The determinants of currency derivatives usage among Indian non-financial firms

Abstract

Purpose Theoretical studies suggest that hedging helps firms to reduce their financial distress costs and underinvestment problem especially if the markets are imperfect. Hence hedging, through the use of currency derivatives, is one of the important financial policies for firms. The purpose of this paper is to empirically examine the determinants of derivatives usage by Indian firms using financial disclosures on currency derivatives by non-financial constituents of S&P CNX 500 for 2009. Design/methodology/approach We manually collect the data on foreign currency derivatives from firms’ annual reports for 2009 and then follow Haushalter’s (2000) approach to examine the determinants of firms’ decision to hedge. A firm can make its hedging decision at once, deciding whether to hedge and how much to hedge. Given the nature of dependent variable that is censored, it is appropriate to use Tobit regression. A firm can also decide its hedging decision in two steps by deciding first on whether to hedge and later how much to hedge. The former is modelled by probit regression and later by conditional regression. Findings Our empirical evidence suggests that forwards are the main instruments for managing currency risk followed by options and swaps. The objectives, in the order of priority, are reduction in exposure associated with foreign currency receivables, foreign currency long-term loans and foreign currency payables. Firm’s decision to hedge is positively related to size, foreign exchange exposure and leverage, while negatively related to liquidity and investment opportunities. We find evidence of higher derivative usage by firms with both higher currency risk and higher financial distress costs. Practical implications The findings of this paper will help corporates, researchers and regulators to understand firms’ motives behind hedging. Originality/value This is the first empirical study that examines the determinants of firm’s decision to hedge and the extent of hedging in the context of emerging economies like India.