International Research Journal of Finance and Economics ISSN 1450-2887 Issue 4 (2006) EuroJournals Publishing, Inc. 2006 http://www.eurojournals.com/finance.

htm

Risk Management by Multinational Corporations: A New Test of the Underinvestment Hypothesis

Peter R. Crabb*

School of Business and Economics Northwest Nazarene University 623 Holly Street, Nampa, ID 83686
E-mail: prcrabb@nnu.edu Tel: 208-467-8404, fax:208-467-8440
Abstract

This study analyzes foreign currency hedging activity of U.S. multinational firms to determine if these firms hedge exchange rate risk to overcome an underinvestment problem. Previous research on this problem shows that firms investment opportunities help to explain exchange rate risk hedging. This study uses more detailed, geographically segmented, firm-level data and alternative econometric specifications to test further implications of the underinvestment problem model. Evidence from this sample supports the conclusion that multinational firms with asset exposure to exchange rates hedge more and firms coordinate hedging and investment decisions. Key words: Multinational Firms, Foreign Exchange. JEL Classification: F23, G15.

I. Introduction
The ability to hedge the risk of movements in exchange rates is vitally important to any firm, and the use of foreign currency derivatives (FCDs) is significant amongt multinational corporations (MNCs). The use of FCDs increased substantially in the 1990s. The Bank of International Settlements (BIS) reports that between March 1995 and 1998 alone, the gross notional values of outstanding, overthecounter (OTC), foreign exchange contracts rose 43%1 Furthermore, firms regularly report that the use of FCDs is significant and widespread. For example, Hewlett-Packard reports billions in outstanding foreign exchange contracts relating to more than 30 foreign currencies in their recent annual reports. Managements discussion states that Hewlett-Packard hedges the effect of currency movements on both their balance sheet and income statements. This study seeks to determine if such use of FCDs is consistent with the underinvestment hypothesis. The underinvestment problem for multinationals

occurs when exchange rate movements reduce cash flow and thereby lower the firms ability to fund good investments. This study tests two implications of this rationale for hedging not covered in previous work and specific to MNCs. First, multinational firms with greater exposure to exchange rates from foreign investment, as opposed to those with exposure from foreign sales, will hedge more. Second, changes in the firms foreign sales and investment positions affects their hedge positions, that is, firms coordinate their hedging and investment strategies.
*I

wish to thank Bruce Blonigen and David Haushalter for their advice and support. All remaining errors are my own and any comments are welcome. 1 BIS (1999) The Global OTC Derivatives Market at End-June 1998, Table 1, http://www.bis.org.

8 International Research Journal of Finance and Economics - Issue 4 (2006) Previous econometric studies have examined how hedging activities affect the valuation of the firm and how characteristics of the firm affect their decision to hedge. However, these studies do not explore all implications of the underinvestment problem. These studies find that the use of FCDs is consistent with the models of firm behavior that predict firms will hedge risks to cash flow in order to overcome an underinvestment problem. This hypothesis, first proposed by Froot, Scharfstein, and Stein (1993), states that firms hedge risk because imperfect capital markets (e.g., agency costs) reduce their ability to meet all profitable investment opportunities. Firms therefore seek to protect their internal cash-flow from risk. Froot et. al. show that firms create value through profitable investment. In order to make profitable investments the firm looks first to its internally generated funds. Since external financing for investment (debt or equity) is likely to be costly, the firm will be forced to cut investment if internal cash flow is not sufficient. Therefore, firms use financial hedging strategies, such as FCDs, to protect value-enhancing, or competitively advantageous, investment. Specifically, the Froot et. al. model predicts that MNCs set hedge positions to reduce the impact of exchange rate movements on cash flow used for future investments. That is, there is a direct relationship between investment activity and hedging activity. Using FCDs as a proxy for foreign exchange hedging activity of multinational firms, this study extends previous literature in the area by directly testing this implication of the Froot et. al. model. An example of this predicted relationship can be found in the annual report of Merck & Co., Inc. The companys report for 1996, a year included in this study, contains the following statement regarding the purpose of their foreign currency hedging activities:

A significant portion of the Companys cash flows are denominated in foreign currencies. The Company relies on sustained cash flows generated from foreign sources to support its long-term commitment to U.S. dollar-based research and development. To the extent the dollar value of cash flows is diminished as a result of a strengthening dollar, the Companys ability to fund research and other dollar-based strategic initiatives at a consistent level may be impaired. To protect against the reduction in value of foreign currency cash flows, the Company has instituted balance sheet and revenue hedging programs to partially hedge this risk. Although the Froot et. al. model is difficult to directly test, in that it requires measures of the firms expected level of investment the study furthers the research on this question by testing for implications of the models results. The hedging activity of U.S. multinational firms is analyzed, including detailed use of FCDs by geographic region. The results provide some support for the underinvestment hypothesis with respect to hedging activity of MNCs. Evidence from this sample reveals that the underinvestment hypothesis is consistent with the hedging activity of MNCs for which the model of Froot et. al. predicts will hedge the most - MNCs with their greatest exposure to exchange rate risk through their foreign production or investment. Further, the more detailed data from the geographic regions and the use of Feasible Generalized Least-Squares estimation provides evidence in support of the key implication of the underinvestment problem, that firms coordinate investment and hedging activities.

II. Previous Research on the Underinvestment Hypothesis

Froot, Scharfstein, and Stein (1993) present a model that finds a unique optimal hedge ratio for the firm. Their paper, generally referred to as the underinvestment problem, is one of the first to suggest that less than a full hedge may be optimal.2 The key assumption driving this result is that the firm faces increasing costs of external financing because of imperfect capital markets. If perfect capital markets existed firms could meet all investment opportunities through external financing. Hedging overcomes an underinvestment problem. The basic premise is that firms create value through profitable investments and when cash flow is insufficient to meet all profitable investment opportunities, the firm will likely fall behind competitors with sufficient cash flow. Cash flow is affected by external factors
2 Theories

that imply a full hedge include Stulz (1984) and Smith and Stulz (1985).

