Fudan Journal of the Humanities and Social Sciences

https://doi.org/10.1007/s40647-020-00305-3

ORIGINAL PAPER

Multinational Companies’ Hedging Effectiveness of Foreign

Exchange Risk: A Quantitative Comparison Study

Xinbo Zhang1,2

Received: 2 July 2020 / Accepted: 5 October 2020

© Fudan University 2020

Abstract
To investigate hedging effectiveness of multinational companies in respect of using
currency derivatives, the author adapts an innovative and multi layers GJR-GARCH-
based model. This model broke down the currency risk faced by MNCs in each busi-
ness area and added six control variables other than foreign sales ratio, all these var-
iables have been proved to be related to MNCs’ currency risk exposure but was not
included into previous models. Moreover, this model absorbs advantages of several
models built in previous studies and combines them into a whole, intact model. This
paper also employed a wide research scope, using a sample of 48 non-financial and
28 financial firms headquartered in USA. Also, comparison between financial and
non-financial firms is an innovation of our research. According to the result, hedging
of non-financial companies in respect of currency risk is ineffective, and financial
companies are more likely using currency derivatives to speculate.

Keywords  Hedging effectiveness · Currency risk · GJR-GARCH · Multinational

companies · Comparison study · Econometrics model

1 Introduction

Foreign exchange risk is one of the more well-studied risks faced by companies all
over the world, since failing to hedge such risks can cause financial losses for multi-
nationals in various ways. Firstly, a company engaged in foreign trade often quotes
to customers in the process of their operations, and thus, the company faces the
problem of currency choice. Currency fluctuations, particularly when combined with
time lags in the process of ordering and making payments, can pose risks to organi-
zations that trade in more than one currency. Secondly, exchange rate fluctuations

* Xinbo Zhang
IBU1709507@xmu.edu.my
1
Xiamen University Malaysia, Sepang, Malaysia
2
Nanjing, China

13
Vol.:(0123456789)
 X. Zhang

will affect the cost of importing raw materials or goods from other countries. In
addition, the uncertainty of exchange rate changes brings great pressure on compa-
nies trying to predict future expenditures and even long-term operations.
Given the effects discussed above, hedging foreign exchange risks effectively is
quite a significant issue for multinational companies (MNCs). What’s more, the on-
going China-US trade war is imposing greater uncertainty on exchange rate fluc-
tuations (Guo et al. 2018), which makes hedging foreign exchange risks more diffi-
cult for these companies. Traditionally, as hedging tools, derivatives are particularly
popular, thanks to their low cost. However, although significant the literature has
focused on the behavior of MNCs trying to hedge their currency risk exposures with
derivatives, gaps still exist from both the empirical and theoretical perspectives. The
main problem from the empirical perspective is the oversimplification of the exist-
ing models used in some studies, while theoretical limitations are mainly due to the
limited scope of these studies.
The oversimplification of the models is due to the fact that there are too many
variables involved in describing the currency risk faced by a company. The sheer
volume of variables makes it difficult to include all of them, so many scholars in pre-
vious studies only used several simple variables. Some scholars have built compre-
hensive models to describe currency risk, including the one proposed by Allayannis
et al. (2001), which decomposes the currency risk factor in six different region-spe-
cific exchange rate indices. However, this model is still not considered comprehen-
sive enough by other scholars, since it assumes that the currency risk faced by a firm
will only be affected by the firm’s sales in different areas. This approach is over-
simplified. Although numerous other variables have been proved to influence the
currency risk faced by a firm, no one has created a model which can combine all of
these variables together. Besides, most scholars use a linear model, even though the
actual conditions may be more complex. Koutmos and Martin (2007) seemed to also
notice that a simple linear model may not be enough to capture the variation. There-
fore, they added a dummy variable to the mean equation of their GARCH model,
with the aim of including into their research the finding that stock returns respond
asymmetrically to currency appreciations and depreciations. A more widely-used
version of the GARCH model is the GJR-GARCH model, which adds this lever-
age variable to the variance equation instead of the mean equation, in order to bet-
ter capture the information leverage effect. However, to date, no one has used this
model in this field.
Theoretical gaps may also result from the insufficient resources available to
researchers, causing their researches to become circumscribed. Previous researches,
represented by the ones listed in the literature review section of this paper, all focus
on a number of specific areas. Most of them mainly focus on non-financial firms, but
they contain no comparison between financial firms and non-financial firms. How-
ever, in reality, non-financial firms usually turn to financial firms for suggestions on
how to hedge currency risks; it is therefore important to compare the hedging strate-
gies of the two kinds of entities. Besides, some researches focus only on particular
currency pairs, such as the research by Hendrawan (2017), which only focused on
the pair of Rupiah-USD. Other studies only focus on specific industries. One exam-
ple would be as the research conducted by MuchokiMwangi and Mohamed (2019),

13
Multinational Companies’ Hedging Effectiveness of Foreign…

which only focuses on oil-producing firms. Others focus on particular derivatives.

