Equity-linked executive compensation,hedging and foreign exchange exposure: Australian evidence

Abstract

Using a sample of 268 Australian firms over the period 2009–2014, we examine the relation between the equity-linked compensation (shares and options) of Australian executives – CEOs, CFOs and directors – and firms’ foreign exchange hedging programmes. We find that the greater the number of shares held by CEOs, the higher its exposure to exchange rate movements. While this suggests that remuneration in the form of shares has a critical downside, we also find evidence for a more positive and important role in foreign exchange risk management for the share- and option-related incentives provided to CFOs.

JEL Classification: G32, G15, F31

Keywords

Derivatives executive compensation foreign exchange exposure hedging options shareholdings

1. Introduction

Australian companies’ executive remuneration has come under the spotlight in recent years. Analysis by the Australian Council of Superannuation Investors (2017) reveals that the mean realised pay of ASX100 firms’ CEO rose 9.3% to Aus$6.23 million in the financial year ending 2017, relative to the previous year – an all-time high. While Australian companies justify the high executive remuneration as essential to attracting top executives from the global talent pool, shareholder groups have argued that remuneration is often excessive – particularly relative to firms’ performance. An important question for firms is how best to structure executive remuneration to ensure that executives act in shareholders’ interest. This issue became particularly pertinent following the 2008 financial crisis, when large equity-related bonuses were blamed for excessive risk-taking. In this article, we investigate the relation between executive compensation, currency hedging and foreign exchange (FX) exposure, in the context of Australian firms’ FX risk management.

FX exposure is a major financial risk faced by firms in an increasingly global economy. In heightening the volatility of firms’ expected future cash flows, exposure to exchange rate movements reduces firm value (Smith and Stulz, 1985) – by increasing expected financial distress costs, enhancing the cost of debt and reducing debt capacity, and exacerbating underinvestment problems (Froot et al., 1993; Smith and Stulz, 1985; Stulz, 1984). Hedging FX risks moderates cash flow volatility and alleviates these concerns. An alternative theoretical perspective invokes agency theory (Smith and Stulz, 1985; Stulz, 1984): managers may hedge in their own interests (or ‘overhedge’) because their personal wealth and utility is tied to the value of the firm.

Empirical support for these theories is mixed. Some studies find that firms use derivatives to maximise shareholder value (Géczy et al., 1997; Mian, 1996; Nance et al., 1993; Nguyen and Faff, 2003), whereas others find support for the managerial risk aversion theories of hedging (Knopf et al., 2002; Kumar and Rabinovitch, 2013; Tufano, 1996). Executive compensation can affect the extent to which hedging is undertaken by the firm. Stulz (1984) and Smith and Stulz (1985) show theoretically that convex compensation contracts, such as those involving options, can discourage managers from hedging because their wealth is an increasing function of firm volatility. This incentive can apply for share as well as option holdings, because shares replicate the payoff of an option written on the firm (Jensen and Meckling, 1976). Rogers (2002) and Coles et al. (2006) show empirically that firms whose managers’ wealth is sensitive to the value of the firm – that is, those who have substantial holdings of stock – are in fact more likely to hedge with derivatives. In the Australian context, Nguyen and Faff’s (2002) finding supports Stulz (1984) and Smith and Stulz (1985): the greater the executive’s shareholding, the less likely that derivatives hedging is undertaken, suggesting that managers are incentivised not to hedge when they hold shares.

Using a sample of 268 firms over the period 2009–2014, we examine the relation between the equity-linked compensation of Australian executives – CEOs, CFOs and directors – and firms’ FX derivatives hedging and FX exposure. CEOs, CFOs and directors are likely to have different degrees of influence on decision-making regarding risk management as a result of divergent expertise, incentives and access to information. For example, CEOs have the greatest influence over the firm’s strategic direction and broader policies, while CFOs are likely to have the more sway over policies that require specialised financial knowledge (Chava and Purnanandam, 2010; Jiang et al., 2010; Kim et al., 2011). Since FX risk management is complex, and requires specialised financial expertise (Nance et al., 1993), we would expect that the incentives faced by CFOs are of greater magnitude in determining the firm’s hedging policies than the incentives faced by CEOs. Directors are likely to influence the firm’s FX risk-management practices via their monitoring and advisory activities.

