Is Operational Hedging a Substitute for or a Complement to Financial Hedging?

Young Sang Kim

Dept of Economics and Finance
Northern Kentucky University
kimy1@nku.edu
Ike Mathur
Dept of Finance
Southern Illinois University
imathur@siu.edu
Jouahn Nam
Dept of Finance and Economics
Pace University
jnam@pace.edu

This version: July 21, 2005

We thank Wallace N. Davidson III, Jim Musumeci, Mark Peterson, Subhash Sharma, an
anonymous reviewer and seminar participants at Southern Illinois University at
Carbondale, Midwest Finance Association 2004 Annual Conference, and the Financial
Management Association 2004 annual meeting for helpful comments.
Correspondence Address:

Ike Mathur
Department of Finance
Southern Illinois University
Carbondale, IL 62901-4626
Phone: 618-453-1421
Fax: 618-453-5626
Email: imathur@cba.siu.edu

Electronic copy available at: http://ssrn.com/abstract=799524

Is operational hedging a substitute for or a complement to financial hedging?

Young Sang Kim a, Ike Mathur b,*, Jouahn Nam c
a

Department of Economics and Finance, Northern Kentucky University, Highland Heights, KY 41099
b
Department of Finance, Southern Illinois University, Carbondale, IL 62901
c
Department of Finance and Economics, Pace University, New York, NY 10038

Abstract
This paper investigates operational hedging by firms and how operational hedging
is related to financial hedging by using a sample of 424 firm observations, which consist
of 212 operationally-hedged firms (firms with foreign sales) and a size and industry
matched sample of 212 non-operationally-hedged firms (firms with export sales). We
find that non-operationally-hedged firms use more financial hedging, relative to their
levels of foreign currency exposure, as measured by the amount of export sales. On the
other hand, though operationally-hedged firms have more currency exposure, their usage
of financial derivatives becomes much smaller than that of exporting firms. These results
can explain why some global firms use very limited amount of financial derivatives for
hedging purpose despite much higher levels of currency risk exposure. We also show that
hedging increases firm value
JEL classification: F23, F21, F31, G32,
Keywords: Operational hedging; Financial hedging: Foreign exchange exposure;
Financial derivatives

*Corresponding author, tel.: +1 618 453 1421 fax: +1 618 453 5626.
Email address: imathur@cba.siu.edu (I. Mathur)

2
Electronic copy available at: http://ssrn.com/abstract=799524

1. Introduction
Stulz (2004) reports that the use of foreign exchange derivatives by industrial firms has a
notional value of $5 trillion, and the similar figure for interest rate derivatives has a notional
value of $15 trillion. Bartram et al. (2004) report that 65% of U.S. firms use derivatives and
37.4% of U.S. firms use foreign exchange derivatives. The large volume of derivatives use by
U.S. firms emphasizes the importance of hedging for firms, and has stimulated significant
research, resulting in the emergence of a rich body of literature that explores the various channels
through which hedging can contribute to increased firm value (e.g., Froot et al., 1993; DeMarzo
and Duffie, 1995; Smith and Stulz, 1985; Geczy et al., 1997; Allayannis and Weston, 2001;
Haushalter, 2000; Graham and Rogers, 2002; Carter et al., 2004b). Earlier studies have advanced
our understanding of how financial hedging can enhance firm value. However, much less
attention has been given to firms operational hedging activities. Thus, this paper addresses the
somewhat less explored but increasingly important issues of the relation between operational and
financial hedging and the valuation effects of operational hedging activities.
Operational hedging can be viewed as either a substitute or a complement to a firms
financial hedging strategy when it intends to reduce the volatility of future cash flows and, thus,
to possibly increase firm value. The relationship between operational and financial hedging has
received less attention and remains largely unexplained. Lim and Wang (2001) show that
financial hedging and corporate diversification are more often complementary than substitutive.
Allayannis et al. (2001) find that operational hedging is not an effective substitute for financial
risk management. Operational hedging strategies increase firm value only when used in
combination with financial hedging strategies. In a similar vein, Pantzalis et al. (2001) find that
operational hedging leads to lower foreign exchange risk exposures for MNCs.

Though these studies shed light on the important role of operational hedging for MNCs,
none of them examines how such firms being exposed to foreign currency risk but not being
operationally hedged, manage their foreign currency risk exposures. More importantly, there are
no empirical studies that explore how firms view operational hedging, as opposed to financial
hedging. For most exporting firms, the need for financial hedging should be greater since they
are not operationally hedged or less hedged. Thus, this paper investigates how financial hedging
can be more effectively used to reduce cash flow variability (transaction exposure), while
operational hedging can be used to mitigate more long-term and permanent risk exposures
(economic exposure).
It is also important to examine whether operational hedging can contribute to increasing
firm value. When an operational hedging strategy serves to stabilize a firms future cash flows,
the value of the firm should increase through a rationale similar to that for financial hedging.
Despite the importance of this potential value effect of a firms operational hedging, no studies
have provided evidence on this relationship. Thus, we investigate whether, and more importantly
how, operational hedging can contribute to increasing firm value.
We investigate this relation between financial and operational hedging for a unique
sample of 424 U.S. firms over the period of 1996 to 2000. A firm should report its sales to
foreign countries as export sales if it manufactures the products in the U.S. However, when it has
foreign manufacturing operations (foreign assets), sales from these operations to foreign
countries should be recorded as foreign sales. These accounting treatments allow separating
firms into operationally hedged and non-operationally hedged firms. Firms reporting foreign
sales are operationally hedged, while firms reporting only export sales are non-operationally
hedged. Operational hedging is defined as the degree of geographic diversification.

This paper contributes to the literature in several ways by providing evidence on the
important role of operational hedging. First, this paper investigates whether operational hedging
is a substitute or a complement to financial hedging. Using a sample of 424 firm observations,
we find that non-operationally hedged firms use more financial hedging relative to their levels of
foreign exchange risk exposure as measured by the amount of export sales. On the other hand,
though firms reporting foreign sales have more currency risk exposure in terms of the level of
foreign activity, their usage of financial derivatives becomes much smaller than those of
exporting firms. These results can explain why some globally diversified firms use very limited
amounts of financial derivatives for hedging purposes despite much higher levels of currency
exposure. We also find a significant positive relationship between operational and financial
hedging in several multivariate regression models, thus supporting the complementary nature of
these hedging strategies.
Second, this paper contributes to the literature by examining the effects of operational
hedging and financial hedging on foreign exchange risk exposure. We find that both financial
hedging and operational hedging are associated with reducing a firms currency exposure. The
results show that a financial hedging strategy is more effective in reducing foreign exchange risk
exposure.
Finally, this paper contributes to the literature by examining the valuation effects of
operational hedging strategies. We find that operational hedging and financial hedging are
associated with increases in firm value. These results support the evidence of Allayannis and
Weston (2001), and Carter et al. (2004b) that financial hedging increase firm value,1 and extends
it to operational hedging strategies.

Allayannis and Weston (2001) and Nain (2004) also show that foreign currency hedging increases firm value by
4.8% and 5.0%, respectively.

