The empirical literature on the use of foreign currency debt by non-financial firms follows two somewhat related paths. The first strand of literature investigates why firms use or issue foreign currency debt (Allayannis and Ofek (2001), Keloharju and Niskanen (2001), Kedia and Mozumdar (2002)). This literature finds strong support for the use of foreign debt as a hedge for foreign currency exposure. There is also some support for the firms’ choice of currency of debt being influenced by differences in the cost of debt in different currencies due to capital market imperfections (Keloharju and Niskanen (2001) and Kedia and Mozumdar (2002)).
The second strand of this literature examines whether foreign debt and foreign currency derivatives are used as substitutes or complements when hedging foreign currency exposure (Géczy, Minton and Schrand (1997), Allayannis and Ofek (2001), Elliot, Huffman and Makar (2003)). In this literature there is support for the notion that foreign debt acts as a substitute for foreign currency derivatives but there is also evidence which shows that the type or source of exposure might influence the choice of hedging strategy (Allayannis and Ofek (2001). This paper examines a firm’s decision on the choice of foreign currency hedging method, comparing foreign currency derivatives and foreign debt, in order to determine whether they are seen as substitutes or complements. In examining whether foreign currency derivatives substitute for or complement foreign debt this paper identifies firm characteristics that have not been previously considered and is the first paper to investigate this issue using non-US data.
Most previous studies conduct tests employing firms that use foreign currency derivatives such as forwards, futures, options and swaps and firms that use foreign currency debt. Their results suggest that foreign currency derivatives substitute for the use of foreign debt in hedging foreign currency exposure. However, these studies fail to distinguish between derivative instruments that are potentially better suited for hedging short-term transaction exposures, such as forward, futures and options and those that are appropriate for hedging long-term multiple period foreign currency exposures, such as foreign currency swaps. This paper argues that empirical tests need to be more explicit about which types of foreign currency derivative might substitute for or complement foreign debt. Therefore, unlike previous studies, the tests in this study control for the type of derivative distinguishing between foreign currency forwards, futures, options on the one hand and currency swaps on the other. Furthermore, the tests also, for the first time to my knowledge, control for the type of foreign currency swap distinguishing between firms that swap foreign debt into domestic debt and firms that swap domestic or foreign debt into foreign debt.
This distinction is important because using foreign currency swaps or issuing foreign debt are not necessarily substitute hedging strategies. For example, a firm that swaps foreign debt into domestic debt to match domestic assets would treat currency swaps and foreign debt as complements, rather than as substitutes. However, a firm wishing to create a foreign currency liability to hedge a foreign operations exposure could achieve this either by swapping debt into the desired foreign currency or issuing debt directly in the desired foreign currency. Therefore, in this second scenario swapping into foreign debt or issuing the desired foreign debt directly are substitute strategies. Clearly breaking down the use of foreign currency derivatives by derivative type facilitates more effective comparisons between the use of foreign currency derivatives and foreign debt. This makes the empirical tests in this paper far more comprehensive than those conducted in previous empirical studies. In addition to distinguishing between firms that swap into domestic debt and firms that swap into foreign debt, this study identifies two types of firm swapping into foreign debt. These are firms that create foreign liabilities using combinations of foreign currency swap and direct foreign debt and firms that only use foreign currency swaps for this purpose. For the latter all of their foreign debt is synthetic foreign debt.
The results in this paper show that firms prefer to use foreign currency debt rather than foreign currency forwards or options to hedge foreign currency exposure arising from assets located in foreign locations. Conversely, the evidence shows that firms engaged in exporting prefer the use of foreign currency forwards or options to the use of foreign currency debt. These results suggest that foreign currency derivatives, such as forwards and options, and foreign currency debt are complementary rather than competing strategies for managing foreign currency exposure.