We look at the effect of both income and wealth measures of equity-linked executive remuneration. We begin by examining the effect of value of shares and options in the executive’s annual compensation package (as a proportion of total compensation). We find very little impact of these income measures on the extent of FX derivatives use and the exposure outcome. This is perhaps not surprising given that annual share and option grants are likely to comprise a relatively small proportion of executives’ wealth – and so are less likely to affect their risk-management behaviour.

Our findings are stronger when we examine the value of executives’ share and options holdings. We find an inverse U-shaped relation between the CEO’s shareholding and the likelihood that the firm hedges with derivatives. At low levels of CEO shareholding, a rise in shareholding is associated with a greater likelihood of derivatives hedging. At higher levels of CEO shareholdings, firms are less likely to use FX derivatives for hedging purposes as holdings increase. The former suggests that CEOs with lower shareholdings have an incentive to hedge, consistent with Rogers (2002) and Coles et al. (2006). The latter may be explained by the fact that substantial shareholdings provide the CEO with the incentive not to hedge; such CEOs may favour enhanced cash flow volatility because the value of a levered firm’s equity rises with its volatility (Jensen and Meckling, 1976). We find a corresponding positive (linear) relation between the CEO’s shareholding and FX exposure. These findings together constitute evidence that for firms in which the CEO’s shareholdings are substantial, insufficient hedging is being undertaken and FX exposure is enhanced.

In the CFO subsample, we find no relation between CFOs’ option and shareholdings and the use of FX derivatives. However, we find an inverse U-shaped relation between FX exposure and CFOs’ share and option holdings. At high levels of equity-linked holdings, exposure falls as shareholdings rise; CFOs with substantial share and options holdings appear to be ensuring – via hedging approaches such as using foreign currency debt or swaps, or possibly by advising the firm on optimal operational hedging – that the firm acts to manage its FX risk. At low levels of holdings, in contrast, an increase in the CFO’s holdings is associated with a rise in the firm’s FX exposure – suggesting that the incentive is not to hedge. These findings suggest that where CFOs’ holdings of equity-linked securities have a high value, firms see the alignment of their interests with those of shareholders, whereas when CFOs’ holdings of shares and options are more modest, they seem to be incentivised to not hedge optimally – perhaps because they like the enhancement of share and option value that results from higher cash flow volatility.

In the director subsample, our FX exposure results are similar to our findings for CFOs: an inverse U-shaped relation between directors’ shareholdings and FX exposure. Where directors have substantial shareholdings, the firm experiences lower FX exposure. This is evidence for a ‘skin in the game’ argument: such directors effectively monitor the firm’s managers to ensure that they act in shareholders’ interests and hedge FX exposure. At lower levels of shareholdings, however, directors’ incentives appear to be directed towards maximising cash flow volatility by allowing sub-optimal hedging.

Our results are robust to controls for endogeneity issues, and the use of the bilateral exchange rates of Australia’s major trading partners – the United States, Japan and China – in lieu of the trade-weighted exchange rate. Furthermore, we split our sample period into two periods based on the direction of the Australian dollar – appreciation and depreciation – and find that our main results hold.¹

This article has four major novel features. The first is that, as well as derivatives use for hedging purposes, we also examine our sample firms’ FX exposure outcome. This allows us to examine whether derivatives hedging has the expected outcome, as well as to investigate the outcome of managerially motivated hedging activity. Furthermore, as FX derivatives hedging is usually only a small part of the firms’ overall FX risk-management activity (Allen and Pantzalis, 1996; Guay and Kothari, 2003; Pantzalis et al., 2001), this analysis can detect the effects of the many alternative FX hedging techniques. Second, we distinguish between types of executives – CEOs, CFOs and directors – on the basis that they have different roles, expertise and interests, and therefore may have divergent incentives relating to firms’ FX risk-management practices.²

Our third novel feature follows from this: our finding of the dominance – in strength, magnitude and robustness – of CFO incentives in FX risk-management decisions. This is probably because CFOs have the appropriate specialised risk-management knowledge and experience, and are therefore likely to have substantial input into or control over hedging decisions as well as overall hedging strategy.³ Furthermore, in general, we find, particularly compared to the outcomes of incentives driving CEOs, CFOs are more likely to be a force for good. CFOs with substantial holdings of equity-linked securities see their interests align with those of shareholders, whereas for CEOs, larger shareholdings are associated with less hedging and higher FX exposure. Fourth, we consider the possibility of nonlinear relations between the executive compensation variables and derivative use as well as FX exposure. This approach has allowed us to uncover relationships between these variables that would have remained undetected in standard linear analysis.

