3. Prior New Zealand Evidence
A number of New Zealand studies have examined the hedging behaviour of listed New Zealand corporates using information that these firms have been required to disclose since the early 1990s. Some detailed survey evidence is also available.
Berkman and Bradbury (1996) use data from New Zealand Stock Exchange (NZSE, now NZX) listed firms (excluding foreign firms and financial firms) on the fair value and the contract value of off- and on-balance sheet financial instruments. None of the 116 firms in the sample indicate that derivative financial instruments are used for speculative purposes.12 They test standard theories of firms' hedging choices, estimating a Tobit model (using fair value and contract value respectively as dependent variables), with a wide range of independent variables: firm market value; interest cover; leverage; tax loss; earnings-price ratio; asset growth/cash flow; managerial share ownership; liquidity; dividend payout; alternative capital instruments; and proportion of overseas assets.
Their results support the view that firms use derivatives to reduce costs of financial distress and to increase the present value of tax losses; a high proportion of liquid assets and a low dividend payout ratio reduce the use of derivatives. Ownership may affect derivative usage, with managers who are part-owners of the firm using derivatives to reduce the variability of firm value. When fair value is used as the measure of hedging activity, Berkman and Bradbury find support for the hypothesis that derivative use is positively related to the value of a firm's growth options.
Berkman et al (1997) report a survey of NZSE listed firms,13 finding that 53% of firms use derivatives (compared with 48% in Berkman and Bradbury). The use of derivatives is strongly correlated with size: 100% of firms with market value of equity greater than US$250 million use derivatives (compared with 65% in the United States; Bodnar et al, 1995); 70% between $50-$250 million use derivatives; 36% with less than $50 million of equity use derivatives (compared with 12% in the United States). Thus New Zealand listed corporate derivative use increases with firm size, and New Zealand corporates use derivatives considerably more than do US firms. The latter result may possibly be due to greater currency exposures for New Zealand compared with US firms. Derivative usage amongst the surveyed New Zealand corporates also varied considerably by sector with usage rates of: 29% for commodity-based firms; 82% for non-durables manufacturing firms; 86% for durables manufacturing firms; 73% for transport & utility firms; 86% for retail & wholesale firms; and 32% for services firms.14
Of the firms that use derivatives, approximately 80% use forward contracts to hedge foreign currency exposures. Firms reported that their main currency exposures were to the US dollar (68.6%) and the Australian dollar (28.5%); the next highest was 2.9% for the Japanese yen. Firms further claimed that derivatives are mainly used to reduce funding costs (69%),15 to hedge contractual commitments (79%); and to reduce fluctuations in earnings (62%).16 None claimed to be using derivatives for speculating. If these claims are accurate, we would not expect to observe selective hedging amongst New Zealand corporates over this period.
Reynolds and Boyle (2006) undertook similar analysis to that of Berkman and Bradbury using 1999 data for 105 domestic non-financial NZSE listed firms. They relate these data to results for sectoral use of currency derivatives from earlier surveys by Marsden and Prevost. The sectoral proportions of firms that use currency derivatives in 1994, 1997, 1999 are: primary sector: 33%, 33%, 50%; other goods sectors: 44%, 50%, 86%; and services/property/IT sectors: 30%, 21%, 36%. This evidence indicates quite different usage rates across years even after controlling for sector. This may indicate either selective hedging or learning behaviour (with a strongly increasing usage rate for the other goods sector and, to a lesser extent, for the primary sector).
Reynolds and Boyle use Tobit analysis to estimate the level of derivative use given that a firm chooses to use derivatives, and logit analysis to evaluate the binary decision to use derivatives. Dependent variables are fair value and contract value of derivative contracts scaled by market value of the firm. Explanatory variables include: Tobin's Q; asset growth; existence of tax-loss carry-forwards; interest cover ratio; leverage; firm value; ownership characteristics; alternative capital instruments; liquidity; dividend payout ratio; overseas assets; and sector dummies. They consider inclusion of R&D expenditures to represent a firm's investment opportunities but are unable to do so since there is no requirement for New Zealand firms to publicly report R&D expenditure. Contrary to the hypothesis of Froot et al (1993), but consistent with the previously cited New Zealand evidence, they find that higher growth firms are less likely to use derivative contracts. Consistent with a wide body of evidence, leverage is positively related to derivative usage, and larger firms are more likely to use derivatives; sectoral effects are also important. Reynolds and Boyle find that tax-loss carry-forwards do not explain the extent of derivative usage; while liquidity (contrary to theory) is related positively to derivative usage.
A larger scale survey (Grimes et al, 2000) sheds more detailed light on the nature of New Zealand firms' currency hedging practices related to transactions with Australia (New Zealand's single largest trading partner). The authors conducted a survey of New Zealand firms, as a special part of the November 1999 National Bank of New Zealand Business Outlook Survey, with questions relating to currency denomination of exports to Australia and currency hedging practices. Unlike prior studies, this survey covered a wide range of firms, being sent to approximately 1,500 firms with responses from 409 firms. Of the respondents, 117 firms had 0-5 employees, 81 had 6-10, 70 had 11-20, 68 had 21-50, and 68 had over 50 employees (5 did not indicate size); the predominance of smaller firms reflects the size distribution of New Zealand firms. The survey included 100 manufacturing firms, 64 agriculture firms, 194 services firms, and 51 "other" firms; 64 firms had exports of at least 50% of total sales, while 53 firms had exports to Australia comprising at least 10% of total sales.
