The Impact of Corporate Derivative Usage on Foreign Exchange Risk Exposure

This paper not only determines why individual firms use foreign currency derivative but investigates also what effects this derivatives usage has on the foreign exchange risk exposure of 471 European nonfinancial firms. We find strong evidence in favor of the existence of economies of scale in hedging and show that European firms engage in hedging programs in response to tax convexity. Results tend to support financial distress motives to hedge, but no evidence is found in favor of agency costs related motives. Whereas the degree of international involvement strongly determines the magnitude and significance of a firm’s exchange rate exposure, it appears that large firms benefit from the diversification of their foreign operations and are to a greater extent capable of implementing operational hedging strategies. Our findings show furthermore that European firms use FCDs to hedge – and not to speculate –. The statistically weak effects these hedging strategies have on firms’ currency exposures reveal, however, that European companies are hedging only a small proportion of the currency risk they are facing.