The remainder of the paper is organized as follows. Section 2 discusses previous studies
and empirical hypotheses. Section 3 describes the sampling procedure. Section 4 describes the
methodology used in this paper. Section 5 presents the results of tests and Section 6 concludes
the paper.
2. Literature review and hypothesis development
2.1. Operational hedging
Researchers argue that operational hedging through geographic diversification is
beneficial for MNCs for reducing the volatility of cash flows. MNCs, which have operations
located in different countries, may benefit from offsetting unexpected changes in foreign
currency exchange rates due to operational hedges. However, Allayannis et al. (2001) find that
operational hedging is not an effective substitute for financial risk management, and support the
conditional complement hypothesis. Pantzalis et al. (2001) find that the ability to construct
operational hedges leads to lower currency exposures for the pooled sample as well as for firms
with positive exposure (net importers) and negative exposure (net exporters). Carter et al. (2001)
find that the combined use of operational and financial hedges is associated with decreased
exchange rate exposure. These results support the complementary hypothesis. Based on this
literature, we hypothesize that operational hedging is complementary to financial hedging since
operational and financial hedging strategies are used for managing different types of risk
exposures, i.e., operational hedging for long-term exposure (economic exposure) and financial
hedging for short term exposure (transaction exposure).
2.2. The rationale for financial hedging
Financial risk management theory, which stems from market imperfections and violations
of the perfect world assumptions, argues that risk management can add value if it reduces

expected tax liabilities (Smith and Stulz, 1985), bankruptcy costs (Myers, 1977; Smith and Stulz,
1985), and the underinvestment problem from costly external financing (Froot et al., 1993).
Smith and Stulz (1985) argue that hedging can reduce expected tax liability since
volatility is costly for firms with convex tax functions. The convexity of the tax code creates tax
advantages that follow from a smoother profit stream through financial hedging (derivatives) and
operational hedging (diversification). In this paper, we use the tax measure, TAX, the book value
of net operating tax loss carry forwards divided by total assets, as a proxy for the tax theory. We
expect to find a positive relationship between TAX and hedging activities.
The cost of financial distress theory argues that hedging, by reducing the variability of
cash flows, reduces the probability of incurring bankruptcy costs (Smith and Stulz, 1985). The
increase in firm value comes from the reduction in the deadweight costs of bankruptcy.
Diversification may also reduce the likelihood of bankruptcy. The proxy for the costs of financial
distress is DEBT, the ratio of total debt to total assets. We expect a positive relationship between
DEBT and hedging activities.
The reduction in the underinvestment problem theory holds that firms can reduce the
need for costly external financing through hedging (Froot et al., 1993). Gczy et al. (1997) find
that firms use of currency derivatives is positively related to research and development
expenditures for a sample of Fortune 500 firms. To test the reduction in the underinvestment
problem theory, this study includes RND, the ratio of research and development expenditures to
total assets. Allayannis and Ofek (2001), Gay and Nam (1998), and Graham and Rogers (2002)
all find that hedging increases with the level of R&D expenditures. A positive relationship
between RND and derivatives usage is expected.

The economies of scale involved in establishing a hedging program is a common

explanation for the relationship between size and hedging. Previous empirical studies find a
strong positive relationship between the size of the firm and the likelihood of hedging activity
(Geczy et al., 1997; Mian, 1996; Haushalter, 2000; Allayannis and Ofek, 2001; Graham and
Rogers, 2002). We include SIZE, the logarithm of total assets, to control for the size effect. We
expect a positive relationship between SIZE and hedging activities.
We also include the quick ratio QUICK, current assets less inventories divided by current
liabilities, to measure the availability of internal funds (Geczy et al., 1997). We expect a negative
relationship between QUICK and hedging activities. In order to control for industry effects we
use dummy variables based on two-digit SIC codes for different industries (INDUSTRY). We
use SEGN, number of industrial segments, as another control variable. Some firms may seek to
derive potential benefits of financial hedging through the use of foreign currency denominated
debt. Thus, we use the indicator dummy variable FDEBT equal to 1 if a firm reports use of
foreign debt and equal to 0, otherwise.
Many of the past empirical studies on risk management utilize the ratio of the notional
amount of total derivatives use to total assets as a proxy for the firms risk exposure and/or to
analyze the use of derivatives as a dichotomous variable. In this paper, we employ both the
dichotomous variable and the continuous variable, the ratio of notional amount of derivatives to
total foreign currency risk exposure, in the regression models for robustness tests.
3. Sample
3.1. Operational hedging data procedure
In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 131, Disclosure about Segments of an Enterprise

and Related Information, which became effective for fiscal years starting after December 31,
1997. SFAS 131 rules require that enterprises report information about operating segments,
products and services, the geographic areas in which they operate, and their major customers.
Under SFAS 131, segment reporting is more consistent with the organizational structure of the
firm and provides more detailed information about geographic segments.
The initial sample of the paper is obtained from the COMPUSTAT Geographic Segment
(CGS) files for 1998. Since firms effectively adopted the new segment rule SFAS 131 in 1998,
we use fiscal year end 1998 for the sample. We initially identified 6,086 companies that have
foreign exchange rate exposure due to foreign sales or export sales. We restrict the sample with
1998 total sales greater than $300 million. We exclude from the sample firms in the financial
industries (SIC codes 6000-6999) or the utility industries (SIC codes 4900-4999). After the size
and industry screening procedure, we obtain 1,643 firm observations from the C.G.S files.
Among these firms, we define firms that report only export sales in the geographic segment file
as non-operationally hedged firms. Export sales represent the amount or percentage of each
segments revenue generated by domestically produced goods or services, sold outside the
domestic country.
To examine the effects of operational hedging on firm value and the relation between
operational and financial hedging, we collect a sample of operationally hedged firms that have
foreign assets or operations in foreign countries and report foreign sales. We match nonoperationally hedged firms with operationally hedged firms of similar size (total sales within
+10%) and in the same industry (SIC code) in the CGS segment files.2 We also require that the

For the industry and size matching process, we match 34.0 percent (72 firms) of the sample using four-digit SIC
codes, 34.4 percent (73 firms) of the sample using three-digit SIC codes, and the remaining 31.6 percent (67 firms)
of the 212 firm sample using two-digit SIC codes. We lose 49 firms in the matching process since we could not find
the appropriate size matches.

sample firms stock returns be available from CRSP. After this size and industry matching
procedure, and financial data requirements, we obtain a final sample of 424 firm observations
that consists of 212 non-operationally hedged and 212 operationally hedged firms. We collect the
number of subsidiaries located in foreign countries, and the number of foreign countries in which
a firm operates from the Directory of Corporate Affiliations: U.S. Public Companies, which was
prepared by National Register Publishings Database Publishing Group in 1999.3 We count only
level 1 non-U.S. subsidiaries, which report directly to the parent company.
3.2. Financial hedging data procedure
Next, for our sample firms, we collect financial derivatives information using the search
terms notional, hedge, forwards, swaps, options, market risk, and derivatives from annual
proxy statements (EDGAR database) in the fiscal year end of 1998. We identify financial
derivatives user as a firm that reports any type of currency derivatives instruments or reports the
notional amount of currency derivatives. We obtain 236 firms that report the use of financial
derivatives and 188 firms that do not report any type of financial derivatives. We record the total
notional amount of currency derivatives use and the types of currency derivatives including
forwards, futures, options, and swaps as well as interest rate derivatives information.
The increase in the complexity of derivatives has also increased the need for corporate
disclosures of positions. SFAS No. 119, Disclosure about Derivative Financial Instruments and
Fair Value of Financial Instruments, added to and amended two other statements (SFAS No. 105
and SFAS No. 107) and requires firms to disclose their objectives and strategies. Firms must
report the contract notional amount of instruments and hedging purpose. The FASB also issued
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in June 1998,