International Research Journal of Finance and Economics - Issue 4 (2006) 9

such as interest rates, commodity prices, and exchange rates. Therefore, the goal of any hedging

program should be to protect cash flow in order to ensure that the firm need not tap the costly capital markets to fund all profitable investments. Froot et. al. show this result for a multinational firm facing exchange rate risk to revenues and costs. A multinational firm chooses a hedge position (foreign currency relative to domestic currency) so as to mitigate variances in expected cash flow. Multinational firms hedge cash flow from operations so that they do not need to go to the costly capital markets in order to meet their expected investment demands, both at home and abroad. Froot et. al. show that the optimal hedge ratio is dependent on both profitable investment opportunities for the firm and direct investment levels relative to cash generated from internal operations.3 Most empirical studies of corporate hedging behavior examine multiple theoretical models. Geczy, Minton, and Schrand (1997) use a logit model to test if firms use of FCDs is consistent with theories of hedging behavior. For the underinvestment hypothesis, their model uses a series of proxies for the firms investment opportunity set such as the ratios of Research and Development expenses (R&D) to Sales and Book Value of the firms assets to its equity (BV). These variables have served as proxies for growth opportunities in previous empirical studies. Their study also incorporates the imperfect capital markets, or costly external finance, condition. They find that the use of FCDs is consistent with the underinvestment problem modeled by Froot et. al.. They also find that managerial wealth and financial distress are significant explanatory factors for the firms use of derivatives. However, the results do not confirm the implication of the agency and financial distress theories of hedging that the firm should completely hedge their exposures to risk. Allayannis and Ofek (2001) identify the correlation between firm characteristics and levels of FCDs. They estimate a logit and tobit model and identify foreign sales and foreign trade (imports plus exports in total sales) as significant factors in explaining the use of FCDs. The variable used as a proxy for hedging activity is the same used in this study, the reported gross notional value of foreign currency derivatives. In a related study, Allayannis and Weston (2001) find that the use of FCDs and the value

of the firm are positively, although non-linearly, related. The results are obtained for a sample of both multinational and national firms and support the theories that increased growth opportunities and increased leverage lead to an increase in the use of FCDs. This result supports the hypothesis that hedging is value maximizing, but does not indicate how a firm determines the appropriate hedging strategy. Each of the above empirical results provide support to each of the theories of hedging discussed and each study finds similar sources of exchange rate risk for multinational firms (foreign sales and assets). However, these studies do not measure the extent to which cross-sectional differences explain the variance in firms hedging activity. The discrete dependent variable nature of the models in these studies can not help answer questions as to the extent to which firms use FCDs. For example, to what extent do firms hedge because of different exposure to exchange rate risk? More recent studies have considered the variance in hedge ratios and the different incentives to hedge. Graham and Rogers (1998) study a broad cross section of U.S. firms and find that derivative use is consistent with the model of underinvestment problems and costs of financial distress. Their estimates use a continuous measure of hedging, as opposed to the yes/no values of the previous research, and find that this additional information helps better identify the determinants of hedging activity. As noted above, the financial distress theories imply a full hedge position, and their results do not distinguish between these possible theories. Gay and Nam (1998) focus only on the underinvestment problem and find support for the theory that firms with greater investment opportunities have higher hedging activity, as measured by the use of derivatives. Their study, however, looks at many types of firms and therefore includes firms financial hedges for interest rate, commodity, and foreign exchange rate risk. It may therefore not be clear which risk is driving the overall hedge position.
3 See

also Mello, Parsons, and Triantis (1995).

10 International Research Journal of Finance and Economics - Issue 4 (2006) Allayannis and Mozumdar (2000) showed that the use of FCDs reduces exposure to exchange rate risk through its effect on internal cash flow. In their sample, firms that hedged exchange rate risk experienced a lower sensitivity of investment expenditures to changes in exchange rates. Similarly, Haushalter, Heron and Lie (2001) showed that companies with a higher likelihood of low investment due to low levels of internal cash flow are adversely affected by uncertainty of future cash flows. Their study of oil producers showed that this result is consistent with the imperfect capital markets

assumption of the Froot, et. al. model. The results presented here further this work by testing the implication of the model that firms coordinate their investment and financing decisions across areas of risk. More specifically, firms coordinate their investing and foreign currency hedging activities across the different currency denominations of such investment. Froot, et. al. (1993) shows strong conditions under which the multinational corporation should hedge exchange rate risks, based on the firms specific investment opportunities. As outlined above, empirical research to date only tests the correlation between the use of FCDs and the incentives to hedge risk. This study tests if firms use FCDs to support investment opportunities and if heterogeneity in these investment opportunities and exchange rate risk explain the hedge positions of multinational firms. Second, this study uses a more detailed sample to test the implications of this underinvestment problem. The firm-level data collected for this study on the use of FCDs by geographic region provides a more accurate measure of firms investment and hedging positions.4 This sample provides another level of cross-sectional analysis MNCs use of FCDs across different currencies and levels of foreign investment.

