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We investigate Swedish firms’ use of financial hedges against foreign exchange exposure. Our survey data lets us distinguish between translation exposure and transaction exposure hedging. Survey responses indicate that over 50% of the sampled firms employ financial hedges, and that transaction exposure is more frequently hedged than is translation exposure. The likelihood of using financial hedges increases with firm size and exposure, and liquidity constraints are important in explaining transaction exposure hedging. Importantly, the existence of loan covenants accounts for translation exposure hedging, suggesting that firms hedge translation exposure to avoid violating loan covenants.

Why widely held firms, whose owners have the ability to hold diversified portfolios of securities, elect to hedge their exposures is the subject of debate. Theoretical research has shown that risk-reduction efforts may enhance value if they reduce cash-flow variability, thus mitigating costs associated with market imperfections (see Smith and Stulz, 1985, Bessembinder, 1991 and Froot et al., 1993). One important source of risk that is widely hedged is foreign exchange (FX) exposure (see, e.g. Bodnar et al., 1996, Bodnar et al., 1998, Berkman et al., 1997, Alkebäck and Hagelin, 1999 and Bodnar et al., 2003). Numerous studies have investigated whether firms’ use of currency derivatives conforms to the predictions of theoretical research.1Mian (1996) examines the currency derivatives usage of a sample of US firms, finding that hedging exhibits economies of scale; however, Mian finds only weak support for theoretical models that seek to explain hedging activities. Like Mian (1996), Géczy et al. (1997) apply a dichotomous measure of currency derivatives use to a sample of US firms, and find that firms with extensive FX exposure and economies of scale are more likely to use currency derivatives. They also find that firms with less liquidity and greater growth opportunities (as measured by R&D expenses) are more likely to use currency derivatives. They interpret this as evidence that firms use currency derivatives to reduce cash-flow variation that might otherwise preclude their investing in valuable growth opportunities. Graham and Rogers (2000) investigate 161 US firms and report that they hedge in response to expected financial distress costs, firm size, and investment opportunities. They also show that firms hedge to increase debt capacity, though not in response to convexities in tax schedules. Allayannis and Ofek (2001) analyze a sample of 378 US firms to uncover the characteristics associated with the adoption of particular levels of currency derivatives use. They corroborate the findings of Géczy et al. (1997) concerning the decision to use currency derivatives, and show that the degree of FX exposure is the only significant factor explaining the notional value of currency derivatives used. Bartram et al. (2004) examine a large sample of firms from 48 countries and find that firm-specific factors associated with derivatives use vary little from country to country. Lel (2004), like Bartram et al. (2004), examines a large sample of firms from various countries, finding that economies of scale, growth opportunities, and financial distress costs are the firm-specific determinants of FX exposure hedging. Brown (2001) studies an American manufacturing firm in depth, and somewhat surprisingly finds that management tends to focus on the impact of hedging on reported earnings rather than directly on cash flow. Firms can also manage FX exposures through specific operational strategies, in addition to using financial hedges. Martin et al. (1999) find that changes in FX exposure are influenced by operational adjustments. Importantly, Allayannis et al. (2003) find that operational hedging is not an effective substitute for financial hedging, but that it may benefit shareholders when used in combination with financial hedging. In addition to choosing among various hedging techniques, firms must also decide which type of FX exposure to hedge. FX exposure can be categorized as either economic exposure,2 transaction exposure, or translation (TL) exposure. TL exposure, in contrast to economic exposure and transaction exposure, has no direct cash-flow effects. For this reason, standard hedging theory does not apply to TL exposure hedging as it does to transaction exposure, and the finance literature generally recommends not hedging TL exposure (see, e.g. Butler, 2004 and Eiteman et al., 2001).3 Nonetheless, some firms do hedge their TL exposure (see, e.g. Bodnar et al., 1996, Bodnar et al., 1998, Berkman et al., 1997, Alkebäck and Hagelin, 1999 and Bodnar et al., 2003), and empirical evidence suggests that managers and investors care about TL exposure (see, e.g. Aggarwal, 1991 and Martin et al., 1998). Importantly, Martin et al. (1998) note that TL exposure may have indirect cash-flow consequences as it affects reported balance sheet accounts. For example, changes in net worth may affect borrowing capacity and cost of capital. Focusing on Swedish firms’ exposures, Hagelin (2003) examines the use of currency derivatives for transaction and TL exposure hedging. Hagelin's (2003) results support the conjecture that firms hedge their transaction exposure so as to increase firm value by reducing costs associated with market imperfections. However, no evidence is found to support the notion that TL exposure hedges are used to increase firm value. This study