Our findings have important implications for policymakers, shareholders and boards of Australian firms. Granting shares and options is a popular and appropriate solution to the well-understood agency problem that managers may be unwilling to proceed with positive net present value (NPV) projects that are highly risky (Coles et al., 2006; Rajgopal and Shevlin, 2002). Our findings show that compensating executives with shares and options can sometimes have a downside: the failure of the firm to optimally hedge FX risks – which results in greater cash flow volatility and lower firm value. At this point, we would customarily recommend to boards that they must be cognisant of the unintended consequences of equity-linked compensation, and carefully monitor not only CEOs but also CFOs to ensure adequate risk management is undertaken. However, our findings on the effect of directors’ share and option holdings on FX risk management suggest that boards can be driven by the same incentives. An important message for shareholders and policymakers is to ensure that executives’ risk-management decisions are properly monitored so that hedging activities are undertaken in shareholders’ interest.

The remainder of this article is structured as follows. Section 2 provides a review of the relevant literature, and section 3 details the data and empirical method employed. Section 4 presents summary statistics as well as the results of our multivariate analyses, and section 5 presents the results of several robustness tests. Section 6 offers concluding remarks.

2. Background

2.1. FX exposure and hedging

A firm is subject to FX exposure if changes in exchange rates affect expected future cash flows, and therefore firm value. This includes direct exposure, encompassing transaction exposure (involving known FX receivables and payables) and expected future FX cash flows. Indirect (or operating) exchange exposure arises from the competitive environment in which the firm operates. All firms are potentially exposed to exchange rate movements, including those that only operate domestically (Hutson and Laing, 2014). A large body of prior literature examines firms’ FX exposure. Early works of Jorion (1990, 1991) estimate the sensitivity of firms’ stock prices to changes in exchange rates, and find weak evidence of firms’ FX exposure. Most subsequent studies have yielded similar findings (see Muller and Verschoor, 2006, for a review). An important explanation for these apparently weak findings is that most firms hedge their currency risks, and the estimated exposure coefficients capture exposure after hedging has taken place (Bartov et al., 1996; Bartram et al., 2010). Allayannis and Ofek (2001) and Nguyen and Faff (2003) find that hedging – proxied by the use of FX derivatives – is associated with lower FX exposure.

A shortcoming of most hedging studies is that a common proxy for hedging activities is the use of derivatives. Derivatives comprise only a small proportion of firms’ financial risk-management efforts (Allen and Pantzalis, 1996; Guay and Kothari, 2003; Pantzalis et al., 2001) because derivative instruments such as forwards, futures and options are mainly used to hedge transaction exposure – which tends to be short-term. It is critical to value-creation that firms act to reduce their longer term direct and indirect exposures (Allayannis and Weston, 2001; Bartram et al., 2010). This can be achieved via techniques such as pass-through, foreign currency debt and operational hedging (Bartram et al., 2010; Hutson and Laing, 2014). Furthermore, Hutson and Laing (2014) find that firms with global operations are less likely to use derivatives than firms that operate in fewer regions. As this suggests that operational hedging can be a substitute for derivatives hedging, derivatives use may be an incomplete and biased proxy for hedging. In fact, because significant exchange exposure for a firm can be considered evidence of insufficient hedging (Hutson and Stevenson, 2010), estimated exposure can be seen as a proxy for the extent and effectiveness of hedging activities (Hutson and Laing, 2014).