III. The Underinvestment Problem for Multinational Corporations

The underinvestment problem results if marginal costs of external financing are increasing in quantity so as to cause the multinational firm to forego an investment opportunity with a positive net present value because of insufficient internal cash flow. Internal cash flow will likely fluctuate because of external shocks such as movements in the exchange rate. Therefore, the firm has an incentive to hedge exchange rate risk so that cash from operations is adequate to meet potential investment opportunities. When external factors reduce internal cash flow the firm will be faced to cut investment below the optimal (under-invest) since the higher cost of external financing will reduce the number of investments with positive net present value. The following is an outline of the hedging model for multinational firms presented in Froot, Scharfstein, and Stein (1993). A firm chooses investment, I, subject to the constraint that it is equal to internal cash flow, w, plus external financing, e. The firms objective is to choose I so as to maximize the present value of net cash flow

P(w) = max F(I) C(e) (1a) where, F(I) is the profit function and C(e) is the convex cost function over external finances.
The firstorder condition for this problem is fI 1 = Ce, where de/dI = 1 for a given w. This is the underinvestment problem; the optimal I* is below the value it would take in the absence of costly external financing, fI = 1. The multinational firm maximizes profits by investing at home and abroad subject to the same increasing costs of external financing, F(I) = fH(IH) + fA(IA) IH IA (1b) where fi(Ii), i = H, A, is the concave production function for the firm over investment at home (H) or abroad (A), and and measure the firms exposure to the random exchange rate variable, . The internal wealth of the firm at the time of investment, w, or its available cash from operations, can be held in domestic or foreign currency, so w = w0(1 + (1-h) ) (1c)
4 Martin,

Madura, and Akhigbe (1999) show that geographic segment data provides better measures of exchange rate risk exposure in a sample of 168 U.S. MNCs with operations in Europe.

International Research Journal of Finance and Economics - Issue 4 (2006) 11 where h is the hedge ratio of the firm and is the home currency price of the foreign currency.
A value of 1 for h implies the firm is fully hedged; that is, there is no effect on wealth from changes in the exchange rate. Therefore, prior to the investment decision, the firm chooses h, its hedge ratio, to maximize expected profits, E[P(w)]. That is, the firm chooses h so that expected profits are unaffected by the exchange rate movements, or the change in . The first-order condition to this problem can be written as cov(Pw, ) = 0 (1d) Equation (1d) says that the hedge ratio, h, is such that the marginal value of the firm, Pw , is unaffected by changes in the relative exchange rate. This result differs from previous theoretical models of hedging in that the objective is not to hedge the total value of the firm, P(w). Moving forward to the time of investment, the exchange rate is known and equation (1b) can be solved for optimal domestic and foreign investments, given wealth w, and C(e). The first-order conditions from this decision state that firms equalize the marginal revenue product of an additional unit of domestic currency across investments and that the marginal return on domestic investment will always be equal to the marginal cost of an additional unit of external finance. Together with the

constraint that total investment is equal to internal wealth plus any external financing, or I = IH + IA = w + e, we can find the optimal amount of investment for a given level of wealth. Note that investment is an implicit function of the variable . Let FA > 0 and IA < 0 be the sensitivity to exchange rate changes of sales (or output from investment IA) and investment abroad, respectively. With the conditions on the profit function and this implicit relationship, Froot et. al. show that equation (1d) can be solved for the optimal hedge ratio, roughly given by h* = 1 - E[ (- ) FA ]/w0 - E[IA ]/w0 (1e) The second and third terms of equation (1e) can be characterized in the following manner: a changing investment opportunity set, E[ (- ) FA
]/w0,

which is the firms expected net profit from investments abroad relative to current cash from operations, and a lock-in term, E[IA
]/w0,

which is the firms expected future investment position abroad relative to current cash from all operations. Given that and measure the firms exposure to the random exchange rate variable through sales (or output) and investment abroad, respectively, equation (1e) shows that the firms exposure to exchange rate risk on net income abroad and net-assets abroad determines the appropriate level of hedging.

IV. Empirical Tests of the Implications of the Underinvestment Problem.

This study uses three methods to test the implications of the Froot et. al. model. These implications, and therefore the structure of the empirical tests, are made clearer by analyzing three general cases for the parameters and , (hereafter referred to as Cases 1, 2, and 3). First, if and are equal, the firm faces identical exchange rate exposure on revenues and costs. This is likely the situation for firms whose revenues and costs are denominated in the same currency. For example, McDonalds Corporation operates foreign restaurants with both sales and expenses in local currency. The second term of equation (1e) (investment opportunity) in this case, Case 1, is zero, so the optimal hedge ratio

is only dependent on the lock-in effect. The second case, Case 2, occurs if = 0 and = 1. Here the firms hedge ratio is a function of both the lock-in variable and changing investment opportunities. Firms falling into this category include any that sell similar products on world markets and their exposure to exchange rate risk falls mostly on the production side. This likely includes manufacturing industries such as semiconductors where production is located in a few currencies, but sold worldwide. Finally, Case 3 occurs if = 1 and = 0. Here the third term is zero so the firm faces risks from 12 International Research Journal of Finance and Economics - Issue 4 (2006) changing investment opportunities only. This situation corresponds to single market exporters or firms with non-traded output such as retailers. The hedge ratio in equation (1e) , h*, is a function of expected investment; that is, investment is a random variable. To account for this, the further assumptions imposed on the model for this study are that firms current investment positions are good forecasts of positions next period and that firms expectations of next period exchange rates are accurate. Each of these assumptions and the three cases for and outlined in the previous paragraph imply the following inequality condition, h*Case 2 h*Case 1 h* Case 3 . (2) This is the first of the direct implications of the Froot et. al. model for multinational firms that this study tests. Multinational firms that primarily face exchange rate exposure through their foreign production activity (case 2) will have the highest level of exchange rate hedging. The implication for case 1 and case 3 firms is not directly evident. Therefore, for purposes of this study these firms will be classified together. The second implication is that the level of exchange rate hedging will be correlated with the firms changing investment opportunities. This study extends previous empirical research on this relationship while controlling for the implications of equation (2) as well. Finally, the implication that firms coordinate their investment strategies and financial hedges is tested using systems of equation estimation techniques. The first tests of the implications are univariate tests (means tests) of the condition in equation (2). To classify the firms as belonging to case 2 or not it is necessary to derive a measure of and . Two regression equations are used to measure the firms sensitivity of foreign sales and foreign production to movements in exchange rates5:

y1it = 0 + 1ext +
(3a) y2it = 0 + 1ext + 2 (3b) where y1it and y2it are the natural logs of firm is ratio of foreign sales to total sales and foreign assets to total assets respectively in period t, and ext is the natural log of the exchange rate facing the firm in period t. The result from this test of the condition in equation (2) serves to test the implications of the model and to determine the appropriateness of the proxy variable for the firms hedge ratio in the later tests. The second methodology used to test implications from the underinvestment problem for MNCs is an analysis of the levels of hedging across firms. To see if firms in the samples adjust their hedge ratio with their investment opportunities and levels of investment risk, the hedge ratio for each firm is measured against sources of risk and investment positions. The proxy for the firms hedge ratio is the notional value of foreign currency derivatives as a percentage of total assets. The model takes the following form: hijt = f(Iijt, Lijt, Gijt, Di) (4) where, i = 1,2, ..., I Firms t = 1,2, ..., T Periods j = 1,2, ..., J Currencies and hijt = Firm is hedge ratio (FCDs/Assets) Iijt = variable for the firms growth, or investment, opportunities Lijt = variable for the firms lock-in effect Gijt = control variables for the firms size, level of cash and debt Di = Dummy variable equal to 1 if the firm is in Case 2 group. The independent variables closely follow previous research. To proxy for the firms investment opportunities this study uses the ratio of the firms market value to book value of assets. To proxy for the lock-in effect, this study uses foreign investment from firm level data on the firms foreign
1
5 For

an overview of measuring the exposure to currency risks of MNCs see Madura (2000).**The approach used here closely follows Adler and Dumas (1984).

International Research Journal of Finance and Economics - Issue 4 (2006) 13 operations. The variables in G also follow previous research and are used to control for the
imperfect

capital markets assumption of the Froot et. al. model. From equation (1e) and the condition in equation (2), the key hypothesis is that the level of operations that the firm hedges will decrease with increasing investment opportunities. Multinational firms increase their holding of foreign currency, either directly or through fewer hedges, when their future foreign investment opportunities decrease. Cash flow in the future will be sufficient to meet smaller investment needs. However, in case 2 (=0, =1 in equation 1), the firms exposure to exchange rate risk is such that an increase in the level of hedging is appropriate (a lower holding of foreign currency relative to domestic). Therefore, dummy variable, D, should be positive, both as an intercept dummy and as a slope dummy interacted with the investment opportunities variable.. The expected sign for the firms lock-in effect is also positive. Firms with exposure to exchange rate risk from production activities (Case 1 and Case 2) must increase their level of hedging as the expected level of future foreign investment increases. In these cases future profits, or cash-flows, are more sensitive to movements in exchange rates and hedging protects internal cash-flows for future investment needs. The expected sign for the control variables, size, cash level, and debt level, are positive, negative, and positive, respectively. Large firms can more easily afford the costs, both operational and actual, of hedging. Firms with greater levels of cash have less need to access the capital markets and will therefore have less need to hedge. Conversely, firms with high levels of current debt are more likely to face higher costs of debt (higher agency costs) and will therefore need the greater protection of their internal cash flow that hedging provides. This variable is also interacted with the investment opportunity variable as in previous research. Furthermore, these variables partially control for the other incentives for firm hedging previously discussed, such as agency costs and financial distress. Note that the subscript, j, is added to equation (4) to indicate the region for the firms sales, assets, and FCDs. This additional source of variance provides more information of the firms lock-in effect as wells as the hedge position. Furthermore, detailed information on the firms foreign operations provides necessary data for a test of the key implication of the Froot et. al. model Do MNCs coordinate investment and hedging? The third methodology to test of the implications of the underinvestment problem for MNCs is a test of the coordination between the level of financial hedging and the level of investment activity. As

previously mentioned, the Froot et. al. model predicts that firms set their hedge position to maximize the expected profit from future investments both at home and abroad. This structure of the model suggests a system of equations to estimate the determinants of the hedge position. This study presents estimates for a simple system of three equations, profit functions for home and abroad, and a hedging equation:

PH = f(FH ijt, IH ijt, Gijt,) (5a) PA ijt = f(FA ijt, IA ijt, Gijt,) (5b) hijt = f(PH ijt, PA ijt, Gijt,) (5c)
ijt

where, the sub- and super-scripts indicate i = 1,2, ..., I Firms t = 1,2, ..., T Periods j = 1,2, ..., J Currencies H = Home A = Abroad, or foreign and the variables are h = Hedge ratio (FCDs/Assets) P = Profits (Operating) S = Output (Sales) I = Investments (Assets) Gijt = control variables (exchange rate, debt, and marketto-book ratio). 14 International Research Journal of Finance and Economics - Issue 4 (2006) Output and Investments should enter equation (5a) and (5b) positively. Profits should enter equation (5c) negatively and positively, for home and abroad respectively. Firms with higher foreign profits will increase the level of hedging. The expected sign for the control variables, debt and market-tobook ratio, in the key equation, (5c), are negative. The expected sign on the control variable, exchange rate, is ambiguous in that it depends on the firms exposure. The key hypothesis test for this system is a test of the correlation across the system of equations. A

Feasible Generalized Least-Squares (FGLS) method of estimation is used for equations (5a), (5b), and (5c). If the equations are actually unrelated, there is no efficiency gain in the FGLS estimated coefficients. However, if firms relate their financial hedging strategy to their investment or production strategies there will be a strong relationship across equations and an efficiency gain in the estimates for equation (5c). A Breusch-Pagan test of the independence of the residuals from each equation is used to test for correlation across equations and thus the implication that multinational firms coordinate their investment hedging activity6.