We thanks Allayannis and Weston for providing part of the sample for these operational measures.

portions of which are augmented by SFAS No.137 and SFAS No.138. Starting with all fiscal
years after June 15, 2000, SFAS No.133 becomes mandatory for all companies. SFAS No.133
requires companies to show changes in all of their derivatives values as assets or liabilities in the
financial statements and measure those instruments at fair value with offsets allocated to current
earnings or other comprehensive income (OCI), even if the derivatives remain in an open
position. Information on other firm characteristics is collected from the COMPUSTAT annual
industrial database and segment database.
4. Methodology
4.1. Operational hedging measures
As proposed by Allen and Pantzalis (1996) and used by Allayannis et al. (2001), we use
four proxies for operational hedging: (i) the log of the number of countries in which a firm
operates (LNCTY); (ii) the number of regions where the firm has subsidiaries (LNSUBS),
NAFTA, Europe, Western Europe, Eastern Europe, East Asia, Other Asia, Central America,
South America, and Africa; (iii) the geographic dispersion of its subsidiaries across different
countries (Dispersion index I); (iv) the geographic dispersion of its subsidiaries across regions
(Dispersion index II). Dispersion indices I and II are calculated as
Dispersion index I = 1 Hirshman-Herfindahl concentration index
= 1 { i [# of countries]2 / [ i (# of countries)]2 }
Dispersion index II = 1 { j [# of regions]2 / [ j (# of regions)]2 }

(1)
(2)

where # of countries equals the number of foreign subsidiaries in country i, and # of regions
equals the number of foreign subsidiaries in geographic region j. These dispersion indices are
close to zero if a firm has subsidiaries in one country or region and equal to one if a firm has

subsidiaries in many countries or regions. Thus, if a firm is more operationally diversified, then
this dispersion index measure also increases.
The effects of operational hedging and financial hedging on foreign exchange risk
exposure are measured by using the two-factor model (Jorion, 1990) Rit = i + i Rmt + i FX t +
it (3), where Rit = monthly rate of return on the ith firms stock in month t, Rmt = monthly rate
of return on the equally weighted market portfolio, and FX t = monthly rate of return on the
broad trade weighted foreign exchange rate. We use monthly return data from the CRSP
database over the period of 1996 to 2000 to estimate foreign exchange risk exposure (FXEXP,
). The data for the nominal broad trade weighted index are obtained from the Federal Reserve
Board database.4
4.2. Multivariate regression model
4.2.1. Substitute vs. complement
We examine whether operational hedging and financial hedging are substitutes or
complements. The basic model is as follows:
FINHEDGE = + 1 TOTFOR + 2 OPERH + Control variables +

(4)

FINHEDGE is the financial hedge ratio, measured as the total notional amount of currency
derivatives divided by total foreign activities. TOTFOR is total foreign activity, measured by
total foreign sales and export sales to total sales, and OPERH refers to operational hedging
variables Dispersion Index I, Dispersion Index II, LNCNTY, and LNSUBS. The control
variables include FDEBT, TAX, SIZE, RND, QUICK, SEGN and INDUSTRY.

We also test by using various estimation periods of 36 month, 48 month, and 60 month, a different market measure
(equally weighted index, and value weighted index), and various currency indices (Major index, OITP index). We
report the result based on the five year estimation periods with the equally weighted market index (Bodnar and
Wong, 2003). The results of alternative methods are similar to the findings in this paper.

10

We use different econometric techniques to test this relation. First, we use a logistic
regression model since the dependent variable, CUSER, is dichotomous. CUSER equals one if a
firm uses any type of currency derivatives instruments and otherwise equals zero. Second, we
alternatively use the continuous dependent variable, the financial hedge ratio, FINHEDGE. If the
invoice currency is the foreign currency, then export sales produce the same exposure to
exchange rates as do foreign sales and FINHEDGE might be a good proxy for foreign activity.
FINHEDGE is similar to Haushalter (2000)s measure of the percentage of production hedged in
the gas and oil industry. With this continuous dependent variable, we employ the left censored
Tobit regression model to test the relation.
4.2.2. Foreign exchange risk exposure regression
Next, we examine the impact of operational hedging and financial hedging on foreign
exchange risk exposure by following the methodology of He and Ng (1998) with indicator
variable D, which equals one if a firm has positive foreign exchange risk exposure (i.e., > 0)
and otherwise equals zero (i.e., < 0). This method is also used by Carter et al. (2004a).
ABSFX (| |) = 0 D + 1 D*FINHEDGE + 2 D*OPERH + 3 D*FDEBT + 4
D*TOTFOR + 5 D*SIZE + 6 D* SEGN + 0d (1-D) + 1d (1-D)*FINHEDGE + 2d (1D)*OPERH + 3d D*FDEBT + 4d D*TOTFOR + 5d D*SIZE + 6d D* SEGN +

(5)

where ABSFX = absolute value of the foreign exchange risk exposure as measured, by the two
factor market model (Jorion, 1990). 5 We control heteroscedasticity in the estimation of the
exposure coefficients by using the weighted least squares (WLS) method and using the inverse of

The reason that we use the absolute value of foreign exchange risk exposure measure is that the details of import
and export activities at the firm level are not available although we obtain export sales information. For this reason,
it is not feasible to identify the sign of the currency exposure to the exchange rate change. Since the focus of this
paper, however, is how risk management strategies affect foreign exchange risk exposure and firm value, the
magnitude of the exposure is more important than the sign of the exposure.

11

the squared standard error of the foreign exposure coefficient from equation (3) as the weight
(see Pantzalis et al., 2001; and Carter et al., 2004a, for details).
The level of foreign exchange exposure, i, and financial risk management decisions are
endogenous. A firms hedging policies affect the magnitude of i since hedged firms will
have lower levels of exposure. On the other hand, i influences a firms hedging policies. A
firm that views itself as more exposed will have greater incentive to hedge (or hedge more). Thus,
the level of i and corporate hedging decisions are determined simultaneously and are
modeled accordingly. To control for the endogenous nature of the hedging decisions, we use a
system of equations using three-stage least squares methodology (3SLS). 6 For the hedging
decision, we use the model in equation (4) and add the endogenous variable absolute value of
foreign exchange exposure in the model. We hypothesize that both financial hedging and
operational hedging are associated with reducing foreign exchange risk exposure.
4.2.3. Tobins q regression
We examine the impact of both hedging strategies on firm value by using the dependent
variable Tobins q (Chung and Pruitt, 1994). The regression model is as follows:
Log (Tobins q) = + 1 FINHEDGE + 2 OPERH + 3 CUSER*OPERH
+ Control variables +

(6)

We include the interaction variable, CUSER*OPERH, which is the financial derivatives

user variable multiplied by operational hedging variables. This variable is included to capture
the effects of operational and financial hedging for firms that use both of these hedging strategies.

