Non-financial firms hedging risks in East Asia: the link between financial derivatives use, firm value and exposures to country risks

Derivatives have been used widely in the world over the last 30 years as an important risk management instrument. Although theoretical researchers suggest that derivatives usage can enhance value of a firm by alleviating costs arising from several market imperfections, the existing evidence is not quite consistent among empirical studies up to date. The purpose of this chapter, therefore, aims to examine determinants of derivatives use, a relationship between derivatives use, firm value and exposures for a sample of 881 non-financial firms in eight East Asian countries in the 2003–2013 period. The analysis is based on a novel and manually collected data.
We find that firms in countries with lower corruption have more incentive to use financial derivatives and use derivatives with greater intensity than those firms located in highly corrupt countries. Better governance induces firms to use derivatives to hedge exposure and mitigate costs. Firms in countries with weak governance use derivatives for speculating and/or selective hedging or self-management purposes. Overall, our findings provide strong evidence of the role of countries’ governance quality in driving firms’ derivatives-related behaviors. This macro-based effect on derivatives use is independent from firm-specific factors, which are frequently invoked by hedging theories.
Regarding relationship between firm value and derivatives use, using Tobin’s Q as a proxy of firm value, we find that low corruption level of home country (host country) induces the use of financial derivatives and rewards domestic firms and domestic MNCs (foreign affiliates) with higher value. Hedging behavior of domestic MNCs outperforms domestic firms and foreign affiliates in terms of firm value. Derivative usage is value-enhancing activity for domestic firms and domestic MNCs, but it does not add value for foreign affiliates.
Finally, we measure exposure to home (host) country risks, and provide novel evidence that financial hedging of domestic firms and domestic MNCs reduces exposure to home country risks by 10.91% and 14.42% per 1%increase in national derivative holdings, respectively, while affiliates of foreign MNCs fail to mitigate exposure to host country risks. Domestic MNCs with derivatives activities reduce exposures of a larger magnitude than do other firms.