V. Data
The sample for this study is annual panel data collected from the S&P COMPUSTAT database for the years 1992 1997. Reporting of FCDs was not required until July of 1990 and until recently the reporting of gross notional values of FCDs was an off-balance sheet item. For this sample, firms that report the currency derivative use (as required by FASB Statement 105) but do not report a specific level are given a value of zero for FCDs. Tobit estimation of the model in equation (4) is used to account for this censoring of the data. Also, the values for FCDs include forward contracts and options on foreign currencies, but do not include swap contracts as these items may be used for purposes other than hedging exchange rate risk (e.g., interest expense management). A potential bias introduced by using the gross notional value of FCDs is that the variable does not indicate the direction of the hedge. However, the sample of U.S. multinationals, each with a functional currency of the U.S. Dollar, suggests that the direction of the hedge is likely to be similar for firms in this study. Appendix 1 details the variables used in each of the tests. As previously mentioned, the proxy for the firms hedge ratio is the ratio of FCDs to total assets (FCDP). The control variables closely follow previous research. The variable for the lock-in term in the Tobit estimations is the ratio of foreign assets to total assets in the firm (FOREIGN ASSETS/ TOTAL ASSETS)7. An ideal data set would include geographic segmentation for each country and its corresponding currency. However, most firms report segmented data for geographic regions only. The most common, non-domestic, geographic regions reported for U.S. multinational corporations are Canada, Europe and Asia-Pacific8. The effect of currency translations on any existing assets of the firm are reported in the shareholder equity portion of the firms balance sheet. The firms operations are translated to U.S.

dollars at an average of the exchange rate over the period9. The sample firms for this study were selected by first identifying firms that reported geographically segmented results for one of the three regions during the year 1996. Financial firms are excluded since many are market makers for FCDs and may or may not hold foreign currency for trading purposes. Next, each of these firms annual reports were reviewed to locate detailed reporting of the gross notional value of FCDs by country or region. For example, Caterpillar, Inc. reports FCDs by European, Japanese, Australian, and Canadian currencies in their 1995, 1996, and 1997 annual reports. Other firms report for only one region or Canada alone. The final result of these two steps is a sample of 32 U.S. multinational firms. Appendix 2 lists the companies included in the sample and the corresponding number of observations for each firm in each geographic region.
6 The

FGLS estimator and Breusch-Pagan L**agrange multiplier test follow Greene (1993). ratio is used as opposed to the possibly more appropriate ratio of foreign capital expenditures to operating income because of a significant missing values.**FOREIGN ASSETS/ TOTAL ASSETS is however significantly correlated (r=0.89) to ratio of foreign capital expenditures to operating income for the firms reporting both. 8 Cummins and Hubbard (1994) describe the geographic segment data in the Compustat database and potential measurement problems. 9 See Jensen, D.L. and E. N. Coffman and R. G. Stephens and T. J. Burns (1994) Chapters 9 and 13.
7 This

International Research Journal of Finance and Economics - Issue 4 (2006) 15

The sample period (1992 - 1997) is characterized by volatility in the value of the U.S. dollar relative to foreign currencies. The exchange rate data (EX) are taken from the Federal Reserve Bank of Atlanta Dollar Index Data. The Atlanta Fed calculates a U.S. dollar index using bilateral trade weights for 18 currencies. In addition, the Atlanta Fed calculates three sub-indices. The European sub-index includes Belgium, France, Germany, Italy, the Netherlands, Spain, Sweden, Switzerland and the United Kingdom. The Pacific group includes Australia, China, Hong Kong, Japan, Singapore, South Korea and Taiwan. The Canadian dollar is treated as a separate sub-index. A rise in the index reflects a strengthening of the dollar against the included currencies. The Atlanta Fed U.S. dollar index and subindices are used in this study because their trade-weighted construction serves to mirror changes in the real value of the U.S. dollar. Hunter (1990) shows that this nominal index and each sub-index is highly correlated with a real index of the value of the U.S. dollar and is therefore a good proxy for the real exchange rate.

VI. Empirical Results

A. Univariate Tests Table 1 reports summary statistics for the sample. The mean value for FCD/AT is close to zero

reflecting the considerable amount of censoring in this variable as discussed in the previous section. The low mean value for CASH/TOTAL ASSETS and the high mean value for DTRATIO in each sample suggest that these firms have a strong incentive to hedge. Low levels of current cash may require the firms to access capital markets to meet investment opportunities, but the high level of current debt may make this option very costly. Table 2 presents correlation coefficients and their corresponding p-values. Notice that MARKET VALUE/BOOK is negatively correlated with FCD/AT, but the measures of exposure are uncorrelated with FCD/AT. This suggests that geographic diversification may reduce exposure and therefore the need for hedging. The results for tests of the condition given in equation (2) are presented in Table 3. The mean value of FCDs as a percentage of total assets is calculated for each of the exposure estimates from equations (3a) and (3b) for foreign sales and foreign assets, respectively. Those firms with significantly higher exposure to exchange rate risk from production, as measured by an estimate of 1, are grouped under Case 2. All other firms are considered belonging to Case 1 or Case 3. To indicate a significant exposure the difference between each firms estimate of 1 and 1 is calculated and those firms whose difference ranks in the lowest quartile (most negative difference) are grouped under Case 210. After accounting for missing values, this approach resulted in approximately 36% of all observations belonging to Case 2. The result of the difference-between-means test supports the conclusion that the hedge ratio of the firms corresponding to Case 2, high exposure to exchange rate risk from production activity, is significantly larger than the hedge ratio for firms in Case 1 or Case 3. B. Multivariate Tests Both coefficient and marginal effects for Tobit estimation of the model in equation (4) for each sample are shown in Table 4. The estimates provide inconclusive support for the predictions of the Froot