2.2. Executive compensation and hedging

Jensen and Meckling (1976) show that the separation of ownership and control gives rise to agency costs as shareholders must monitor and ensure managers engage in activities that are in shareholders’ interests. They further show that shareholders can reduce these agency costs by linking managers’ compensation and wealth to the value and performance of the firm. A potential adverse effect of tying executives’ wealth to the value of the firm is that it can make managers overly risk averse; managers often have a substantial proportion of their wealth and utility invested in the firm and are likely to be poorly diversified. They may be unwilling to undertake value-enhancing projects if those projects are particularly risky.

To overcome this tendency to risk aversion among managers, Jensen and Meckling (1976) and Guay (1999) show that shareholders must ensure that the relation between managers’ wealth and firm value is convex; that is, managers’ compensation and wealth is increasing firm value. The most straightforward way to achieve this is by using options-based compensation. By providing managers with convex compensation contracts, shareholders can ensure that managers invest in all positive NPV projects, regardless of their riskiness. Several studies confirm that such contracts have the desired effect. Guay (1999) finds that the convexity of CEOs’ equity portfolios is positively related to the volatility of firms’ stock returns; Rajgopal and Shevlin (2002) find that the sensitivity of the value of executives’ stock options to share price volatility positively affects the riskiness of exploration activities undertaken by oil and gas firms and Coles et al. (2006) show that firms spend more on R&D when their CEOs’ wealth is more sensitive to firm value.

These studies highlight the need for shareholders to set managers’ compensation contracts to encourage them to take appropriate levels of business risk. Such compensation contracts, however, may have adverse effects on managers’ willingness to manage financial risk. Stulz (1984) and Smith and Stulz (1985) show theoretically that managers whose wealth and utility is a concave function of firm value will hedge financial risk, while those whose well-being is a convex function of firm value may neglect to hedge. As financial risk management is value-enhancing, this theory points to a serious downside of convex compensation contracts. Tufano (1996) finds that gold mining firms are less likely to hedge gold price risk the more options their managers hold, and Rogers (2002) shows that firms whose managers’ wealth is sensitive to the risk of the firm are less likely to use interest rate and currency derivatives for hedging purposes. Using Australian data, Nguyen and Faff (2002) similarly report a negative relation between firms’ derivatives use and managers’ equity holdings.

2.3. Executive compensation and other financial decisions

Several studies have examined the effect of the remuneration-related incentives of CEOs and CFOs on financing decisions such as leverage and earnings management. Chava and Purnanandam (2010) show that CFO incentives dominate those for CEO in debt maturity choices and earnings smoothing decisions, while CEO incentives dominate for leverage and cash holdings decisions. They suggest that their findings are consistent with CEOs determining broader corporate policies while delegating to CFOs decisions that require more specialised financial knowledge. Jiang et al. (2010) find that CFOs’ incentives are more important than CEOs in determining earnings management, because CFOs have the ultimate responsibility of managing the financial side of the business. In a study of CEO and CFO incentives and stock price crash risk, Kim et al. (2011) find that crash risk is positively related to the sensitivity of the value of the CFO’s option portfolio to changes in the stock price, but only weakly related to the same sensitivity for CEOs. They similarly suggest that CFOs’ incentives are more influential than CEOs’ when sophisticated financial expertise is essential. The findings of these studies suggest that in relation to financial decision-making, CFOs’ incentives tend to dominate those of CEOs.

3. Data and method

3.1. Data and sample

The initial sample consisted of the top 300 companies listed on the Australian Securities Exchange (ASX). Banks and other financial firms were removed since the nature of their business permits them to hold derivatives for reasons other than hedging. The final sample consists of 268 firms over the period 2009–2014. Executive compensation and executive equity holdings data were obtained from SIRCA Corporate Governance Database; FX derivative use, foreign sales and multinationality data were manually collected from companies’ annual reports and other control variable data were collected from DatAnalysis. Companies’ annual reports were obtained from Connect 4. Finally, stock return, market return and exchange rate data are from DataStream. We measure firms’ FX exposure relative to Australia’s Trade Weighted Index (TWI), and in robustness tests, we examine exposure to the bilateral exchange rates of Australia’s three major trading partners: the United States, Japan and China.