For example, Ben-David (2013), only focuses on futures. A paper with a sufficiently
wide scope is needed to provide reference for scholars and practitioners all over the
world.
In conclusion, the main gap in this research field is that extant researches are not
comprehensive enough. On the one hand, the models used in previous studies do
not contain all the variables proven to be relevant to the topic; the functional forms
of the models used in these studies are oversimplified. On the other hand, the focus
of these studies, which contain only particular kind of firm, industry, currency or
derivative, is too narrow. The research gap raises a research question for us. Specifi-
cally, how can we conduct a study that is comprehensive enough, with a sufficiently
wide scope and large enough sample size to provide adequate information and reach
a definitive conclusion in this field? Also, can we make innovations to the econo-
metrical model used, in order to make it more comprehensive and more capable of
capturing all relevant effects, thus making the study’s conclusions more accurate and
credible?
To answer these research questions, this paper has the following objectives: first,
build a multi-layered comprehensive panel data model, in order to incorporate as
many of the variables that have been proven to be relevant to the topic as possible.
Secondly, to improve the functional forms of current models in this research field,
apply the GJR-GARCH concept in the model. Lastly, expand the current scope of
research by incorporating currency risk from all major foreign sales areas over the
world in which a MNC can conduct business. Then, compare the hedging behav-
iors and effectiveness of financial firms and non-financial multinational firms. This
paper makes a significant contribution to existing literature in the following aspects:
first, the innovative and comprehensive model built in this paper will push empiri-
cal research in this field one step ahead. This will make a significant contribution
to a cutting-edge topic in econometrics, namely the panel data analysis. Secondly,
the wide scope of focus of this research can lead to a universal conclusion being
reached. Thus, the paper has reference value for any and all scholars around the
world who are interested in conducting research in relevant fields. The results can
guide practitioners in various industries, helping them to review their effective-
ness in terms of currency derivative usage. Thirdly, this paper summarizes previous
researches and incorporates their conclusions and contributions in designing meth-
odologies and in the process of building models. As such, this study functions as a
one-stop reference for those who are conducting researches in this field.

2 Literature Review

Many studies have focused on the hedging effectiveness of MNCs, as studies of this
nature can provide practical value for the business world. Nzioka and Maseki (2017)
researched the effects of internal hedging, external hedging, and inflation on the
financial performance of non-banking companies on the Nairobi Stock Exchange,
using return on equity as a proxy for financial performance. The study found that
internal hedging techniques, which consist of invoicing in the home currency,

13
 X. Zhang

matching, leads and lags, as well as money market hedges, are more effective than
external hedging techniques, which include options, forwards, futures, and swaps.
This is due to the complexities and higher costs associated with external techniques,
as those techniques require arrangements to be made with third parties. However,
a contradictory conclusion was reached in a study conducted by Muchoki et  al.
(2019), which used a sample of 36 oil marketing firms. That study found that exter-
nal hedging techniques are more effective for oil marketing companies. Futures were
not a common tool used by oil marketing firms to manage foreign currency risks
(compared to forwards). As a result, oil marketing firms using currency forwards
were considered effective, while the currency futures were considered ineffective
in terms of foreign currency exposure management. Therefore, the study concluded
that currency risk exposure is an important factor in the hedging effectiveness of oil
marketing firms. This contradiction suggests that hedging effectiveness is a compli-
cated topic, and as such, comparison studies are needed to avoid arriving at biased
conclusions.
In respect of currency risk exposure, which is concluded as significant by the
abovementioned research by Muchoki et  al. (2019), Döhring (2008) studied the
exposure risk of the exchange rate in terms of transaction risk and translation risk.
The study conducted a survey of 33 non-financial companies in the EuroStoxx50
index and found that 32 non-financial blue-chip companies systematically use
financial derivatives to hedge transaction risk. These companies also use different
derivatives to hedge different risks. In the Döhring research, as 32 of these firms
use forwards to hedge currency risk, exchange rate forwards were found to be the
most commonly-used derivative tool to hedge future cash flows. In addition, 28
of the 32 studied firms used exchange rate options to hedge uncertain future cash
flows, and 22 of those companies mainly used swaps to hedge longer-term regu-
lar transactions. The optimum way to choose financial derivatives was studied by
Hendrawan (2017). That study examined the impact of forwards, forward options,
and the no hedging strategy for managing currency exposure between the Indo-
nesian rupiah and the USD, within the time span from January 2006 to Decem-
ber 2016. The study compared the results when using no hedging, forwards, and
forward options as hedging instruments with a contract term of 3 months. This
study identified that forward options make no positive contribution, while the no
hedging strategy has a 36% positive contribution, while forward contracts have a
72% positive contribution in managing currency exposure. The results show that
using forward contracts is better than using forward options and not hedging in
managing currency exposure. Another study related to our topic, which was con-
ducted in Indonesia, was conducted by Fiskara et  al. (2015). That study exam-
ined the role of currency hedging on the performance of non-financial firms in
Indonesia, using panel estimation. The survey’s results reported that there is no
evidence that currency hedging activities affect capital or firm performance in
Indonesia. This result underlines the low intensity of currency hedging activities
in Indonesia, due to the lack of incentives and low derivative transactions within
underdeveloped foreign currency markets. Most Indonesian firms use natural
hedging techniques. A similar study carried out in emerging markets by Muiru
et al. (2018) investigated the effects of foreign exchange risk hedging techniques