The hedging regression results are not reported. The basic results are similar to our findings in Table 4. The results
are available upon request.

12

We also include the control variables, SIZE, DEBT, RND, CAPX, ROA, Credit rating and
industry dummy variables in Tobins Q regression.
5. Results
5.1. Univariate tests
Table 1 presents summary statistics for the sample of 424 firm observations. Panel A
shows the number of observations, mean, standard deviation, first quartile, median, and third
quartile for firm characteristics and operational hedging measures. The average [median] of total
assets is $5.5 billion [$1.4 billion]. Average [median] export sales are $541 million [$112 million]
while average foreign sales are $1.7 billion [$0.5 billion]. The amount of foreign sales is larger
than export sales. On average, 23% of total sales is from foreign sales or export sales. The
average number of foreign subsidiaries is 11 while the average number of foreign countries is 7.
The two other operational hedging measures, Dispersion Indices I and II, show how MNCs are
dispersed in different geographic areas. The average for Dispersion Index I (II) is 0.45 (0.32).
Table 1, Panel B, presents financial derivatives usage information. The notional amounts
of foreign currency derivatives as well as the types of instruments are reported. The number of
observations, mean, standard deviation, first and third quartile, and median values are reported.
Approximately 55% of the 424 total sample firms report the use of financial derivatives. Among
financial derivatives users, 78% of firms use foreign currency derivatives (183/236). The results
are close to the Bodnar et al. (1996) survey results. Foreign currency forward contracts are the
most popular instruments (69% of 236 derivatives users).
Table 2 shows univariate tests of firm characteristics. Panel A provides the difference in
mean and median statistics of firm characteristics by operational hedging strategy. Since we
obtain the control sample by matching by size and industry, the average difference in total assets

13

and total sales in the two sub-samples is not statistically significant. The average and median
value of total debt to total assets is lower for operationally hedged firms and statistically
significant. However, R&D/total assets, foreign exchange exposure, and the absolute value of
foreign exchange exposure are not significantly different in the two samples while the total
foreign activity ratio is significantly higher for operationally hedged firms. The interesting
finding in this table is the average financial hedge ratio, which for non-operationally hedged
firms is 0.38 while the average for operationally hedged firms is 0.14. The difference in means
for the two samples is statistically significant at the 1 percent level. Since operationally hedged
firms are naturally hedged and have flexibility in their production and marketing strategies
related to exchange rate changes, the need for financial hedging is lower than that for nonoperationally hedged firms.
Table 2, Panel B, provides mean and median difference tests for firm characteristic
variables and operational hedging proxies by financial derivatives usage. In the sample,
approximately 56% of the total sample (236 firms) is derivatives users and 44% of the sample
(188 firms) is derivatives non-users. The size variable is larger for financial derivatives users.
Contrary to the financial distress explanation, total debt to total assets is lower for derivatives
users. Consistent with the growth opportunity hypothesis, however, R&D expenditures to total
assets is higher for derivatives users. Export sales are higher for financial derivatives non-users
while foreign sales are lower.
The main interest in this paper is the relation between operational hedging variables and
financial hedging activities. The average and median values of all four proxies for operational
hedging variables are significantly higher in the derivatives users group. Consistent with the
complementary hypothesis of the relation between operational and financial hedging, the results

14

suggest that more operationally hedged firms are likely to use financial derivatives. However, we
draw this inference cautiously since confounding effects such as size are not controlled for in this
relationship.
Table 3 presents the Pearson correlation coefficients for financial and operational
hedging variables. All of the four operational hedging variables (Dispersion index I, Dispersion
index II, number of subsidiaries and number of countries) are very highly inter-correlated (e.g.,
0.90, 0.91, and 0.93 for Dispersion index I and other variables, respectively). Financial and
operational hedging variables are significantly positively correlated. Both the derivatives use and
the financial hedge ratio are positively correlated with all four proxies for operational hedging
variables. The results support the complementary nature of the risk management strategies of
financial and operational hedging. This finding supports the argument that operational hedging is
used for managing long term exposure (economic exposure) and financial hedging is used for
managing short term exposure (transaction exposure). The absolute value of the foreign
exchange risk exposure measure and financial hedging are negatively correlated, consistent with
earlier financial risk management literature (Allayannis et al., 2001).
5.2. Multivariate regression tests
5.2.1. Complement vs. substitute test
Table 4 reports the multiple regression results for the relation between operational and
financial hedging in multiple regression models. The dichotomous dependent variable equals one
if a firm reports the use of any type of currency derivatives use including forwards, swaps, and
options and equals zero otherwise. Logit regression models show that total foreign activity,
which is the sum of foreign export sales and foreign sales, is positively related to financial
derivatives usage. This positive relation between foreign activity and financial derivatives is

15

consistent with Geczy et al. (1997) and Allayannis and Weston (2001). They also find a strong
positive relationship between the foreign sales ratio and foreign currency derivatives usage. After
controlling for this foreign activity and other determinants of financial hedging, we find a strong
positive relation between operational hedging (Dispersion index I) and financial hedging. The
results are very similar when other proxies for operational hedging measures are used. We find a
negative but statistically insignificant relation between foreign debt and the financial hedging
variable. To control for the effects of the determinants of financial hedging, we include the
control variables tax loss carry forward, size, debt ratio, growth opportunity, quick ratio, the
number of industrial segments, and industry dummy variables using two digit SIC code in all
other regression models. The results still hold when the control variables are included. The signs
and magnitude of the control variable coefficients are generally consistent with the earlier risk
management literature.
We reestimate the multivariate regression model using the left censored Tobit model and
the continuous financial hedge ratio variable. The basic results on the complementary nature of
operational and financial hedging do not change. All of the four proxies for the operational
hedging variables are statistically significant and positive. The sign and magnitude of other
control variables are similar to the results for the Logit regression models except that the foreign
activity variable is no longer significant. In summary, we identify a strong positive relation
between operational hedging and financial hedging. This result supports the complementary
nature of both hedging strategies.
5.2.2. Foreign exchange risk exposure results
Table 5 provides the results for the effects of operating and financial hedging on foreign
exchange risk exposure. The dependent variable in this regression is the absolute value of foreign

16

exchange risk exposure measure. The effects of financial hedging on currency exposure are
investigated by including the financial hedge ratio. Total foreign activity is measured as the
amount of export sales or foreign sales at fiscal year end 1998. We use three-stage least square
regression model to control for endogeneity between hedging strategies and the level of foreign
exchange risk exposure. In addition, we use the indicator variable, D, to separate the effects of
financial and operational hedging strategies for positive and negative exposure following He and
Ng (1998). We calculate foreign exposure using the two factor market model with equally
weighted market index and monthly foreign exchange rate index for a five year period as
suggested by Bodnar and Wong (2003).
As shown in the regression, we find significant negative effects of financial hedging on
currency exposure for net importer and net exporter. For net importers, financial hedging is
effective in controlling a firms exposure to unexpected currency exchange rate changes. We also
include operational hedging variables in the regression models. The coefficients for the four
operational hedging variables are also negative but insignificant for net importers (i.e., positive
foreign currency risk exposure). For net exporters, we also find that financial hedging reduces
foreign currency risk exposure effectively. The coefficients for the operational hedging variables
are positive but statistically insignificant for the different regression models. The results show
that financial hedging plays an important role in hedging foreign currency risk exposure. The
coefficients for the number of segments for net exporters are positive and statistically significant.
Other control variables are insignificant. Overall, we find that both financial hedging and
operational hedging are associated with foreign exchange risk exposure change.
5.2.3. Firm value effect (Tobins Q)