3.2. Method

To test the relation between current year executive compensation and the likelihood of hedging, as well the effect of executives’ holdings of shares and options on hedging, we estimate the following logit models

D e r i v a t i v e s d u m m y_{i, t} = f (c u r r e n t s h a r e s_{i, t} + c u r r e n t o p t i o n s_{i, t} + c o n t r o l s_{i, t})

(1)

D e r i v a t i v e s d u m m y_{i, t} = f (s h a r e h o l d i n g s_{i, t} + o p t i o n s h o l d i n g s_{i, t} + c o n t r o l s_{i, t})

(2)

$D e r i v a t i v e s d u m m y_{i, t}$ is a binary variable that takes the value of 1 if firm i mentions the use of FX derivatives for hedging purposes in its annual report during year t,⁴ and 0 otherwise. $c u r r e n t s h a r e s_{i, t}$ is the market value of share-based compensation awarded in year t as a proportion of the total compensation of the particular executive in firm i, and $c u r r e n t o p t i o n s_{i, t}$ is the market value of option-based compensation awarded to executives in year t as a proportion of the total compensation of the executive in firm i. $s h a r e h o l d i n g s_{i, t}$ and $o p t i o n s h o l d i n g s_{i, t}$ are the number of shares and options⁵ in firm i held by the executive in year t, scaled by total number of shares held by all executives.⁶

We take a two-step approach to test the relation between firms’ FX exposure and executive compensation. In the first step, firms’ FX exposure is measured using Adler and Dumas’ (1984) and Jorion’s (1990) market-based model

r_{i, t} = α_{0, i} + α_{1, i} r_{m, t} + α_{2, i} s_{t} + ε_{i, t}

(3)

where $r_{i, t}$ is firm i’s weekly log stock return, $r_{m, t}$ is the weekly return on the market (as proxied by the All Ordinaries Index), $s_{t}$ is the weekly log difference exchange rate and $ε_{i, t}$ is a random error term. $α_{2, i}$ is an estimate of the sensitivity of firm i’s stock price to changes in exchange rates, after controlling for the effect of market movements. The market return is included since exchange rate movements are highly correlated with other macroeconomic factors (Jorion, 1990). We use weekly data to estimate annual exposures for each firm for the years 2009–2014 inclusive.

In the second step, estimated exposure $α_{2, i}$ is used as the dependent variable in fixed effects panel regressions in order to test the effect of executive compensation on FX exposure.⁷ The model is specified as follows in equations (4) and (5)

{\sqrt{| α_{2, i} |}}_{i, t} = f (c u r r e n t s h a r e s_{i, t} + c u r r e n t o p t i o n s_{i, t} + c o n t r o l s_{i, t})

(4)

{\sqrt{| α_{2, i} |}}_{i, t} = f (s h a r e h o l d i n g s_{i, t} + o p t i o n s h o l d i n g s_{i, t} + c o n t r o l s_{i, t})

(5)

3.3. Control variables

3.3.1. Bonus

As cash bonus constitutes a substantial proportion of non-salary compensation for the executives in our sample firms (see Table 1), we include bonus as a control variable. Bonus is the value of the executive’s cash bonus as a proportion of total compensation.

Table 1.

Summary statistics.