13
Multinational Companies’ Hedging Effectiveness of Foreign…

on the financial performance of publicly listed firms in Kenya. The study sample
consisted of 54 firms that were listed on the Nairobi Securities Exchange from
2011 to 2016. The authors used panel data and a generalized least squares model
to analyze the data. The results show that, when hedging strategies and hedg-
ing tools are implemented appropriately, firms can achieve their financial objec-
tives, improve their financial performance, and create value for shareholders. In
addition, the majority of public listed Kenyan firms use natural hedging, because
the derivatives market in Kenta is not yet well developed. A study with a wider
scope was conducted by Ben-David (2013), who researched the effectiveness of
the foreign currency hedging abilities afforded by the futures market. Six emerg-
ing market currencies were focused upon, namely, Turkey, Russia, India, Brazil,
South Africa, and Mexico. The author investigated the emerging market curren-
cies, examining the influence that possible mispricing and the lack of liquidity
can have on hedging effectiveness. As a result, the regression method has since
been used to evaluate the effectiveness of futures contracts as a hedging mecha-
nism for emerging market currencies. In conclusion, only South Africa and Tur-
key indicated consistent hedge effectiveness, whereas Russia and Turkey exhib-
ited reasonable hedge effectiveness. By comparing these studies, it seems that,
generally speaking, the emerging market practices of MNCs with regard to hedg-
ing currency risk are not effective. Other studies also focus on developed markets.
A study conducted by Bahoo et al. (2018) found that, in a sample of the top 100
American non-financial companies, the majority consistently use derivative con-
tracts to hedge against multiple risks, such as currency, commodity, and interest
rates. Overall, the use of currency derivatives appears to have a positive effect on
American companies’ financial performance. However, in 2009 and 2010, while
the positive relationship still existed, the effect was less significant because of
the 2008 financial crisis. It seems that the MNCs in developed markets are more
capable of properly using derivatives to hedge currency risks.
Still other studies found that certain derivatives are more effective than others
in hedging foreign exchange risk. Nova et al. (2015) concluded that exchange rate
derivatives behave differently under different conditions. Swaps are more effec-
tive (compared to option contracts) under the conditions described in the study.
Additionally, Ahmed et al. (2013) concluded that, overall, foreign exchange risk
hedging was found to be significant and contributes favorably to firm value and
financial performance. The authors used Tobin’s as a proxy for firm value and
return on invested capital, and return on assets as proxies for financial perfor-
mance. Hedging with forwards was found to positively contribute to firm value.
However, in this study, hedging exchange rate risk with options was negatively
associated with firm value, while the effect of hedging with futures and swaps
was found to be insignificant. Furthermore, the authors revealed that the 2008
financial crisis did not change hedging practices or their effects on firms’ value
and financial performance. Therefore, there remains a dispute on whether a finan-
cial crisis can harm MNCs’ hedging effectiveness against currency risk, as well
as which derivative is the most useful tool for hedging. Therefore, only by con-
ducting research that is set within peaceful time periods, and by combining all
derivatives as a whole, can a definitive conclusion be reached.

13
 X. Zhang

3 Methodology

The two main categories of firms that we want to study are financial firms and
non-financial firms. The classification that distinguishes between these two cat-
egories is based on the classification criteria given by Yahoo Finance. In this arti-
cle, a financial firm is a firm that is classified as providing financial services; a
non-financial firm is a firm that is classified as a firm that offers non-financial
services, including basic materials, utilities, and technologies, etc.
For these firms, we have a three-step selection process. First, firms must be
headquartered in the United States of America (USA). Secondly, in the annual
reports, firms must enclose a notional amount of foreign currency derivatives,
which many firms did not. Thirdly, following Muller and Verschoor (2006), we
grouped the selected firms into six geopolitical groups: EU, UK, Asia, Australia,
Latin America, and South Africa. In the end, based on the three-step selection
process, the results yielded a total of 28 financial firms and 48 non-financial
firms. In the Table 1, we present the distribution of the sample firms across the
financial and non-financial sectors. We also enclose the relevant information with
regard to the regions in which the selected companies operate, other than the
USA. This information is also presented in Table 1.
In respect of choosing economic factors, this article considers two types of
risk, namely the market risk factor and the exchange rate risk factors. We use the
Center for Research in Security Prices (CRSP) as a proxy for the market risk fac-
tor. The exchange rate risk factors are measured as the continuously compounded
rates of change in a worldwide trade-weighted US dollar exchange rate index, and
in region-specific trade-weighted exchange rate indices. The regional indices are
calculated by the following formula:
/( )
∑ ∑( )
Xt = ((expk +impk ) expk +impk ∗ Xk,t
l,n l,n

where n is the number of countries included in the region; e­ xpk is the export flow
from the USA toward country k; ­impk is the import cash flow from country k toward
the USA, and Xk,t is the bilateral exchange rate between the US dollar and country
k’s currency. The weights of the region-specific indices, updated monthly, are based
on each country’s proportion of trade in the total import and export flows of the
region with the USA.