The survey included 138 exporters to Australia that reported the currency denomination of their Australian exports. These comprised New Zealand dollars (NZD, 46%), Australian dollars (AUD, 46%), US dollars (USD, 2%), "Other" (0%) and "Mixed" (5%).17 Currency denomination varied considerably by sector with Manufacturing (31% NZD, 66% AUD, 3% USD/Mixed); Agriculture (69% NZD, 15% AUD, 15% USD/Mixed); Services (62% NZD, 29% AUD, 10% USD/Mixed); Other Sectors (50% NZD, 38% AUD, 13% USD/Mixed).18
Within the survey, 173 firms indicated their hedging practices with respect to AUD exposures: 61% hedged none of these exposures, 9% hedged all exposures, while 30% hedged some exposures. In addition, 172 firms indicated their hedging practices with respect to non-AUD currency exposures: 52% hedged none of these exposures; 8% hedged all exposures; while 41% hedged some exposures. Firms did not generally consider hedging costs to be high: 81% of firms answered that AUD hedging costs were low or very low (on a five point scale); 72% answered that non-AUD hedging costs were low or very low. A higher proportion of smaller firms (less than 50 employees) found AUD hedging costs to be high than did larger firms.19
Finally, the study analysed actual hedging practices of firms that exported at least 10% of their sales to Australia. This revealed strongly divergent hedging practices between small and large firms. Of small firms (<25 employees) 80% hedged none of their AUD exposures (and 82% hedged none of their non-AUD exposures) compared with 7% and 10% respectively for large firms (>50 employees); mid-sized firms sat between these extremes. None of the small firms hedged all of their AUD or non-AUD exposures compared with 36% (AUD) and 19% (non-AUD) for large firms. This evidence is consistent with prior findings that firm size if positively correlated with currency hedging.20
In a paper in the Reserve Bank of New Zealand Bulletin, Brookes et al (2000) discuss corporate use of currency hedging instruments. They differentiate between short run volatility of "up to an annual frequency" and longer cycles "that last a year or more" (see their Fig 1, p.23, reproduced below). The figure, and the concept of an exchange rate "cycle", implies that the exchange rate exhibits mean reversion of the type considered relevant for oil price hedging by Meredith (2006).
Figure 1: Exchange Rate Fluctuations: Short-term and Long-term Cycles
Source: Brookes et al (2000), p.23.
Brookes et al base their discussion of currency hedging practices in part on interviews with New Zealand firms. They consider that the forward points component of forward exchange rates (reflecting interest rate differentials) influences New Zealand firms' perceptions of the cost of forward contracts, and hence their willingness to use them. As an example, they note that NZD interest rates have consistently been above most trading partner interest rates, meaning that forward selling rates for foreign currencies against the NZD were generally below the spot rate. This was perceived as an inducement for exporters to hedge, and for importers not to. They explain, however, that if forward points are part of an arbitrage condition, they are not an added cost or benefit, and to consider them as such represents a misperception on the part of firms.21
Reflecting the survey findings of Grimes et al (2000), Brookes et al note that forward contracts are virtually costless to the user. They provide an excellent hedge against short-term exchange rate exposures (e.g. for near-term, contracted export sales); however, hedging for longer-term exchange rate cycles is more problematic. This is especially the case when export sales are uncertain, in which case a forward contract can lead to firms taking an unintended currency position if the expected export sale does not eventuate.22
While forward contracts do not result in material direct costs, they do impose an indirect cost by utilising credit lines, with the size of the credit allocation increasing as the length of the forward contract increases. Small and/or highly leveraged firms are most likely to be affected by this crowding out of access to credit, and so may make less use of forwards than do large firms. Accounting requirements may also affect use of forwards for longer term hedges which are not be tied to an explicit transaction, so creating reported earnings volatility.
Currency hedges other than forward contracts are also available, including options, balance sheet hedging and natural hedges. Use of foreign currency loans may be an avenue that is available to larger corporates; thus hedging using forwards could conceivably be more prevalent for smaller firms (contrary to the usual scale argument). Invoicing exports in local currency is another method of hedging. However the authors note that this does not automatically represent an economic hedge, especially where the local currency price varies in a spot fashion to reflect exchange rate changes.
Brookes et al argue that forwards have advantages for short-term transactions owing to their relative flexibility: "Contracts can readily be rolled forward, or closed out, according to the firm's view of the exchange rate." (p.27). To the extent that this comment is a reflection of firms' views, it indicates that selective hedging, based on prospective exchange rate views, is an approach adopted by some New Zealand firms. This comment is consistent also with the notion (reflected in Figure 1) that the NZD exhibits longer term mean reversion properties.
The authors conclude that New Zealand firms tend to limit currency hedging to relatively short horizons and to "ride out" longer-term cycles, with long-term hedging perceived to be risky. They perceive a general pattern of substantial hedging of known trade receipts and payments out to six months, with less cover for flows expected between six and twelve months ahead, and a rapid fall-off in the extent of cover for transactions expected to occur beyond twelve months.
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