A derivative is any financial instrument whose pay off depend directly on the value of an underlying variable. Usually derivatives are promises or contracts to sell or buy the underlying asset at a future date with both the price quantity and other specifications defined. Contracts can be binding to both parties and one party with the other party reserving the option to exercise or not. Derivatives usually trade in organized stages as well as over the counter. Firms today face many risks; hence they have adapted to new ways of hedging against them. Common types of derivatives used include interest swaps, options, future and forward contracts. Derivatives speculate losses; hence the investors are able to minimize on the possible losses.
The main goal and purpose of this research paper is to set up a hypothesis that examines the possible outcome of using foreign currency derivatives on the value of firms. Ways in which firms engage in these derivatives will also be of interest to us. At the end of the research paper, the reader will be able to understand the direct relationship between the use of foreign currency derivatives and the firm market value.
The key issues addressed are how currency derivatives affect the value of a firm by hedging against the exchange rate movements, why firms that use other types of derivatives still use currency derivatives. Non-hedgers argue that the high interest rates incurred in the premium are loses rather than profits since the whole basis is speculation. Various scholars have blushed away the whole idea of hedging and insist on holding of a well diversified portfolio. This is the case argued by Modigliani and Miller. They hold that risk management is of great irrelevance to firms. There is little argument in the literature as to why there is an increase in the use of the derivatives in hedging in aiming to increase the firm’s value. Therefore, the relationship between hedging and market value will be examined.
For many firms, the use of foreign currency derivatives (FCDs) yields high returns to the investor, as it may, for example, considerably mitigate underinvestment. The firms are, therefore, prone to exchange rate movements due to import and export activities. A firm that does not use foreign currency may not be affected by fluctuations in the exchange rates. Hence it becomes essential for the firms trading in foreign currency to hedge against these variations and make high returns.
For firms with foreign transactions, their value is likely to be influenced by the exchange rate performance over the year. Assuming a firm with a long position in the foreign currency has sales, the rewards of hedging will be more the year the dollar appreciates. Hedging is comparatively less beneficial in the year the dollar depreciates to non-hedged firms than hedged firms. Hedging adds value to firms during both the dollar's appreciating and the dollar's depreciating stage. It becomes clear that hedging payment is much greater during those years in which the dollar has appreciated.
The research on derivatives cannot be propagated further without mentioning other researchers who have written about the same. Several theories introduced reach at optimal policies through improvements in the Modigliani and Miller model. Stulz, a scholar argues that risk aversion is what propels corporate hedging. He also argues that the introduction of taxes and financial distress costs such as bankruptcy can push the models of corporate hedging to the optimum. Some argue that hedging can increase investment hence avoid the problem of cash flows and high costs due to external financing. Other scholars state that optimal hedging is only possible when investors have complete information on the expected market returns.
The universal unavailability of facts on hedging activities affects empirical assessment of hedging theories. During the early 90’s and toady, disclosing of firm's positions in currency derivatives is not possible and considers an essential constituent of strategic competitiveness. Recent empirical studies, distinguish between the various types of hedging employed; explaining the different factors that are critical for each.
All these studies above scrutinize factors that affect a firm’s decision to use derivatives. The studies have shown that the currency derivatives are used to mitigate risk exposure rather than speculating. The strategy behind the use of derivatives is to increase the value of the firm. Therefore a hypothesis will be developed to investigate whether the use of derivatives in firms increases the value net worth.
The study data develops from a sample population conducted. Financial firms are, however, not included in the study as most of them are market makers and their motivation in using the currency derivatives may be different. For the firms in the sample, it was outright that firms that engage in foreign currency risks need to hedge themselves against losses due to the high investments they usually make.
A Tobin's Q is a proxy for a firm's net worth. Tobin's Q refers to the ratio of the market return of the firm to costs of replacement of assets evaluated at the year end. The replacement cost of assets is calculated as the total of the replacement cost of fixed assets plus inventories. It’s estimated that the replacement cost of fixed assets is by inferring the depreciation design of gross fixed assets. To calculate the market value of the firm's debt, the Tobin incorporates and determines the relationship between the parameters to be examined.
To conclude that hedging increases the net worth of the firm, we need to eliminate the effect of all other variables that could have an effect on firm value. Various controls describe the reason that we use those variables in our multivariate tests and the theoretical ground that led us to use them. Many factors can be attributed to the use of derivatives in firms. The size of the firm affects in that the larger the firm, the higher the likelihood there is for the firm to use the derivatives. Availability of large fixed start-up costs makes it easy to use the derivatives.
Access to financial markets stimulates the investor to use the derivatives as their net present value is high due to the high returns from venturing into many markets. Some firms have enough leverage due to the high long-debt. Also, a profitable firm is likely to trade at a premium relative to a less profitable one. Thus, if hedgers find it more profitable, they will have a higher ratio and use more derivatives.
This article has thoroughly examined the use of FCDs and the exact relationship between their use and the net worth of a company. Examination of firms exposed to currency exposure investigates whether investors with a high market valuation, gets returns from foreign currency derivatives. The Tobin Q as an approximation provides significant evidence that the use of FCDs positively relates with the firm market value. Many firms continue hedging against loss due to the high investment they have made.