et. al.
model; in many cases the marginal effects are very small. Consistent with previous research the investment opportunity set significantly affects the firms hedge ratio, but the signs are incorrect. A potential cause of the incorrect sign for the coefficient on the intercept dummy, D, may be the small variance in currency exposure for this sample. As previously noted, the variance in exposure for the sample is potentially reduced by diversification across currencies. A further possibility is that that firms hedge positions are coordinated across currencies; the variables listed may be significant
10 Similar

results were obtained by classifying firms under a more arbitrary method using two-digit SIC codes.**Using a two-digit SIC code classification

resulted in the identical ranking for a firm for more than 79 percent of the sample.**Under this approach,**Case 1, where firms face identical exchange rate risk on both revenues and costs, corresponds to industries with low trade in both**inputs and outputs (SIC codes 40 49 and 60 89).**Case 2, where firms face only exchange rate risk with production activities, corresponds to industries with high trade in outputs, but low trade in inputs (SIC codes 00 14 and 20 39.**Case 3, where only firms revenues are exposed to exchange rate risk, corresponds to industries with low output trade (SIC codes 15 19 and 50 59).**Estimations of equation (4) using this approach (not reported) provide qualitatively similar results.

16 International Research Journal of Finance and Economics - Issue 4 (2006) determinants of the firms decision to hedge exchange rate risk, but variance in these variables may not explain the choice of how much to hedge. The final test looks at this possibility by measuring the coordination between investment and hedging. Table 5 reports the estimates for the system of equations, (5a), (5b), and (5c). The coefficient estimates are generally consistent with expectations and each set of equations has overall significance. The null hypothesis of independence (no correlation) across the equations, however, is rejected. The sample variables reflect some coordination by the firm across different investment positions and currency regions. Further analysis of the correlation matrix of residuals shows that the hedging equation, (5c), is significantly correlated with equations (5a) and (5b) the other two (0.17 and 0.27, respectively). These results provide some evidence that hedging and investment activities may be coordinated at the geographic region or country level. Note, however, the coefficient estimates for equation (5c) are again very small. As in the previous test, the marginal effects of these variables are small.

VII. Conclusions
Using FCDs as a proxy for foreign exchange hedging activity of firms, this study tests key implications of the underinvestment problem for MNCs modeled by Froot et. al.. The results provide some support for the underinvestment hypothesis. In particular, the underinvestment hypothesis is consistent with the hedging activity of firms for which the model of Froot et. al. predicts will hedge the most, MNCs with their greatest exposure to exchange rate risk through their foreign production or investment (Case 2). There is further evidence for the implication of the model that firms coordinate investment and hedging activities. The robust statistical measures in this study suggest that further empirical research on this important problem is necessary since the coordination of hedging and investment activity may increase firm

value. Difficulty in collecting geographically segmented, firm-level data for this study was noted, but more firms are reporting detailed information on the use of FCDs each year and future studies using this measure of hedging will benefit from this increased level of reporting. International Research Journal of Finance and Economics - Issue 4 (2006) 17

Appendix 1.
FCDP: The ratio of the gross notional value of foreign exchange contracts to total assets. CASH: Cash and cash equivalents. MARKET VALUE/BOOK: The ratio of the firms market value to its book value. TOTAL INCOME: Operating income of the firm after amortization and depreciation. SALE: The total net-sales of the firm. EX: U.S. dollar value index using 1984 bilateral trade weights for Europe, Asia Pacific, or Canada regions. (Federal Reserve Bank of Atlanta) FOREIGN ASSETS: Identifiable foreign assets. FOREIGN INCOME: Operating income from foreign geographical regions and/or foreign affiliates. FOREIGN SALES: Total foreign sales (exports and affiliate sales). DTRATIO: The ratio of long-term debt to total outstanding debt of the firm. SIZE: The natural log of the sum of firm market value and total debt. FOR. INCOME EXPOSURE: The sensitivity of foreign income to changes in the exchange rate as measured by the coefficient estimate from a regression of the natural log of foreign income on the natural log of the exchange rate - Equation (3). FOR. ASSET EXPOSURE: The sensitivity of foreign assets to changes in the exchange rate as measured by the coefficient estimate from a regression of the natural log of foreign assets on the natural log of the exchange rate- Equation (3). FOR. SALES EXPOSURE: The sensitivity of foreign sales to changes in the exchange rate as measured by the coefficient estimate from a regression of the natural log of foreign sales on the natural log of the exchange rate- Equation (3). SIC the primary standard industrial classification for the firm. Sources: S&P COMPUSTAT database, 10-K reports to the U.S. Securities and Exchange Commission (SEC), The Federal Reserve Bank of Atlanta. 18 International Research Journal of Finance and Economics - Issue 4 (2006)

Appendix 2.
Company listing and the number of observations for each firm by geographic region.
Observations by Geographic Segments Geo Seg Area Code(s) Company Name Asia-Pacific Region European Region Canada Grand Total AIR PRODUCTS & CHEMICALS INC 4 4 4 12 ALCAN ALUMINIUM LTD 4 4 ALLIEDSIGNAL INC 5 5

