and Rimbey, J.N. (1998) ‘The impact of ownership structure on corporate
debt policy: a time-series cross-sectional analysis’, Financial Review, Vol. 33, No. 3,
pp.85–98.
Morck, R. and Nakamura, M. (1999) ‘Banks and corporate control in Japan’, Journal of Finance,
Vol. 54, No. 1, pp.319–339.
Myers, S.C. (1977) ‘The determinants of corporate borrowing’, Journal of Financial Economics,
Vol. 5, No. 2, pp.147–175.
Nance, D.R., Smith, C.W. and Smithson, C.W. (1993) ‘On the determinants of corporate hedging’,
Journal of Finance, March, Vol. 48, No. 1, pp.267–284.
Panaretou, A., Shackleton, M.B. and Taylor, P.A. (2013) ‘Corporate risk management and hedge
accounting’, Contemporary Accounting Research, Vol. 30, No. 1, pp.116–139.
Purnanandam, A. (2008) ‘Financial distress and corporate risk management: theory and evidence’,
Journal of Financial Economics, Vol. 87, No. 3, pp.706–739.
Schiozer, R.F. and Saito, R. (2009) ‘The determinants of currency risk management in Latin
American non-financial firms’, Emerging Markets Finance & Trade, Vol. 45, No. 1,
pp.49–71.
Shaari, N.A., Hasan, N.A., Palanimally, Y.R. and Mohamed, R.K.M.H. (2013) ‘The determinants
of derivative hedging: a study on Malaysian firms’, Interdisciplanary Journal of
Contemporary Research in Business, Vol. 5, No. 2, pp.300–316.
 The determinants of exchange rate risk management in developing countries 67

Simanjuntak, D.S. (2001) ‘Good corporate governance in post-crisis Indonesia: initial conditions,
windows of opportunity, and reform agenda’, Report of the Sub Regional Seminar on
Governance Re-invented: The Progress, Constraints, and Remaining Agenda in Bank and
Corporate Restructuring in East and South-East Asia, pp.27–65, Seoul, South Korea.
Smith, C.W. and Stulz, R.M. (1985) ‘The determinants of firms’ hedging policies’, Journal of
Financial and Quantitative Analysis, Vol. 20, No. 4, pp.391–406.
Smith, C.W. and Watts, R.L. (1992) ‘The investment opportunity set and corporate financing
dividend and compensation policies’, Journal of Financial Economics, Vol. 32, No. 3,
pp.263–292.
Stulz, R.M. (1984) ‘Optimal hedging policies’, Journal of Financial and Quantitative Analysis,
June, Vol. 19, No. 2, pp.127–140.
Stulz, R.M. (1990) ‘Managerial discretion and optimal financing policies’, Journal of Financial
Economics, Vol. 26, No. 1, pp.3–27.
Stulz, R.M. (2004) Should We Fear Derivatives?, NBER Working paper No. 10574 [online]
http://www.nber.org/papers/w10574 (accessed 26 July 2012).
Sutayanto, D. (2013) ‘Indonesia’s top ten companies ranked by largest market capitalization’
[online] http://www.indonesia-investments.com/finance/financial-columns/
indonesias-top-ten-companiesranked- by-largest-market-capitalization/item637
(accessed 21 January 2014).
Vallejo, M.C. (2009) ‘The effects of commitment of non-family employees of family firms from
the perspective of stewardship theory’, Journal of Business Ethics, Vol. 87, No. 3,
pp.379–390.
Wang, X. and Fan, L. (2011) ‘The determinants of corporate hedging policies’, International
Journal of Business and Social Science, Vol. 2, No. 6, pp.29–38.
Witt, M.A. and Redding, G. (2013) ‘Asian business systems: institutional comparison, clusters and
implications for varieties of capitalism and business systems theory’, Socio-Economic Review,
Vol. 11, No. 2, pp.265–300.
World Bank (2012) GDP Ranking of the Year 2012 [online] http://data.worldbank.org/
data-catalog/GDPranking-table (accessed 15 January 2014).

View publication stats