Firm complexity and FX derivatives use.(foreign exchange )(Author abstract)

Introduction

Complexity is the degree of information asymmetry between managers' and shareholders' knowledge of a firm's cash flows and risks to those cash flows. It is the amount of information that would have to be transmitted to eliminate the asymmetry. We have two main interests in this research: to test a complexity theory of corporate FX derivatives use and to test it simultaneously against six other theories using structural equations methods common in other disciplines but dormant in finance since Titman and Wessels (1988).

Why do many firms manage foreign exchange (FX) exposures at the firm level rather than devolving the responsibility to shareholders? Researchers have examined a number of deviations from perfect markets assumptions, including underinvestment, managerial interests, financial distress, scale economies, and tax convexity. Corporate treasurers often cite an additional reason, however: the quantity of information that would have to be conveyed to shareholders and the impediments to doing so. Consider, for example, the comments of Berenson (2001): "Even medium-sized companies often have offices and sales around the world. No shareholder could personally check all of the operations ..." Discussions with treasurers also reveal that even the most financially sophisticated firms face challenges in maintaining corporate awareness of the FX exposures of foreign business units.

DeMarzo and Duffle (1991, 1995) analyze theoretical models of FX exposure management in which it is infeasible or inefficient for stockholders to receive sufficient information to manage their individual portions of those exposures. Firm complexity, strategic interest in safeguarding proprietary business plans, and fixed and decreasing hedging costs are among the reasons cited. One implication is that shareholders might best execute homemade FX exposure management for a simple domestic firm operating in a single, mature, well-understood industry. More complex firms operating in several industries, countries, and new technologies may be less amenable to shareholder hedging.

Firms face two levels of decisions about FX exposures. First is the qualitative decision of whether the benefits exceed the costs of preparing for, establishing, maintaining, and monitoring a hedging program. For those that embark on a program, a second, quantitative decision is the extent of hedging positions. We think of these respectively as the use decision and the extent decision. Here we develop empirical counterparts for complexity and other hedging theories and simultaneously test their ability to explain hedging use and extent. Our data set comprises all US nonfinancial firms with sales of $1 billion or more.

Previous empirical studies generally examine the use decision with nonparametric bivariate methods and with probit regression. Those with quantitative data on hedging positions also perform tobit or heckit analysis, both of which correct for the censoring of the hedging positions at zero. In contrast, we simultaneously estimate the two equations for use-no use and extent of use. We also correct for the censored nature of extent, but with a maximum likelihood approach different from tobit or heckit. In addition to these structural equations, we simultaneously estimate seven measurement equations that relate seven theoretical concepts to 11 observable proxies.

We find clear evidence that links complexity, managerial options ownership, financial distress, and primitive risk to FX derivatives behavior. Our estimates do not support underinvestment or scale economies theories in explaining hedging.