17

The dependent variable in this regression is Tobins Q (Chung and Pruitt, 1994). In Table
6, the regression model in the first column shows the relation between financial hedging and firm
value. Financial hedging is positively associated with firm value. Also, this result holds when we
include the operational hedging variable and other control variables. The results are consistent
with earlier findings in risk management literature. The regression model in the second column
shows the effect of operational hedging measured by dispersion index I. Operational hedging is
strongly positively associated with an increase in firm value. The results do not change when we
include the various control variables. The sign of the control variables are consistent with
previous literature, in general. Firms with high growth opportunity (R&D expenditures / total
assets) and profitability (return on assets) increase firm value. We also control industry effect for
all regression models. Interestingly, when we use the interaction dummy variable for both
financial and operational hedging, the coefficients of financial and operational hedging variables
are significant. However, the coefficients of the interaction variables are negative and
insignificant in all regression models. This result may be attributed to the complementary nature
of both financial and operational hedging. Overall, the valuation effects of operational hedging
and financial hedging are positive. We also reestimate the models using industry-adjusted
Tobins Q following Lang and Stulz (1994). The results are consistent with the evidence that
financial hedging adds 5.4% to firm value on average7 and operational hedging increase firm
value as a range of 4.8% to 17.9% in Table 6.
6. Conclusions

Our results are similar to previous results. For example, Allayannis and Weston (2001) conclude that foreign
currency hedging adds 4.8% to firm value on average and Nains (2004) results indicate a 5% increase in firm value.
Similarly, Bartram et al. (2004) show 4-9% for a global sample including U.S. firms, and Carter et al. (2004b) give a
range of 12-16% for fuel hedging by airlines. The industry-adjusted Tobins q results are available from the authors.

18

This paper investigates the interrelationship between operational and financial hedging
activities, the effects of these hedging strategies on foreign exchange risk exposure, and the
effects of operational and financial hedging on firm value. The sample consists of 212 export
sales firms (non-operationally hedged firms) and 212 size and industry matched foreign sales
firms (operationally hedged firms). The results indicate that operational and financial hedging
strategies are complementary. MNCs employ both operational and financial hedging strategies to
manage their overall risks. These results regarding the complementary nature of the relation are
robust when we use different proxies for operational hedging, and are also robust when we use
different econometric techniques, Logit and Tobit regressions. Operational hedging can be
effective in managing long-term exposure (economic exposure) while financial hedging can be
effective for hedging short-term exposure (transaction exposure).
Consistent with the complementary hypothesis, the results show that both hedging
strategies are effective in reducing foreign exchange risk exposure. Moreover, consistent with
Carter et al. (2004b), both operational and financial hedging strategies are associated with
enhancing firm value. These results emphasize the importance of operational and financial
hedging for managing firm risk. Also, the results explain why some globally diversified firms
use limited amounts of financial derivatives for hedging purposes, despite much higher levels of
foreign exchange risk exposure.
Acknowledgements
We thank Wallace N. Davidson III, Jim Musumeci, Mark Peterson, Subhash Sharma, an
anonymous reviewer and seminar participants at Southern Illinois University at Carbondale,
Midwest Finance Association 2004 Annual Conference, and the Financial Management
Association 2004 annual meeting for helpful comments.

References

19

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21

Table 1
Descriptive statistics
This table presents the descriptive statistics for operational and financial hedging measures for the sample of 424 observations for fiscal year end 1998. Firm
characteristics are obtained from COMPUSTAT and operational hedging measures (the number of subsidiaries and number of foreign countries) are hand
collected from the Directory of Corporate Affiliations in 1999. Panel A provides information about several operational hedging measures. Total assets are
measured as book value of total assets for fiscal year end 1998. Total Sales are measured as the amount of total sales. Export sales and foreign sales are collected
from the COMPUSTAT geographic segment files. The foreign activity ratio is measured as export sales and foreign sales divided by total sales. Foreign debt
dummy variable equals 1 if the company reports the use of foreign debt, otherwise equals zero. The number of subsidiaries (foreign countries) is measured as the
number of non-U.S. located subsidiary (foreign countries) from the Directory of Corporate Affiliations. Dispersion index I (Dispersion index II) is measured as
one minus Hirshman-Herfindahl index for the number of countries (regions) where the company is located. The Hirshman-Herfindahl index is constructed as the
sum of the squared "market shares" for each country (region) where the market share for each country (region) is defined as the proportion of total subsidiaries in
each country (region). Panel B shows the financial derivatives usage information including currency and interest rate forwards, swaps, and options. The financial
hedge ratio is measured as the total notional amount of currency derivatives divided by total foreign activities. Number of observations, Mean, standard deviation,
first quartile, median, and third quartiles are reported.
Panel A. Operational hedging measures
Variables
Number of
Mean
Standard
First quartile
Median
Third quartile
observations
deviation
Total assets ($ million)

424

5549.5

24741.2

648.5

1430.6

2999.4

Total sales ($ million)

424

4414.1

12877.2

703.2

1389.8

3328.9

Export sales ($ million)

212

541.1

2076.4

48.8

112.1

248.2

Foreign sales ($ million)

212

1725.2

4874.0

204.1

548.8

1112.3

Foreign activity ratio

424

0.2290

0.1931

0.0779

0.1656

0.3365

Foreign debt

424

0.0919

0.2893

0.0000

0.0000

0.0000

Number of subsidiaries

378

11.31

26.84

1.00

3.00

12 (Max: 402)

Number of foreign countries

378

6.86

10.03

1.00

2.00

9 (Max: 94)

Dispersion index I (country based)

378

0.4477

0.4104

0.00

0.50

0.8760

Dispersion index II (region based)

378

0.3196

0.3243

0.00

0.279

0.6400

22

Panel B. Financial hedging information (Financial derivatives users only. All amounts in $ million.)
Standard
Number of
Mean
Variables
deviation
observations
Currency derivatives notional amount

First quartile

Median

Third quartile

183

741.12

2880.49

19.80

57.90

337.00

Forwards contracts

162

635.55

2756.24

20.00

60.35

306.00

Swaps

18

842.69

2154.80

11.00

138.80

405.00

Options

45

542.61

1075.25

16.70

118.50

368.90

Interest rate derivatives

146

1090.27

8120.84

50.00

139.55

400.00

Forwards/futures

134.00

N.A

134.00

134.00

134.00

Swaps

139

1103.00

8322.17

44.00

127.00

400.00

Options

11

478.69

711.14

50.00

200.00

525.00

Total derivatives notional amount

236

1254.50

8757.94

44.00

145.00

530.00

Financial hedge ratio (users only)