AMP INC 3 3 6 ANHEUSER-BUSCH COS INC 4 4 8 APPLIED MATERIALS INC 5 5 10 BLACK & DECKER CORP 5 5 5 15 CATERPILLAR INC 3 3 3 9 COOPER INDUSTRIES INC 5 5 10 CORNING INC 5 5 10 CROWN CORK & SEAL CO INC 5 5 10 DRESSER INDUSTRIES INC 5 5 5 15 EASTMAN KODAK CO 5 5 10 GOODYEAR TIRE & RUBBER CO 3 3 6 INGERSOLL-RAND CO 5 5 5 15 ITT INDUSTRIES INC 4 4 8 JOHNSON CONTROLS INC 3 3 6 MATTEL INC 5 5 10 NCR CORP 3 3 3 9 OMNICOM GROUP 4 4 4 12 PACCAR INC 5 5 10 PFIZER INC 4 4 8 PHARMACIA & UPJOHN INC 3 3 6 PHILLIPS PETROLEUM CO 6 6 12 PROCTER & GAMBLE CO 3 3 6 QUAKER OATS CO 5 5 10 RALSTON PURINA CO 4 4 8 RAYTHEON CO -CL B 4 4 4 12 SEAGATE TECHNOLOGY 4 4 TENNECO INC 5 5 5 15 TIME WARNER INC 4 4 4 12 TRW INC 4 4 Grand Total 105 128 64 297

International Research Journal of Finance and Economics - Issue 4 (2006) 19

Table 1: Summary Statistics

Descriptive statistics for key variables as defined in Appendix 1.

Variable Mean Standard Deviation 3rd Quartile 1st Quartile FCD/AT 0.05 0.07 0.06 0.00 MARKET VALUE/BOOK 4.00 3.38 4.27 2.33 CASH/TOTAL ASSETS 0.05 0.05 0.07 0.01 FOREIGN ASSETS/TOTAL 0.14 0.15 0.21 0.02 FOREIGN INCOME /TOTAL 0.09 0.66 0.22 0.00 DTRATIO 0.74 0.22 0.91 0.63 FOR. SALES/TOTAL SALES 0.14 0.14 0.23 0.03 SALE* 8136.60 5222.38 10883.70 4766.10 TOTAL ASSETS* 8333.25 6192.75 11321.00 1702.66 FOR. INCOME EXPOSURE 0.88 3.64 02.67 -1.60 FOR. SALES EXPOSURE 0.66 3.27 0.2.49 -1.30 FOR. ASSET EXPOSURE 1.05 3.59 3.13 -1.37 *In millions of U.S. dollars.

20 International Research Journal of Finance and Economics - Issue 4 (2006)

Table 2: Correlation Matrices

Pearson correlation coefficients, and corresponding p-values below, for key variables.
1 2 3 4 5 6 7 8 9 10 1 FCD/AT 1 2 MARKET VALUE/BOOK -0.08 1.00 0.1590 3 CASH/TOTAL ASSETS 0.1996 0.02 1.00 0.0005 0.7528 4 FOREIGN ASSETS/TOTAL 0.5444 0.0692 0.2289 1.00 0.0000 0.2346 0.0001 5 FOREIGN INCOME /TOTAL 0.0143 0.0636 0.0894 0.1638 1.00 0.8059 0.2748 0.1244 0.0047 6 FOR. SALES/ TOTAL SALES 0.4375 0.1747 0.3569 0.8714 0.1473 1.00 0.0000 0.0025 0.0000 0.0000 0.0110 7 DTRATIO 0.0482 0.0459 0.0648 0.0282 0.1496 0.0787 1.00 0.4077 0.4309 0.2653 0.6289 0.0098 0.1763 8 FOR. ASSET EXPOSURE 0.0042 0.0680 0.0229 0.0941 0.0520 0.1352 0.1576 1.00 0.9419 0.2428 0.6937 0.1057 0.3721 0.0197 0.0065 9 FOR. INCOME EXPOSURE 0.0039 0.1579 0.0174 0.1531 0.0238 0.1455 0.2392 0.73 1.00 0.9467 0.0064 0.7652 0.0082 0.6828 0.0121 0.0000 0.0000 10 FOR. SALES

EXPOSURE 0.0095 0.0147 0.0446 0.0657 0.0751 0.0995 0.2701 0.9095 0.76 1.00 0.8711 0.8007 0.4440 0.2593 0.1971 0.0871 0.0000 0.0000 0.0000

Table 3: Univariate Test

t-Test for difference-between-means.

FCD / TOTAL ASSETS Case 1 or 3 Case 2 Mean 0.0393 0.0554 Variance 0.0039 0.0062 Observations 190 107 Hypothesized Mean Difference 0 t Stat -1.9420 p- value 0.0265

International Research Journal of Finance and Economics - Issue 4 (2006) 21

Table 4: Tobit Model Estimates of Foreign Currency Derivative Use

Estimates of the determinants of the ratio of gross notional foreign currency derivatives to total assets of the firm for 297 observations on U.S. multinational firms from 1992 to 1997. The dummy variable, D, equals one when the firms exposure to foreign sales and foreign assets corresponds to case 2 described in the text. Statistically significant variables in bold.
Variable Estimated Coefficient StandardError t-statistic dP/Dx Constant -0.0293 0.0758 -0.3866 -0.0092 MARKET VALUE TO BOOK -0.0048 0.0023 -2.0791 -0.0015 MARKET VALUE TO BOOK *D 0.0034 0.0026 1.2830 0.0011 FOREIGN ASSETS/ TOTAL 0.2765 0.0258 10.7052 0.0866 D -0.0283 0.0140 -2.0253 -0.0089 CASH/TOTAL ASSETS 0.2046 0.0630 3.2497 0.0641 DTRATIO 0.1457 0.0486 2.9980 0.0456 MARKET TO BOOK * DTRATIO 0.0000 0.0000 -0.4893 0.0000 SIZE 0.0012 0.0076 0.1567 0.0004 Standard Deviation Of Residuals 0.0620 0.0028 21.9863

22 International Research Journal of Finance and Economics - Issue 4 (2006)

Table 5: Seemingly Unrelated Regression Estimates for the Coordination Between Investment and Hedging.