Panel A: Descriptive statistics
	Mean	SD	Min	25th	Median	75th	Max	Skew
Derivatives dummy	55.93	49.66	0	0	1	1	1	−0.24
Absolute exposure	0.74	0.77	0	0.23	0.52	0.95	8.52	2.84
Cash bonus	16.58	15.74	0	0.14	13.53	28.57	60.54	0.71
Current shares	0.55	3.36	0	0	0	0	24.77	6.46
Current options	3.54	11.34	0	0	0	0	66.2	3.84
Shareholdings	38.31	113.88	0	1.08	5.16	28.34	1739.73	7.00
Options holdings	2.49	7.17	0	0	0	1.79	98.23	6.08
Total assets	3587.63	11,998.73	6.86	236.55	702.54	2401.56	160,735.67	8.10
Debt/assets	0.16	0.15	0	0.01	0.13	0.26	1.07	0.97
Quick ratio	3.61	10.98	0.03	0.78	1.18	2	226.06	10.52
Market-to-book	2.23	7.66	−29.55	0.75	1.3	2.37	253.25	25.66
Foreign sales	0.29	0.37	0	0	0.06	0.55	1	0.94
ABHK	3.42	1.83	1	2	3	5	7	0.17
Panel B: Foreign currency (FX) derivatives use					Panel C: Industry information
	Hedgers	Non-hedgers	Difference			Code	Number	%
Absolute exposure	0.636	0.871	–0.235		Oil and gas	1	24	8.96
Cash bonus	0.200	0.123	0.077		Basic minerals	1000	83	30.97
Current shares	0.007	0.004	0.003		Industrials	2000	53	19.78
Current options	0.027	0.046	–0.019		Consumer goods	3000	22	8.21
Shareholdings	33.41	43.07	–9.66		Health care	4000	14	5.22
Options holdings	1.39	4.05	–2.66		Consumer services	5000	43	16.04
Total assets	5400.80	864.7	4536.10		Telecommunications	6000	5	1.87
Debt/assets	0.191	0.106	0.085		Utilities	7000	10	3.73
Quick ratio	10.989	6.32	4.669		Technology	9000	14	5.22
Market-to-book	2.08	1.931	0.149				268	100
Foreign sales	0.272	0.309	–0.037
ABHK	3.657	3.133	0.524

Panel A of this table presents summary statistics for the full sample. Panel B shows the difference in means for each variable for firms that do and do not hedge their exchange rate exposure with derivatives; bold values indicate statistical significance at the 1% level based on a t test. Panel C presents a breakdown of the industries in which firms in the sample operate. Derivatives dummy is a binary variable that takes the value of 1 if the firm hedges its foreign exchange exposure with derivatives, and 0 otherwise. Absolute exposure is firms’ absolute foreign exchange exposure |α_{2, i}| estimated by equation (3), to the trade-weighted index. Bonus, current shares and current options are the value of executives’ cash bonus, share-based compensation and options-based compensation, respectively, as a proportion of their total compensation. Shareholdings and options holdings are the number of shares and options held by the executive, in millions. In subsequent tables, shareholding and option holdings are scaled by total number of shares held by executives. Total assets is total assets in millions of dollars. Debt/assets is the ratio of firms’ total debt to total assets. Quick ratio is the ratio of firms’ cash and marketable securities to current liabilities. Market-to-book is the market value of ordinary shares outstanding scaled by the book value of shares outstanding. Foreign sales is proportion of firms’ sales outside of Australia. ABHK is Aggarwal, Berrill, Hutson and Kearney’s (2011) classification system used to measure firms’ operational hedging; it ranges from 1 (domestic firms) to 7 (global firms).

3.3.2. Size

The relation between size and hedging is an empirical question. On one hand, theory suggests that firms hedge to reduce the probability and hence expected cost of financial distress (Smith and Stulz, 1985; Stulz, 1984). Since financial distress costs are fixed, they are proportionately higher for smaller firms. Under this argument, small firms are more likely to hedge because they derive more benefit from hedging. On the other hand, the implementation of a hedging programme involves substantial fixed costs and therefore exhibits economies of scale (Nance et al., 1993), suggesting large firms are more likely to hedge using derivatives than small firms. Prior literature suggests that the latter effect dominates; large firms are more likely to hedge than small firms as a result of the economies of scale associated with hedging (Allayannis and Ofek, 2001; Géczy et al., 1997; Mian, 1996; Nance et al., 1993). Size is measured by the natural log of total assets.

3.3.3. Financial distress costs

Theory suggests that firms benefit from hedging if financial distress is costly (Smith and Stulz, 1985). This is because, by smoothing expected future earnings, hedging reduces the probability of firms encountering financial distress, thereby reducing expected financial distress costs. This benefit is expected to be greater for highly levered firms since these firms face a greater probability of default. Empirical evidence is mostly consistent with this hypothesis (e.g. Géczy et al., 1997; Nance et al., 1993; Nguyen and Faff, 2002). The ratio of total debt to total assets is included as a proxy for financial distress costs.