Table 1  Number of companies belong to each category

EU UK Asia Latin America South Africa Total

Financial firm 28 29 28 25 20 29
Non-financial firm 47 48 46 46 37 48
Total 75 77 74 71 57 77

13
Multinational Companies’ Hedging Effectiveness of Foreign…

Since the objective of this article is to test the hedging effect of foreign currency
derivatives, we thus need to obtain foreign exchange exposure as accurately as pos-
sible. Following Jorion (1990), foreign exchange exposure is calculated as follows:
Ri,t = ai + 𝛽i Rm,t + 𝛾i 𝜃t + 𝜀i,t (1)
where Ri,t refers to the return of firm i in period t; Rm,t is the stock market return in
period t; βi is firm i’s return sensitivity to market fluctuations; θt is the movement in
the trade-weighted US dollar world exchange rate index; γi is firm i’s exposure to the
exchange rate index, net of the effect these currency movements have on the overall
market; εi,t denotes the white noise error term, and γi refers to the sensitivity of stock
returns to unanticipated changes in exchange rates. From this equation, a statistically
significant positive γi indicates that an appreciation of the domestic currency has a
positive impact on a firm’s stock return. Economically speaking, a firm with such
characteristics reacts like a net importer. In contrast, we expect a statistically signifi-
cant negative γi belonging to a net exporter.
The underlying assumption that Eq. (1) made is a constant variance of dependent
variables. To test this hypothesis, we use an ARCH test to check the validity of the
null hypothesis of the error terms of Eq. (1), that εi,t is homoskedasticity. If we do
not reject the null hypothesis, we perform an ordinary least squares regression. Oth-
erwise, we add a GARCH (1, 1) process [Eq. (1)]. The model is as follows:
Rit = ai + 𝛽i Rmt + 𝛾i 𝜃t + 𝜀it (2)

(3)
√
𝜀it = 𝜇it ∗ hit

hit = 𝛿i + 𝜏i 𝜀2i,t−1 + 𝜈i hi,t−1 (4)

The trade-weighted world exchange rate index did not always correspond to every
firm’s trade patterns and cannot address the problem of low and negative correla-
tions between some exchange rates. Thus, we adopt the methodology suggested
by Allayannis et al. (2001) and decompose the currency risk factor in six different
region-specific exchange rate indices. The model is as follows:
Rit = ai + 𝛽i Rm,t + 𝜁i 𝜗t + 𝜀it (5)

(6)
√
𝜀it = 𝜇it ∗ hit

hit = 𝜔i + 𝜏i 𝜀2i,t−1 + 𝜈i hi,t−1 (7)

where 𝜁i,t 𝜗i,t = 𝛾EU,t 𝜃EU,t + 𝛾UK,t 𝜃UK,t + 𝛾AS,t 𝜃AS,t + 𝛾AU,t 𝜃AU,t + 𝛾LA,t 𝜃LA,t + 𝛾SA,t 𝜃SA,t
(8)
Under Koutmos and Martin’s (2007) work, a dummy variable St is added to the
mean equation. This is done to test the hypothesis that stock returns respond asym-
metrically to currency appreciations and depreciations. Until now, no one has ever

13
 X. Zhang

used GJR-GARCH to capture the leverage effect. We thus extend the mean equation
in our standard model to a new form:

hit = 𝜔i + (𝜁i Ii,t−1 + 𝜏i )𝜀2i,t−1 + 𝜈i hi,t−1 (9)

{
0, if Rit > ai
Ii,t−1 =
1, if Rit ≤ ai (10)

For the explanatory variable, we use foreign currency derivatives (FCD). Two meth-
ods can be used to measure the FCD. First, we can use dummy variables. If the com-
pany has used foreign currency derivatives, FCD = 1; if not, FCD = 0. Secondly, we
can use the ratio between the notional amount of foreign currency derivatives and
the total asset. In this article, we use the second method, because we need to test the
hypothesis that financial firms are more effective than non-financial firms in terms
of hedging effectiveness.
Finally, there are six control variables:

1. Foreign sales ratio (Fsri,t)

Multinational firms are more likely to have liabilities denominated in foreign cur-
rency, and thus are more likely to be influenced by exchange rate fluctuations. Jor-
ion (1990) verified this conclusion in his research. We thus use the company’s ratio
export revenue divided by total revenue to represent that company’s foreign sales.

2. Size (Sizei,t)

There are two schools of thought regarding how the size of a company influences its
foreign exchange risk exposure. Nance et al. (1993) indicate that, the larger the size
of a company, the better that company can manage foreign risk by hiring experts.
Thus, a negatively correlated relationship exists between size and foreign exchange
exposure. Gilson and Warner (1997) pointed out that smaller-sized companies face
a higher probability of financial distress and thus are more motivated to manage for-
eign exchange risk. As such, a positively correlated relationship exists between size
and foreign exchange. We use the natural log of the total assets to represent the size
of a company.

3. Growth (Growi,t)

The better a company’s potential to grow, the more opportunities there are to invest,
and the higher the need for external financing. On the one hand, debt holders will
require the firm to manage foreign risk to reduce the volatility of future cash flows.
On the other hand, to obtain external finance, a company must maintain its high
credit rating. Thus, there exists a negatively correlated relationship with foreign
exchange risk. Handayani et  al. (2018), however, points out that the better a com-
pany’s growth potential is, the more volatile that company’s stock price will be. This

13
Multinational Companies’ Hedging Effectiveness of Foreign…

leads to a higher foreign exchange exposure. Thus, the relationship between a com-
pany’s growth potential and its foreign exchange exposure is not obvious. We use
the annual growth rate of a company’s revenue as a proxy variable.

4. Solvency (Soli,t)

He and Ng (1998) points out that the less solvent a company is, the less foreign
exchange exposure that company has. We use the solvency ratio as a proxy for a
company’s solvency.