Estimates of the coordination between hedging activity and investment activity in multiple regions and currencies (equations (5a), (5b), and (5c)) for 297 observations on U.S. multinational firms from 1992 to 1997. Statistically significant variables in bold.
Variable Estimated Coefficient Standard Error t-statistic Dependent Variable: Domestic Operating Income Independent Variables: Domestic Sales 0.1135 0.0067 16.8400 Domestic Assets 0.0228 0.0054 4.2200

DTRATIO -9.0303 1.2315 -7.3330 MARKET VALUE TO BOOK 47.0301 6.4411 7.3020 Constant -56.6736 54.5118 -1.0400 F-Test of overall significance: 233.8075 p-value: 0.0000 Dependent Variable: Foreign Operating Income Independent Variables: FOREIGN SALES/TOTAL 0.0070 0.0080 0.8680 FOREIGN ASSETS/ TOTAL 0.0895 0.0089 10.0090 DTRATIO -1.5025 0.4040 -3.7190 EX -0.0401 0.3233 -0.1240 MARKET VALUE TO BOOK 8.3558 2.2277 3.7510 Constant 33.6649 36.1424 0.9310 F-Test of overall significance: 78.2924 p-value: 0.0000 Dependent Variable: FCD/AT Independent Variables: Domestic Operating Income 0.0000 0.0000 -5.1500 Foreign Operating Income 0.0002 0.0000 8.9590 DTRATIO 0.0001 0.0002 0.3990 EX 0.0004 0.0002 2.1750 MARKET VALUE TO BOOK -0.0027 0.0012 -2.2360 Constant 0.0126 0.0202 0.6270 F-Test of overall significance: 22.7986 p-value: 0.0000 Breusch-Pagan test of independence: chi2(3) = 30.967, p- value: 0.000

International Research Journal of Finance and Economics - Issue 4 (2006) 23

References
[1] Adler, Michael and Bernard Dumas (1984), Exposure to Currency Risk: Definition and Measurement, Financial Management, Summer, 41 - 51. [2] Allayannis, George and Abon Mozumdar (2002), Cash Flow, Investment, and Hedging, AFA 2001 New Orleans Meetings. [3] Allayannis, George and Eli Ofek (2001), Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives, Journal of International Money and Finance, 20, 273 296. [4] Allayannis, George and James P. Weston (2001), The Use of Foreign Currency Derivatives and the Firm Market Value, Review of Financial Studies, 14. [5] Chow, Edward H. and Wayne Y. Lee and Michael E. Solt (1997), The Economic Exposure of U.S. Multinational Firms, Journal of Financial Research, Summer, p.p. 191 - 210. [6] Cummins, Jason G. and R. Glenn Hubbard (1994), The Tax Sensitivity of Foreign Direct Investment: Evidence From Firm-Level Panel Data, National Bureau of Economic Research Working Paper No. 4703. [7] Froot, K. and D. Scharfstein and J. Stein (1993), Risk Management: Coordinating Corporate Investment and Financing Policies, Journal of Finance, 48, 1629 - 1658. [8] Gay, Gerald D. and Jouhan Nam (1998), The Underinvestment Problem and Derivatives Usage by Corporations, Financial Management, 27. [9] Geczy, Christopher and Bernadette A. Minton, and Catherine Schrand (1997), Why Firms Use Currency Derivatives, The Journal of Finance, 52, 1323 - 1354. [10] Graham, John R. and Daniel A. Rogers (2002), Do Firms Hedge in Response to Tax

Incentives, Journal of Finance, 57, 815 - 839. [11] Greene, William H. (1993), Econometric Analysis, Second Edition, Prentice-Hall, p.p. 487 493. [12] Haushalter, David and Randall Heron and Erik Lie (2002), Price Uncertainty and Corporate Value, Journal of Corporate Finance, 8, 271 286. [13] Hunter, Karen R. (1990), F.Y.I., Inflation and the Dollar Index, The Federal Reserve Bank of Atlanta Economic Review, September/October. [14] Levi, Maurice D. (1993), Exchange Rates and the Valuation of Equity Shares, in Exchange Rates and Corporate Performance, edited by Yakov Amihud and Richard M. Levich, Irwin Professional Publishing, p.p. 37 - 48. [15] Madura, Jeff (2000). Measuring Exposure to Exchange Rate Fluctuations in International Financial Management , Sixth Edition, South-Western College Publishing, p.p. 275 304. [16] Martin, Anna D. and Jeff Madura and Aigbe Akhigbe (1999) Economic Exchange Rate Exposure of U.S.-Based MNCs Operating in Europe, The Financial Review, 34, 21 -26. [17] Mello, Antonio S. and John E. Parsons and Alexander J. Triantis (1995), An Integrated Model of Multinational Flexibility and Financial Hedging, Journal of International Economics 39, 27 - 51. [18] Smith, Clifford, and R. M. Stulz (1985), The Determinants of Firms Hedging Policies,

The Journal of Financial and Quantitative Analysis, 28, 391 - 405. [19] Stulz, R. M. (1984), Optimal hedging policies, Journal of Financial and Quantitative Analysis, June.