3.3.4. Liquidity

Liquidity may act as a substitute for hedging by acting as a buffer against volatile cash flows (Nance et al., 1993). Firms that hold substantial cash or cash equivalents are less likely to default on their debt and bear lower expected costs of financial distress (Nance et al., 1993; Smith and Warner, 1979). Such firms may therefore be less likely to hedge their FX risk. Liquidity is measured by the quick ratio, which is defined as the ratio of firms’ cash and marketable securities to current liabilities.

3.3.5. Underinvestment costs

Myers (1977) shows that, when firms have debt in their capital structure, managers may forgo positive NPV projects that increase the value of the firm if a substantial portion of the benefits accrue to debt holders. Hedging can mitigate this concern by ensuring that adequate cash flows are available to invest in all positive NPV projects (Froot et al., 1993). Consistent with Nance et al. (1993) and Géczy et al. (1997), the ratio of the market value of common stock to the book value of common stock is included as a proxy for underinvestment costs.

3.3.6. Foreign sales

Firms’ foreign sales is included since studies such as Allayannis and Ofek (2001) and Bartram (2004) find that firms with a high proportion of foreign sales are more likely to use derivatives and have higher ex ante FX exposure. Foreign sales is measured by the proportion of foreign sales that make up total sales.

3.3.7. Operational hedging

An operational hedge is achieved when a firm diversifies its activities to match the currencies of its costs and revenues, thereby eliminating exposure to FX fluctuations. Previous studies find a negative relation between operational hedging and FX exposure (e.g. Bartram et al., 2010; Hutson and Laing, 2014; Pantzalis et al., 2001). The classification system developed by Aggarwal, Berrill, Hutson, and Kearney (2011) (ABHK) is used as the proxy for operational hedging. Under this scheme, the world is divided into six regions based on the inhabited continents: Africa, Asia, Europe, North and Central America, South America and Oceania. The breadth of firms’ operations is then classified into one of seven groups depending on the number of regions in which they engage. Firms are considered to be domestic (D) if they operate only in their home country, regional (R) if they operate in more than one country in their home region and transregional (T) if they operate beyond their home region. Firms are considered T2 if they operate in two regions, T3 if they operate in three regions, T4 four regions and T5 five regions. Finally, firms are classified as global (G) if they operate in all six regions. We use location of subsidiaries to define our sample firms into the ABHK classifications. The ABHK scheme is implemented in empirical tests by assigning a number from 1 to 7 to each firm, such that ABHK = 1 for domestic firms, 2 for R firms, 3 for T2 firms, 4 for T3 firms, 5 for T4 firms, 6 for T5 firms and 7 for firms classified as G. A squared ABHK term is also included in our multivariate analysis since Hutson and Laing (2014) find an inverse U-shaped relation between FX exposure and firms’ multinationality.

3.3.8. Industry

Due to different competitive structures as well as extent of involvement in international business, firms’ FX exposure differs across industries (Hutson and Stevenson, 2010). Industry dummies based on Industry Classification Benchmark (ICB) codes are included to control for industry effects.

Finally, the control variables used in equations (1), (2), (4) and (5) are essentially the same except that we also include derivatives dummy as a control in the exposure regressions, equations (4) and (5).

4. Results

4.1. Summary statistics

Panel A of Table 1 presents summary statistics for our variables. The median firm in our sample has assets of Aus$702.54 million, a debt-to-assets ratio of 13%, foreign sales of 6% of total sales and a presence in three regions of the world. Fifty-six percent of the firms in the sample use FX derivatives for hedging purposes. On average, executive compensation is more likely to be in cash (16.6%) rather than equity-based (0.55% and 3.54% for current equity and options, respectively). Since total assets, quick ratio and market-to-book are highly positively skewed, the natural log of these variables is used in our multivariate analysis.