5. Liquidity (Liqi,t)

Bartram (2004) points out that a significant relationship exists between German
companies’ liquidity and their foreign exchange exposure, especially when examin-
ing by a non-linear model. We use the current ratio as a proxy for liquidity.

6. Profitability (Proi,t)

Choi and Prasad (1995) point out that, the more profitable a company in its foreign
sales, the more foreign exchange rate exposure that company will have. We use the
net profit margin as a proxy for a company’s profitability.
Based on the discussion above, we eventually obtain a multivariate linear regres-
sion model:
Rit = ai + 𝛽i Rm,t + 𝜁i 𝜗t + 𝜀it (11)

(12)
√
𝜀it = 𝜇it ∗ hit

hit = 𝜔i + (𝜁i Ii,t−1 + 𝜏i )𝜀2i,t−1 + 𝜈i hi,t−1 (13)

{
0, if Rit > ai
Ii,t−1 =
1, if Rit ≤ ai (14)

where 𝜁i,t 𝜗i,t = 𝛾EU,t 𝜃EU,t + 𝛾UK,t 𝜃UK,t + 𝛾AS,t 𝜃AS,t + 𝛾AU,t 𝜃AU,t + 𝛾LA,t 𝜃LA,t + 𝛾SA,t 𝜃SA,t
(15)
𝛾n,t = 𝜆i + ai FCDi,t + 𝛼2 Sizei,t + 𝛼3 Fsri,t + a4 Growi,t + 𝛼5 Soli,t + 𝛼6 Liqi,t + 𝛼7 Pr oi,t + 𝜀i
(16)
where n represents the region; t represents time (t = 2016, 2017, 2018), and λi and εi
represent constant and white noise error terms, respectively.
The model is in three-layer form. The first layer consists of Eqs.  (11), (12),
(13) and (14), which is a GARCH model. The second layer is Eq. (15), which is a
breakdown of the foreign exchange rate risk faced by the company according to its
business operations area. The third layer is Eq.  (16), which is a breakdown of the

13
 X. Zhang

currency risk faced in each business area and serves as a measurement of the effec-
tiveness of hedging.
To explain the equation system, we take a bottom-up approach. The third layer
of the equation investigates what actually contributed to the establishment of the
foreign exchange rate exposure position of the companies; we give factors such as
size, growth, liquidity, and others. We use the total currency derivative to total asset
ratio as a proxy of the hedging activities implemented by the company and investi-
gate whether these activities can reduce the foreign exchange rate risk exposure of
the company. The coefficient of this factor, ai, should be significant and negative if
hedging activities are effective. If so, when the proportion of currency derivative in
total assets increases, the company’s breakdown of foreign exchange rate risk (|θn, i|)
will decrease, since |θn, i| is always positive.
Then, in the second layer, if each breakdown segment of foreign exchange rate
risk exposure (the foreign exchange rate risk exposure in different business areas) is
effectively reduced by using financial derivatives, the total foreign exchange rate risk
exposure (iϑt) will be reduced. Then, in the first layer, the return of company stock
is more determined by the market and less influenced by foreign exchange rate risk
exposure.
Therefore, in judging hedging effectiveness, we will consider whether ai is sig-
nificant and negative. If so, the hedging is effective, and vice versa.

4 Data Insights and Modeling Result

4.1 Stationary Test

In order to avoid spurious regression, we need to ensure that both dependent varia-
bles and independent variables are stationary time series. Here, we choose the KPSS
test. Here is the null hypothesis and the alternative hypothesis:

H0 The time series is stationary.

Ha The time series is non-stationary.

As indicated in Table 2, for both independent variables and dependent variables, the
test statistics are smaller than the 5% critical value, and thus, we cannot reject the
null hypothesis. Therefore, we can conclude that both the dependent variables and
independent variables are stationary. We can perform a regression analysis between
them.

Similarly, the stationary test result for financial firms is presented in the following
Table 3.
As indicated in Table  3, for the dependent variables of financial firms, the test
statistics are smaller than the 5% critical value, and we can perform a regression
analysis between those variables and the independent variables (which were pre-
sented in Table 2).

13
Multinational Companies’ Hedging Effectiveness of Foreign…

Table 2  Stationary Test for Variables in Eq. 11 (non-financial firm)

KPSS test results (test statistics)

Firm stock returns

RTN 0.50 BMY 0.21 F 0.10
GOOG 0.07 EBAY 0.07 PFE 0.18
ABBV 0.06 APD 0.37 JNJ 0.06
MDLZ 0.32 MAS 0.09 INTC 0.11
MMM 0.10 KODK 0.17 ADI 0.02
MRK 0.11 LHX 0.09 AMGN 0.41
WMT 0.07 BDX 0.08 WDC 0.04
MCK 0.41 MAT 0.32 LII 0.05
T 0.07 LH 0.06 KO 0.09
ABC 0.06 GE 0.06 TTC​ 0.15
COST 0.04 MSFT 0.03 TXN 0.23
WBA 0.19 CSCO 0.09 MCHP 0.05
BA 0.26 GM 0.45 DISCA 0.11
CMCSA 0.14 FDX 0.16 PEP 0.14
PG 0.08 AAPL 0.13 EL 0.07
AMD 0.05 ORCL 0.14 KMB 0.12
Currency indices
EU/US 0.11 SA/US 0.12 MKT_RTN 0.16
UK/US 0.14 Asia/US 0.07
AUS/US 0.14 Latin/US 0.05
1% Significance level 0.74 5% Significance level 0.57 10% Significance level
0.35