236

0.4692

1.1814

0.0026

0.0828

0.3306

Currency notional amount (total sample)

424

319.927

1924.83

0.000

0.000

44.60

Financial hedge ratio (total sample)

424

0.2604

0.9091

0.000

0.000

0.1207

23

Table 2
Univariate tests by operational hedging and financial hedging
This table presents the univariate tests for operational and financial hedging measures for the sample of 424 observations in fiscal year end 1998. Firm
characteristics are obtained from COMPUSTAT and operational hedging measures (the number of subsidiaries and number of foreign countries) are hand
collected from the Directory of Corporate Affiliations in 1999. Panel A provides firm characteristics by operational hedging measures. Firms are operationally
hedged if they report foreign sales or foreign assets. Non-operationally hedged firms are firms that report export sales but do not report foreign sales or foreign
assets. Total assets are measured as book value of total assets for fiscal year end 1998. Total sales are measured as the amount of total sales. Panel B shows firm
characteristics by financial derivatives usage. The number of subsidiaries and foreign countries are measured as the number of non-U.S. located
subsidiaries/foreign countries from the Directory of Corporate Affiliations. Dispersion index I (Dispersion index II) is measured as one minus the HirshmanHerfindahl index of the number of countries (regions) where the company is located. The Hirshman-Herfindahl index is constructed as the sum of the squared
"market shares" for each country where the market share for each country (region) is defined as the proportion of total subsidiaries in each country (region).
Means, standard deviations, medians, t statistics and Z statistics are reported.
Panel A. Firm characteristics by operational hedging
Non-operationally hedged
Operationally hedged
t-statistics
Z-statistics
Number of firms = 212
Number of firms = 212
Mean
Standard
Median
Mean
Standard
Median
deviation
deviation
Total assets ($ million)

5206.47

25245.48

1062.63

5892.69

24281.38

1663.69

-0.29

-3.77 ***

Total sales ($ million)

3952.33

9872.78

1083.48

4876.04

15314.36

1683.64

-0.74

-3.73 ***

Total debt/total assets

0.263

0.182

0.253

0.224

0.162

0.210

2.26 **

2.03 **

R&D/total assets

0.047

0.049

0.025

0.053

0.056

0.030

-1.02

0.52

Foreign exchange
exposure ()

-0.165

1.447

-0.217

-0.306

1.489

-0.327

0.98

0.77

Foreign exchange
exposure

1.030

1.027

0.756

1.095

1.052

0.759

-0.63

-0.70

Foreign activity ratio

0.128

0.123

0.092

0.330

0.197

0.307

-12.67***

Currency derivatives

213.54

988.46

0.000

426.31

2535.30

426.31

-1.14

-2.47 ***

Financial hedge ratio

0.380

1.158

0.000

0.141

0.535

0.002

2.73 ***

-0.95

Tobins Q

1.540

0.960

1.246

1.646

1.065

1.286

-1.07

-0.62

Industry adjusted Q

-0.075

0.602

-0.108

-0.096

0.651

-0.123

0.32

0.12

24

-12.02 ***

Panel B. Firm characteristics by financial derivatives usage

Derivatives non-users
Number of firms = 188
Mean
Standard
Median
deviation

Derivatives users
Number of firms = 236
Mean
Standard
Median
deviation

t-statistics

Z-statistics

Total assets ($ million)

1502.5

2670.0

736.9

8773.5

32750.8

2088.2

-3.40 ***

-9.84 ***

Total sales ($ million)

1408.7

1809.4

760.3

6808.3

16819.4

1991.4

-4.90 ***

-9.45 ***

Total debt/total assets

0.274

0.191

0.266

0.219

0.154

0.205

3.24 ***

3.00 ***

R&D/total assets

0.023

0.037

0.009

0.050

0.057

0.025

-5.75 ***

-5.97 ***

Tax ratio

0.015

0.062

0.000

0.022

0.077

0.000

-1.10

Quick ratio

1.396

0.855

1.167

1.304

0.689

1.094

1.21

Industrial segments

2.430

1.142

2.00

3.381

1.339

3.000

-7.74 ***

-7.50 ***

Export sales

0.075

0.121

0.029

0.054

0.095

0.000

1.94 *

2.48 ***

Foreign sales

0.097

0.153

0.000

0.219

0.242

0.150

-6.32 ***

-4.98 ***

Foreign debt

0.064

0.245

0.000

0.114

0.319

0.000

-1.85 *

-1.79 **

Foreign exchange exposure

()

-0.126

1.484

-0.246

-0.323

1.453

-0.293

1.35

0.85

Foreign exchange
exposure

1.074

1.028

0.750

1.053

1.050

0.757

0.19

0.12

Number of subsidiaries

4.25

9.28

1.00

16.27

33.29

6.00

-5.10 ***

-7.44 ***

Number of countries

3.12

4.53

1.00

9.49

11.85

5.00

-7.37 ***

-7.31 ***

Dispersion index I

0.274

0.368

0.000

0.569

0.394

0.750

-7.45 ***

-7.17 ***

Dispersion index II

0.183

0.278

0.000

0.415

0.320

0.500

-7.48 ***

-6.83 ***

Financial hedge ratio

0.000

0.000

0.000

0.467

1.179

0.081

-6.10 ***

-16.36 ***

Tobins Q

1.511

0.955

1.257

1.655

1.055

1.246

-1.46

Industry adjusted Q

-0.079

0.627

-0.084

-0.091

0.627

-0.146

0.19

***, **, * significant at the 1%, 5%, and 10% levels, respectively.

25

-2.57 ***
0.78

-1.49 *
0.38

Table 3
Correlation matrix
This table presents the Pearson correlation coefficients for financial and operational hedging variables. Currency derivative is a dummy variable equal to 1 if a firm
reports any notional amount of currency derivatives and otherwise equal to zero. Financial hedge ratio is measured as the total notional amount of currency derivatives
divided by total foreign activities (foreign sales or export sales). Foreign activity is a dummy variable equal to 1 if a firm reports foreign sales or foreign assets and
otherwise equal to zero. Foreign sales ratio is measured as foreign sales divided by total sales. Total foreign activity is measured as the sum of foreign sales and export
sales divided by total sales. foreign exchange exposure is calculated using the two factor model (Jorion, 1990). Dispersion index I (Dispersion index II) is measured as
one minus the Hirshman-Herfindahl index of the number of countries (regions) where the company is located. Number of subsidiaries (Countries) is the log of the
number of non-U.S. located level 1 subsidiaries (foreign countries where a firm operates). Tobins Q is the ratio of market to book value.