analyzes the association between characteristics of firms and their hedging of transaction and translation exposures. Our major contribution, however, is that we examine the relationship between TL exposure hedging and the existence of loan covenants. Firms may well hedge TL exposure because of loan covenants requiring them to uphold certain standards of financial performance as a condition for retaining access to funds, and such performance measures are affected by translation gains and losses (see, e.g. Butler, 2004 and Eiteman et al., 2001). Smith and Warner (1979) suggest that firms enter into covenants that may be affected by TL gains and losses. They show that covenants based, implicitly or explicitly, on net worth are common. To the best of our knowledge, the present study is the first attempt to document empirically the relationship between the existence of loan covenants and TL exposure hedging.4 Questionnaire data covering a sample period from 1998 to 2001 is used to study whether recorded relationships hold over time. We define hedging as including not only hedging with currency derivatives, but also hedging with foreign-denominated debt. This, together with the use of data covering four years, should improve the reliability of the results. Use of financial hedges to reduce FX exposure is widespread, and over 50% of the sampled firms hedge FX exposure. We find that transaction exposure is more frequently hedged than TL exposure, although up to 20% of the firms hedge their TL exposure. The survey responses indicate that about one-tenth of the sample firms changed their hedging polices concerning TL, committed transaction (CT), and anticipated transaction (AT) exposures each year in favor of adopting hedging; these policy changes seldom meant that firms quit hedging. We estimate logit regressions to analyze firm characteristics associated with the likelihood of using financial hedges. In line with prior studies of US firms (Mian, 1996, Géczy et al., 1997, Graham and Rogers, 2000 and Allayannis and Ofek, 2001), we find that larger firms are more likely to employ financial hedges. We also find that firms with greater FX exposure are more likely to use financial hedges. Our findings regarding firm size and FX exposure are consistent with the conjecture that fixed costs act as a barrier to hedging for small firms and firms with less FX exposure. The logit results also show that the likelihood of using financial hedges for CT exposure increases with decreasing liquidity, supporting the view that firms with low liquidity hedge to reduce the probability of encountering financial distress, as suggested by Nance et al. (1993). Interestingly, we document a significant positive association between TL exposure hedging and the existence of loan covenants; this suggests that firms hedge TL exposure to avoid violating loan covenants. There is still the question of to what extent the results of this study may be generalized to non-Swedish firms. The results of Bartram et al. (2004) and Lel (2004) indicate that firm-specific factors associated with derivatives use vary little from country to country (including Sweden); this suggests that our results could well be valid for non-Swedish firms. This perception is also supported by the across-the-board similarity in terms of hedging practices, indicated in recent survey studies (see Bodnar et al., 1996, Berkman et al., 1997, Alkebäck and Hagelin, 1999, Bodnar and Gebhardt, 1999, De Ceuster et al., 2000, Mallin et al., 2001 and Bodnar et al., 2003), among firms in different countries.5 The study is organized as follows: Section 2 describes the sample selection procedure and presents our findings regarding firms’ FX exposure and hedging practices. Section 3 describes the research design and defines the variables; the cross-sectional results are presented in Section 4, which is followed by a conclusion.

In this study, we examine Swedish firms’ use of financial hedges to hedge foreign exchange exposure for the 1998–2001 period. We use survey data that lets us differentiate between hedging aimed at translation exposure and hedging aimed at transaction exposure. The survey responses show that use of financial hedges is widespread: over 50% of the responding firms employ financial hedges, and transaction exposure is more frequently hedged than is translation exposure. About 20% of the sampled firms hedge their translation exposure, an interesting finding given that the finance literature generally recommends not hedging translation exposure. Butler (2004), among others, however, argues that translation exposure hedging may be rational in the presence of loan covenants that require a firm's financial performance to remain at certain levels, and given that violating a loan covenant can lead to reduced borrowing capacity. We document a positive relationship between existence of loan covenants and translation exposure hedging; this relationship supports the conjecture that firms hedge translation exposure in order to secure their access to funds. As theoretically predicted, liquidity is negatively related to transaction exposure hedging, supporting the assumption that firms hedge in response to expected financial distress costs. We also find that the likelihood of hedging foreign exchange exposure increases with firm size and exposure, suggesting that the existence of economies of scale influence a firm's hedging decisions. Thus, the evidence suggests that Swedish firms hedge in way that is consistent with shareholder value maximization.