Table 3  Stationary test for variables in Eq. 11 (financial firm)

KPSS test results

JPM 0.18 CB 0.24 FDS 0.03

BAC 0.19 SPGI 0.30 AB 0.03
V 0.06 AIG 0.27 EV 0.60
MA 0.12 MET 0.09 LM 0.15
C 0.28 MCO 0.16 HLI 0.21
PYPL 0.06 AFL 0.08 CIT 0.13
AXP 0.08 STT 0.42 VIRT 0.21
MS 0.28 NTRS 0.17 MKTX 0.15
GS 0.37 AMP 0.25 RGA​ 0.25
BLK 0.26 AJG 0.08
1% Significance level 0.74 5% Significance level 0.57 10% Significance level
0.35

13
 X. Zhang

Table 4  Stationary test for variables in Eq. 16 (non-financial firm)

Variables Test statistics

KPSS test statistics Foreign currency derivatives 0.27

Foreign sales 0.25
Growth rate of total revenue 0.23
Liquidity 0.21
Size 0.14
Solvency 0.32
Profitability 0.12
Test critical value 1% level 0.74
5% level 0.57
10% level 0.35

Table 5  Stationary test for variables in Eq. 16 (financial firm)

Variables Test statistics

KPSS test statistics Foreign currency derivatives 0.41

Foreign sales 0.18
Growth rate of total revenue 0.56
Liquidity 0.23
Size 0.37
Solvency 0.10
Profitability 0.32
Test critical Value 1% level 0.74
5% level 0.57
10% level 0.35

In addition to the stationary test for Eq.  11, a stationary test for Eq.  16 is also
required. Table 4 shows the results for non-financial firms.
Table 5 shows the results for financial firms.
As the two tables above indicated, for both independent variables and dependent
variables, the test statistics are smaller than the 5% critical value; thus, we cannot
reject the null hypothesis and perform a regression analysis between them.

4.2 ARCH Effect

To test the autoregressive conditional heteroskedasticity (ARCH), we can apply the

Ljung-Box test to {at}, which is the residual of the mean equation.
As shown in Table 6, 81.25% of firms have a p value of below 5%. Thus, we can
conclude that a very obvious ARCH effect exists for the stock returns of these firms.

13
Multinational Companies’ Hedging Effectiveness of Foreign…

Table 6  ARCH test for variables in Eq. 11 (non-financial firm)

ARCH effect test (p value)

RTN 4.53E−13 BMY 0.984176 F 0.096459

GOOG 0.004373 EBAY 0.996564 PFE 3.33E−16
ABBV 2.22E−16 APD 9.99E−16 JNJ 0.00091
MDLZ 2.39E−06 MAS 3.98E−05 INTC 0.000164
MMM 0.029597 KODK 2.68E−12 ADI 2.03E−06
MRK 6.01E−10 LHX 2.28E−07 AMGN 0.005387
WMT 0.851388 BDX 5.40E−06 WDC 0.059679
MCK 0.151456 MAT 0.00986 LII 0.01311
T 2.65E−07 LH 0.40358 KO 0.001289
ABC 0.008949 GE 0 TTC​ 3.96E−05
COST 0.004197 MSFT 0 TXN 3.81E−07
WBA 3.44E−10 CSCO 3.16E−09 MCHP 0.256968
BA 0.057796 GM 0.943897 DISCA 0.024506
CMCSA 0.02217 FDX 0.000146 PEP 1.89E−05
PG 0.501863 AAPL 1.28E−13 EL 0.303189
AMD 4.53E−13 ORCL 0.524423 KMB 2.69E−05

We use GARCH (1, 1) to fit the model. Similarly, ARCH tests for the stock returns
of financial firms are also carried out, and the same conclusion is reached (Table 7).

4.3 Hausman Test and LM test

This section chooses a more suitable model for panel analysis.

Here, we make the following hypotheses:

Table 7  ARCH test for variables in Eq. 11 (financial firm)

ARCH effect test (p value)

JPM 1.20E−10 CB 0 FDS 0.004142199

BAC 0 SPGI 0 AB 0
V 0 AIG 0.000298486 EV 5.06E−10
MA 0 MET 2.56E−10 LM 1.08E−08
C 0 MCO 3.50E−11 HLI 0.000607449
PYPL 2.94E−07 AFL 5.02E−05 CIT 0
AXP 0.768777788 STT 3.70E−07 VIRT 0.969486577
MS 4.09E−09 NTRS 2.94E−06 MKTX 0.937924001
GS 1.53E−06 AMP 2.55E−13 RGA​ 1.87E−09
BLK 0 AJG 3.91E−07
1% Significance level 0.74 5% Significance level 0.57 10% Significance level 0.35

13
 X. Zhang

Table 8  Hausman and LM test result (non-financial firm)

Hausman test Lagrange multiplier test
2
χ p-value χ2 p-value

6.288 0.3917 33.311 7.855e−9

Table 9  Hausman and LM test result (financial firm)

Hausman test Lagrange multiplier test
2
χ p-value χ2 p-value

5.2154 0.5165 4.6253 0.0315

H0: Random effect.

H1: Fixed effect.