Currency
derivative
Financial
hedge ratio
Foreign
activity
dummy
Foreign
sales
Total
foreign
activity
Foreign
exchange
exposure

Currency
derivative

Financial
hedge
ratio

Foreign
activity
dummy

Foreign
sales ratio

Total
foreign
activity

Foreign
exchange
exposure

Foreign
exchange
exposure

Dispersion
Index I

Dispersion
Index II

Number of
subsidiaries

Number of
countries

Tobins Q

1.0000

0.2559 a

0.1423 a

0.2811 a

0.2605 a

-0.1115 b

-0.0148

0.3551 a

0.3522 a

0.3789 a

0.3764 a

0.0704

1.0000

-0.1319 a

-0.1080 b

-0.1493 a

0.0910 b

-0.1120 b

0.1498 a

0.1820 a

0.1329 a

0.1415 a

0.0923 b

1.0000

0.7649 a

0.5250 a

-0.0607

0.0057

0.0923 c

0.0890 c

0.0813

0.0786

0.0538

1.0000

0.8657 a

-0.1346 a

0.0989 b

0.1902 a

0.1923 a

0.2056 a

0.2219 a

0.1562 a

1.0000

-0.1566 a

0.1168 b

0.1672 a

0.1683 a

0.1980 a

0.2169 a

0.1897 a

1.0000

-0.0787

-0.1347 a

-0.1263 b

-0.1067 b

-0.1193 b

-0.1067 b

1.0000

-0.0677 c

-0.0683

-0.0813 c

-0.0622

-0.0209

1.0000

0.9054 a

0.9148 a

0.9371 a

0.1229 a

1.0000

0.8617 a

0.8904 a

0.1401 a

1.0000

0.9817 a

0.1219 a

1.0000

0.1358 a

Foreign
exchange
exposure

Dispersion
index I
Dispersion
index II
Number of
subsidiaries
Number of
countries
Tobins Q

1.0000

a b c

, , significant at the 1%, 5%, and 10% levels, respectively.

26

Table 4
Complement vs. substitute tests
This table shows the multiple regression results for the sample of 424 firms for fiscal year end 1998. In the Logit regressions, the dependent variable is a dummy
variable equal to one if a firm reports any type of derivatives and otherwise equal to zero. In the Tobit regression, the dependent variable is measured as total
currency derivatives notional amount divided by foreign sales or export sales. Total foreign activity is measured as the sum of export sales and foreign sales
divided by total sales. Dispersion index I (Dispersion index II) is measured as one minus the Hirshman-Herfindahl index of the number of countries (regions)
where the company is located. Foreign debt is a dummy variable equal to 1 if the company reports the use of foreign debt, otherwise zero. The tax ratio is the
ratio of tax loss carry forwards to total assets. Industry is a dummy variable using two digit SIC code. T-statistics are reported in parentheses.
Logit regression: Dependent = Derivatives use
Tobit regression: Dependent = Financial hedge ratio
Dispersion index I
Dispersion index II
Number of Number
Dispersion index I
Dispersion index II
Number of Number
subsidiaries of
subsidiaries of
countries
countries
Intercept

-7.288***
(-4.31)

-7.288***
(-4.31)

-7.942***
(-6.90)

-7.330***
(-4.34)

-7.022***
(-4.27)

-7.063***
(-4.17)

-3.640***
(-5.42)

-1.711*
(-1.85)

-3.792***
(-5.62)

-1.729*
(-1.86)

-1.647 *
(-1.75)

-1.624*
(-1.73)

Operational
hedging

1.279***
(2.94)

1.275***
(2.86)

1.043***
(3.13.)

1.016***
(2.99)

0.359***
(3.09)

0.388***
(2.96)

0.927***
(3.26)

0.861***
(3.05)

0.556**
(2.50)

0.518**
(2.35)

0.117*
(1.73)

0.154**
(2.00)

Total
foreign
activity

1.326*
(1.70)

1.419*
(1.74)

1.370*
(1.76)

1.454*
(1.79)

1.337*
(1.64)

1.334*
(1.64)

-1.043**
(-2.30)

-1.089**
(-2.42)

-1.021**
(-2.24)

-1.065**
(-2.35)

-1.098**
(-2.42)

-1.116**
(-2.46)

Foreign debt

-0.183
(-0.40)

-0.217
(-0.47)

-0.207
(-0.45)

-0.235
(-0.50)

-0.223
(-0.48)

-0.230
(-0.49)

-0.009
(-0.03)

-0.018
(-0.07)

-0.014
(-0.05)

-0.021
(-0.08)

-0.027
(-0.10)

-0.025
(-0.09)

Tax ratio

1.353
(0.65)

1.422
(0.67)

1.401
(0.67)

1.456
(0.69)

1.374
(0.64)

1.322
(0.62)

2.547**
(2.02)

2.641**
(2.13)

2.513**
(1.97)

2.605**
(2.08)

2.562**
(2.04)

2.551**
(2.04)

Total assets

0.836***
(5.70)

0.848***
(5.68)

0.857***
(5.91)

0.869***
(5.88)

.836***
(5.60)

0.849***
(5.70)

0.313***
(3.83)

0.314***
(3.88)

0.346***
(4.25)

0.345***
(4.28)

0.352***
(4.21)

0.345***
(4.17)

Total debt/
total assets

-0.219
(-0.28)

-0.302
(-0.38)

-0.155
(-0.20)

-0.251
(-0.31)

-0.277
(-0.35)

-0.251
(-0.31)

-0.276
(-0.51)

-0.327
(-0.60)

-0.395
(-0.72)

-0.434
(-0.79)

-0.532
(-0.96)

-0.466
(-0.84)

R&D/total
assets

11.888***
(3.69)

11.369***
(3.27)

11.771***
(3.68)

11.369***
(3.29)

11.406***
(3.31)

11.334***
(3.29)

1.978
(1.12)

0.653
(0.36)

2.073
(1.17)

0.768
(0.42)

0.826
(0.45)

0.776
(0.42)

Quick ratio

-0.181
(-1.00)

-0.160
(-0.88)

-0.163
(-0.90)

-0.144
(-0.79)

-0.144
(-0.79)

-0.141
(-0.78)

0.215*
(1.80)

0.244**
(2.07)

0.209*
(1.75)

0.241**
(2.04)

0.236**
(1.99)

0.239**
(2.02)

Number of
segments

0.406***
(3.50)

0.399***
(3.41)

0.385***
(3.30)

0.380***
(3.23)

0.388***
(3.30)

0.385***
(3.27)

0.158**
(2.41)

0.171**
(2.57)

0.151**
(2.28)

0.162**
(2.42)

0.167**
(2.50)

0.166**
(2.48)

Industry

NO

YES

NO

YES

YES

YES

NO

YES

NO

YES

YES

YES

LR chi2

167.63

170.42

168.81

171.17

172.09

171.23

65.68

80.08

65.73

76.33

73.81

74.81

Pseudo R2

0.298

0.305

0.299

0.306

0.308

0.306

0.069

0.085

0.070

0.081

0.078

0.079

***, **, * significant at the 1%, 5%, and 10% levels, respectively.

27

Table 5
Foreign exchange risk exposure tests
This table shows the multiple regression results for the sample of 424 firms for fiscal year end 1998. The dependent variable
is the absolute value of foreign exchange risk exposure. We use three stage least squares to control endogeneity between
hedging and foreign exchange risk exposure. Also, we use the weighted least square method using one over squared standard
error of the coefficient of foreign exposure in equation (3). Foreign exchange risk exposure is calculated using the two factor
model (Jorion, 1990). To separate foreign exposure, we employ the indicator variable D, equal to 1 if the foreign exposure is
positive, otherwise equal to zero, following He and Ng (1998). The financial hedging ratio is measured as total currency
derivatives notional amount divided by total foreign activity. Operational hedging is measured by four different

proxies: Dispersion index I, Dispersion index II, log of number of subsidiaries and number of foreign countries.
Dispersion index I (Dispersion index II) is measured as one minus the Hirshman-Herfindahl index of the number of
countries (regions) where the company is located. Total foreign activity ratio is the sum of export sales and foreign sales
divided by total sales. Foreign debt is a dummy variable equal to 1 if the company reports the use of foreign debt, otherwise
zero. Industry is a dummy variable using the two digit SIC code. T-statistics are reported in parentheses. Adjusted R-squares
and F-statistics are reported.

