Foreign Currency Debt Financing, Firm Value, and Risk: Evidence from Korea Surrounding the Global Financial Crisis

Abstract

We examine the valuation effect of foreign currency (FC) debt financing, relative to local currency (LC) debt financing. Employing extensive data from Korean firms during 2002–2012, we document strong evidence that firms using FC debt financing have significantly lower values than firms using LC debt financing. Even during the pre‐global financial crisis period when the LC value appreciated, we find no evidence of a higher firm value associated with FC debt financing. Further analyses on the possible causes of the negative association of FC debt and firm value reject the conjecture of higher firm risk resulting from the usage of FC debt but lend empirical support for the inefficiency in hedging by Korean firms. While the heavy usages of currency derivatives by Korean firms with FC debt financing lead to lower firm risk, such usages fail to generate higher firm values mainly due to their inefficient and improper hedging with currency derivatives. Our empirical results remain robust to different model and sample specifications.

Hedging operating and financing risk with financial derivatives during the global financial crisis

“…The negative effect of foreign currency debt on firm value reaffirms Korean firms' exposures to increased financing risk and capital costs through the serious liquidity and currency mismatches that the record‐level of foreign currency debt brought during the crisis, deteriorating Korean firms' business performance. This finding is consistent with the evidence in previous studies (e.g., Allayannis et al, 2003; Bae et al, 2016).…”

“…Financing risk wise, foreign currency debt ratio of Korean firms reached a record level of 6.4% during the global financial crisis, which was a significant increase from its precrisis level of 6.1% and a level well above their foreign currency assets ratio of 5.3% (Bae et al, 2016). Accordingly, Korean firms were exposed to increased financing risk through a serious liquidity mismatch between foreign currency debt and foreign currency assets, causing their financial positions to worsen.…”

Currency derivatives for hedging: New evidence on determinants, firm risk, and performance

“…It is also shown that sample Korean firms incur an average loss of 0.08% of total assets from currency derivatives transactions during our sample period, and that high EXE firms incur significantly larger transaction losses than low EXE firms (0.14% vs. 0.01%). These findings suggest the possibilities of ineffective and complex risk management programs (Copeland & Joshi, ; Hagelin & Pramborg, ), implementation of non‐optimal hedges and excessive costs of currency derivatives use (Bae et al, ); and/or constraints in managing foreign exchange risk (Allayannis et al, ; Clark & Judge, ).…”

“…For example, firms often fail to employ optimal hedge ratios or proper transactions of currency derivatives for hedging, thus, either over‐ or under‐hedging their exchange rate exposures. Then, the consequence would be such that as currency derivatives use may reduce foreign exchange risk, this reduction in risk may not necessarily lead to an increase in firm value due to the non‐optimal hedging and/or excessive costs of hedging (Bae et al, ). To this end, our paper takes empirical approaches distinctively different from those in the existing studies.…”

“…On the one hand, several studies have advanced rationales for the positive effect of corporate hedging with derivatives on firm value: reduced corporate tax liability generated by less volatile profits (Graham & Smith, ; Smith & Stulz, ); reduced cost of underinvestment associated with a reduction in the agency conflict between bondholders and shareholders (Bessembinder, ; Froot, Scharfstein, & Stein, ); reduced financial distress costs that also facilitate higher leverage (Leland, ; Smith & Stulz, ). On the other hand, other studies have referred to rationales for the negative or no valuation effects of hedging with currency derivatives: ineffective and complex risk management program (Copeland & Joshi, ; Hagelin & Pramborg, ); managerial motives to invest in value‐reducing projects with protected capital (Tufano, ); failure to implement optimal hedge ratios and excessive costs of using currency derivatives (Bae, Kim, & Kwon, ); underdeveloped derivatives markets and constraints in managing foreign exchange risk (Allayannis, Brown, & Klapper, ; Clark & Judge, ).…”