As Table 8 shows, the χ2 test statistic is 6.288, with a p-value above 0.10. Thus, we
cannot reject the null hypothesis. Therefore, we can conclude that, between the ran-
dom effect model and the fixed effect model, the random effect model is the more
suitable.
As for the LM test, its null and alternative hypotheses are as follows:

H0: Mixed-effect.
H1: Random effect.

The p-value for test statistics is significant at a 5% significance level, as shown in

Table  8. Hence, we can reject the null hypothesis and conclude that, between the
mixed-effect model and the random effect model, the random effect model is more
suitable.
Similarly, for financial firms, the results of the Hausman test and LM test show
that we should also use a random effect model here (Table 9).

4.4 Model Diagnostic

In this part, we mainly test whether there is a presence of heteroskedasticity and

autocorrelation in the error term of the model. If these two effects are present, we
have to use a heteroskedasticity and autocorrelation consistent (HAC) covariance
estimator in modeling. The hypotheses for the BP test are:

H0: No heteroskedasticity problem.

H1: Heteroskedasticity problem.

For the BG test:

13
Multinational Companies’ Hedging Effectiveness of Foreign…

H0: No serial correlation problem.

H1: Serial correlation problem.

The test results for non-financial firms are as follows.

As shown in Table 10, the results for both tests show that H0 is rejected, which
means that both heteroskedasticity and serial correlation are present. Therefore, a
HAC covariance estimator must be used to solve these problems.
Similarly, for financial firms, the BP test and BG test results reject H0, which
means we again must use the HAC covariance estimator (Table 11).

4.5 Results

The final results of this model for non-financial firms (based on HAC estimator) are.
As shown in Table 12, even if a sandwich estimator is applied to the model, there
is still no significant relationship between foreign exchange exposure and foreign
currency derivatives. Thus, we can conclude that the non-financial firms in this
study did not effectively hedge foreign exchange exposure.
For financial firms, the result is different. As shown in Table 13, the coefficient ai
in Eq. 6 is positive and significant. This means that the use of financial derivatives

Table 10  BG and BP test result (non-financial firm)

BG test BP test
F statistic p-value BP statistic p-value

5.2058 0.02477 136.53 < 2.2e−16

Table 11  BG and BP test result (financial firm)

BG test BP test
2
χ p-value BP statistic p-value

19.431 0.000227 32.017 1.62e−05

Table 12  Modeling result for non-financial firms

Variable name Coefficient p-value

Intercept 1.712195 0.007311***

Foreign currency derivatives 0.237899 0.544783
Foreign sales 0.148641 0.280190
Size − 0.128300 0.004313***
Liquidity 0.055427 0.854494
Solvency 0.156162 0.641412
Revenue growth rate − 0.125516 0.696381

***1% significance level; **5% significance level; *10% significant level

13
 X. Zhang

Table 13  Modeling result for non-financial firms

Variable name Coefficient p-value

Intercept 0.0941489 0.23267

Foreign currency derivatives 0.0041320 0.03790**
Foreign sales − 0.1112476 0.17603
Size 0.0087331 0.28540
Liquidity 0.0039210 0.70094
Solvency − 0.0128084 0.86193
Revenue growth rate − 0.2227441 0.00111***

***1% significance level; **5% significance level; *10% significant level

did not effectively reduce the foreign exchange rate risk exposure, or, to be more
specific, the use of currency derivatives increases the foreign exchange rate risk
exposure of these firms. Considering that they are financial firms, they may use cur-
rency derivatives as a speculation tool instead of as a hedging tool. This assertion is
subject to further research.

5 Conclusion

In this paper, the author uses a multi-level regression model to study the hedging
effectiveness of financial and non-financial firms. A sample of 48 non-financial and
28 financial firms, all of which are headquartered in the USA, is used. As for our
final conclusion, non-financial firms’ hedging efforts with currency derivatives are
not effective, while financial firms seem to be using currency derivatives for specu-
lation purposes, rather than for hedging. Although the result is frustrating, it can
serve as a warning for non-financial MNCs to revise their hedging strategies against
currency risk. However, at least one point is clear: non-financial firms should not
totally mimic the way financial firms use currency derivatives, since the main goal
of non-financial firms using currency derivatives is hedging but not speculating.
For further researches, one of our hypotheses is that separating currency risk
exposure into several parts, according to geographic region, can be better than just
using an index of US dollar strength to represent currency risk. The author tested
this hypothesis, and the result shows that if the separated index was used, 72.91%
of the companies’ hedging activity was found to be effective in at least one year for
one region. However, if an integrated index was used, the hedging activity of only
37.5% of the companies was effective in at least one year. Therefore, the use of a
separated index can be a better way to study the problem. Unfortunately, we do not
have enough data to use the separated index, since no data provided in the annual
report of companies give the usage of currency derivatives according to geographic
regions or currencies. We ultimately used the integrated index to represent currency
risk exposure, and further studies should be carried out using the separated index to
deal with the problem.

13
Multinational Companies’ Hedging Effectiveness of Foreign…

Compliance with Ethical Standards 

Conflict of interest  I, Zhang Xinbo, the only author of this paper, states here that there is no conflict of
interest within this paper.