Dispersion
index I

Dispersion
index I

Dispersion
index II

Log(Number of
subsidiaries)

Log(Number
of countries)

1.184***
(2.98)

2.016***
(3.26)

1.980***
(3.21)

2.001***
(3.18)

2.039***
(3.26)

D * financial
hedging ratio

-0.269***
(-5.90)

-0.293***
(-6.42)

-0.277***
(-6.00)

-0.279***
(-6.06)

-0.292***
(-6.40)

D * operational
hedging

-0.024
(-0.11)

-0.014
(-0.06)

-0.077
(-0.45)

-0.017
(-0.30)

-0.006
(-0.09)

D * foreign debt

0.178
(0.71)

0.201
(0.81)

0.194
(0.78)

0.201
(0.80)

0.207
(0.84)

D * total foreign
activity

0.198
(0.47)

0.145
(0.34)

0.201
(0.47)

0.179
(0.42)

0.148
(0.35)

D * log(total assets)

-0.055
(-0.94)

-0.055
(-0.93)

-0.049
(-0.85)

-0.050
(-0.82)

-0.054
(-0.88)

D * number of
segments

-0.002
(-0.03)

-0.008
(-0.14)

-0.007
(-0.14)

-0.009
(-0.16)

-0.008
(-0.15)

(1-D)

1.043***
(3.41)

1.869***
(3.32)

1.881***
(3.34)

1.876***
(3.28)

1.927***
(3.38)

(1-D)* financial
hedging ratio

-0.215***
(-3.91)

-0.237***
(-4.37)

-0.225***
(-4.13)

-0.221***
(-4.08)

-0.237***
(-4.41)

(1-D) * operational
hedging

0.159
(0.98)

0.162
(1.00)

0.198
(1.51)

0.031
(0.82)

0.054
(1.23)

(1-D) * foreign debt

-0.066
(-0.42)

-0.063
(-0.41)

-0.078
(-0.50)

-0.071
(-0.45)

-0.073
(-0.47)

(1-D)* total foreign

activity

-0.187
(-0.69)

-0.208
(-0.76)

-0.233
(-0.86)

-0.224
(-0.82)

-0.258
(-0.95)

(1-D) * log(total
assets)

-0.051
(-1.16)

-0.055
(-1.26)

-0.060
(-1.39)

-0.054
(-1.18)

-0.058
(-1.31)

(1-D) * number of
segments

0.097**
(2.25)

0.099**
(2.30)

0.095**
(2.20)

0.099**
(2.29)

0.096**
(2.23)

NO

YES

YES

YES

YES

Adjusted R square

0.553

0.551

0.553

0.551

0.552

F-statistics

35.98

24.18

24.35

24.16

24.20

Industry

***, **, * significant at the 1%, 5%, and 10% levels, respectively.

28

Table 6
Firm value effect tests (Tobins Q)
This table shows the multivariate regression results for the sample of 424 firms for fiscal year end 1998. The
dependent variable is Tobins Q, measured as the ratio of the market value of assets to book value of assets
following Chung and Pruitt (1994). The financial hedge ratio is total currency derivatives notional amount
divided by total foreign activity. Operational hedging is measured by four different proxies: Dispersion index I,
Dispersion index II, log of number of subsidiaries and log of number of countries. Dispersion Index I
(Dispersion Index II) is measured as one minus the Hirshman-Herfindahl index of the number of countries
(regions) where the company is located. The interaction variable is financial derivatives user variable multiplied
by operational hedging variables. Industry is a dummy variable using the two digit SIC code. White (1980)
corrected standard errors are reported in parentheses. Adjusted R-squares and F-statistics are reported.
Dispersion
index I
Intercept

0.316
(0.440)

Financial
hedging ratio

0.054*
(0.027)

0.333
(0.433)

0.283
(0.435)

0.343
(0.434)

0.051*
(0.028)
0.179**
(0.094)

Operational
hedging

Dispersion index
II

Foreign
derivatives*
operational
hedging

0.235*
(0.142)

0.289
(0.437)

Log(number of
subsidiaries)
0.390
(0.439)

0.052*
(0.028)
0.135*
(0.072)

-0.116
(0.151)

0.178*
(0.103)

0.314
(0.440)

Log(number of
countries)
0.390
(0.439)

0.056**
(0.028)
0.040
(0.021)

-0.087
(0.112)

0.078**
(0.035)

0.319
(0.440)
0.054*
(0.028)

0.048*
(0.025)

-0.052
(0.036)

0.084**
(0.042)
-0.053
(0.043)

Log(total
assets)

0.015
(0.030)

0.006
(0.031)

0.009
(0.031)

0.009
(0.031)

0.011
(0.030)

0.005
(0.031)

0.009
(0.031)

0.006
(0.031)

0.009
(0.031)

Total debt/
total assets

0.332
(0.250)

0.366
(0.255)

0.364
(0.255)

0.365
(0.255)

0.362
(0.255)

0.358
(0.253)

0.357
(0.253)

0.370
(0.255)

0.365
(0.254)

R&D/ total
assets

6.113***
(0.926)

6.027***
(0.929)

6.101***
(0.929)

6.045***
(0.926)

6.107***
(0.924)

6.036
(0.931)

6.131***
(0.924)

6.025***
(0.930)

6.109***
(0.923)

Capital exp /
total assets

0.145
(0.662)

0.114
(0.652)

0.168
(0.655)

0.098
(0.657)

0.140
(0.661)

0.118
(0.658)

0.174
(0.664)

0.103
(0.657)

0.155
(0.663)

Return on
assets

3.625***
(0.574)

3.675***
(0.578)

3.632***
(0.571)

3.675***
(0.579)

3.630***
(0.572)

3.670
(0.580)

3.615***
(0.571)

3.676***
(0.580)

3.622***
(0.572)

Number of
segments

0.015
(0.020)

0.013
(0.020)

0.014
(0.020)

0.011
(0.020)

0.013
(0.020)

0.011
(0.020)

0.013
(0.020)

0.011
(0.020)

0.012
(0.020)

Credit rating

YES

YES

YES

YES

YES

YES

YES

YES

YES

Industry

YES

YES

YES

YES

YES

YES

YES

YES

YES

Adjusted
R-squares

0.377

0.377

0.379

0.378

0.378

0.376

0.380

0.377

0.380

F-statistics

13.49

13.49

12.44

13.48

12.44

13.45

12.53

13.49

12.51

***, **, * significant at the 1%, 5%, and 10% levels, respectively.

29