References
Ahmed, H., A. Azevedo, and Y. Guney. 2013. The effect of hedging on firm value and performance: evi-
dence from the nonfinancial UK firms. European Financial Management 44: 1–31.
Allayannis, G., J. Ihrig, and J.P. Weston. 2001. Exchange-rate hedging: financial versus operational strate-
gies. American Economic Review 91 (2): 391–395.
Bahoo, S., S. Khan, and M.A. Kanju. 2018. Do derivatives increase American corporate’s financial per-
formance? City University Research Journal 8 (2): 219–235.
Bartram, S.M. 2004. Linear and nonlinear foreign exchange rate exposures of German nonfinancial cor-
porations. Journal of International Money and Finance 23 (4): 673–699.
Ben-David, T.A. 2013. The effectiveness of hedging foreign exchange rate risk: an emerging market per-
spective (Doctoral dissertation).
Choi, J.J., and A.M. Prasad. 1995. Exchange risk sensitivity and its determinants: a firm and industry
analysis of US multinationals. Financial Management 77–88.
Döhring, B. 2008. Hedging and invoicing strategies to reduce exchange rate exposure-a euro-area per-
spective (No. 299). Directorate General Economic and Financial Affairs (DG ECFIN), European
Commission.
Fiskara Indawan, Sri Fitriani, Indriani Karlina, and Melva Viva Grace. 2015. The role of currency hedg-
ing on firm performance: a panel data evidence in Indonesia. Bulletin of Monetary Economics and
Banking, Bank Indonesia, 17(3): 1–20, January.
Gilson, S.C., and J.B. Warner. 1997. Junk bonds, bank debt, and financing corporate growth. Bank Debt,
and Financing Corporate Growth (October 1997).
Guo, M., L. Lu, L. Sheng, and M. Yu. 2018. The day after tomorrow: evaluating the burden of Trump’s
trade war. Asian Economic Papers 17 (1): 101–120.
Handayani, H., H. Muharam, W. Mawardi, and R. Robiyanto. 2018. Determinants of the stock price vola-
tility in the Indonesian manufacturing sector. International Research Journal of Business Studies 11
(3): 179–193.
He, J., and L.K. Ng. 1998. The foreign exchange exposure of Japanese multinational corporations. The
Journal of Finance 53 (2): 733–753.
Hendrawan, R. 2017. Forward, forward option and no hedging which one is the best for managing cur-
rency risk? Journal Keuangan dan Perbankan 21(3).
Jorion, P. 1990. The exchange-rate exposure of US multinationals. Journal of Business 331–345.
Koutmos, G., and A.D. Martin. 2007. Modeling time variation and asymmetry in foreign exchange expo-
sure. in Journal of Multinational Financial Management 17(1): 61–74. February 2007.
Mariana Vila Nova, António Melo Cerqueira, and Elísio Brandão. 2015. Hedging with derivatives and
firm value. FEP Working Papers 568, Universidade do Porto, Faculdade de Economia do Porto.
MuchokiMwangi, A., and S. Mohamed. 2019. Effectiveness of external hedging technique on foreign
currency exposure of the oil marketing companies in Kenya.
Muiru, Monica, Kisaka, Sifunjo, and Kalui, Fredrick. 2018. Effect of foreign exchange risk hedging tech-
niques on financial performance of listed firms in Kenya. International Journal of Accounting and
Financial Reporting 8(3).
Muller, A., and W. Verschoor. 2006. Asymmetric foreign exchange rate exposure: evidence from U.S.
multinational firms. Journal of Empirical Finance, Elsevier, vol. 13(4–5), pp. 495–518, October.
Nance, D.R., C.W. Smith Jr., and C.W. Smithson. 1993. On the determinants of corporate hedging. The
journal of Finance 48 (1): 267–284.
Nzioka, O.M., and F.M. Maseki. 2017. Effects of hedging foreign exchange risk on financial perfor-
mance of non-banking companies listed at the nairobi securities exchange. European Scientific
Journal 13(10).

13
 X. Zhang

Zhang Xinbo  is a bachelor of economics student in Xiamen University Malaysia (XMUM). He joined
XMUM in the year of 2017 and is planning to graduate in 2021. Mr. Zhang Xinbo has distinguished
academic record during his bachelor studies. He has a CGPA 3.80 of 4.00, and scored global top 4%
in GMAT exam, as well as both 96th percentile in quantitative part and verbal part in GRE exam. He
has also been awarded with silver prize of ZhongQing Cup national college student mathematics model
building competition, gold price of national college student software application skills competition, and
bronze price of China-Malaysia youth entrepreneurship competition. He was also awarded with first-class
distinguished student scholarship by XMUM in 2020. Mr. Zhang Xinbo has research interest in econo-
metrics models, especially GARCH family models. His article titled “The influence of registration system
reform based on computer big data on IPO mispricing—evidence from China’s growth enterprise mar-
ket” was accepted by International conference on Electronic, Electrical and Computer Application 2020
(ICEECA 2020), which is indexed by EI. He also received distinction award in his bachelor graduate
thesis, which applied an ARIMA-GARCH model. Mr. Zhang Xinbo has also interned in several leading
organizations in industries. He was a consultant intern in Nielson Company, Beijing branch during July to
September in 2019. He also interned in Bank of China International in Shanghai, February to April 2020.
Finally, he is now a part-time assistant to Sales & Trading Department of JP Morgan Chase & Co., in its
Wallstreet headquarter.

13