Panel B of Table 1 shows mean values of our variables for firms that hedge with derivatives (hedgers) versus those that do not (non-hedgers). Hedgers are significantly less exposed to FX movements (using a difference-in-means test), compensate their managers with significantly fewer options and have managers with fewer accumulated shares and options. The finding that hedgers use fewer options in their managerial compensation packages is prima facie evidence that options-based compensation encourages managers to not hedge their FX exposures. Hedgers also pay their managers a higher bonus, are larger, are more highly levered, hold more liquid assets and are more multinational than non-hedgers. These results are mostly in line with expectations, with the exception that hedgers hold more liquid assets than non-hedgers. Panel C of Table 1 presents a breakdown of the sample firms based on ICB codes. The sample consists of firms operating across nine industries, with basic minerals having the highest representation (31% of the sample) and telecommunications the lowest (2% of the sample). Overall, there is reasonable diversity of industries in the sample.

Table 2 presents summary statistics on FX derivatives use and FX exposure by year. Panel A shows that more than half of our sample firms use derivatives, and there is little variation in derivative users each year. This result is unsurprising given that derivatives hedging decision requires significant fixed costs and expertise to implement (Allayannis and Ofek, 2001). Panel B of Table 2 reports firms’ FX exposure (α_{2, i}) estimated via equation (3) for each year. Those with positive FX exposure outnumber those with negative exposure in all years except 2012. Positive FX exposure implies that an appreciation of the Australian dollar is associated with an increase in the firm’s share price, while negative exposure implies that the share price falls when the Australian dollar appreciates. Positive exposure is expected in firms that are net importers, since appreciations in the Australian dollar reduce the local costs of their inputs, and negative exposure is likely among net exporters. Finally, consistent with the literature on firm-level FX exposure, few firms exhibit significant exposure (at the 5% level). The highest proportion of firms with significant exposure occurred in 2009 (14%).

Table 2.

Foreign currency (FX) derivatives use and foreign exchange (FX) exposure.

Panel A: Foreign currency derivatives use
	2009	2010	2011	2012	2013	2014
Yes	148	146	142	142	143	147
No	112	114	118	118	117	104
% yes	56.92	56.15	54.62	54.62	55.00	58.57
Panel B: Foreign exchange exposure
	2009	2010	2011	2012	2013	2014
Mean absolute exposure	0.945	0.716	0.580	0.748	0.715	0.727
Standard deviation	0.907	0.799	0.544	0.705	0.738	0.859
Min	0.006	0.000	0.002	0.001	0.001	0.004
Median	0.643	0.529	0.456	0.572	0.493	0.447
Max	6.250	8.523	3.035	4.594	4.359	7.889
Positive	146	166	163	117	150	142
Positive and significant	25	16	15	9	13	12
Negative	114	94	97	143	110	118
Negative and significant	11	6	6	16	7	6
% significant overall	13.85	8.46	8.08	9.62	7.69	6.92
Panel C: Foreign currency derivatives use and foreign exchange exposure, by industry
	Oil and gas	Basic mineral	Industrials	Consumer goods	Health care	Consumer services	Telecommunications	Utilities	Technology
% using derivatives	32.64	35.14	66.04	85.61	40.48	73.26	63.33	60.00	36.90
Mean absolute exposure	0.846	0.885	0.618	0.583	0.734	0.552	0.666	0.503	0.703
Positive	89	319	183	64	26	122	9	23	45
Positive and significant	9	32	26	4	1	7	0	1	6
Negative	55	164	110	68	58	124	21	37	39
Negative and significant	3	6	7	6	6	14	4	3	3
% significant overall	8.33	7.87	11.26	7.58	8.33	8.54	13.33	6.67	10.71

This table presents summary statistics for foreign currency derivatives use and firms’ foreign exchange exposure α_{2, i} (estimated by equation (3)) to the trade-weighted index for the years 2009–2014. Panel A shows the number and percentage of firms that hedge their foreign exchange exposure with derivatives in each year. Panel B shows summary information for foreign exchange exposure α₂; absolute exposure refers to the absolute value of the exposure coefficient|α_{2, i}|. Significance of the exposure estimates is defined at the 5% level. Panel C shows mean foreign exchange exposure by industry. Firms are classified into industries based on Industry Classification Benchmark (ICB) codes.

Panel C of Table 2 presents a breakdown of FX derivatives use and FX exposure by industry. Average absolute FX exposure varies across industry. Basic minerals firms have the highest exposure, and Utilities the lowest. This is comparable to Hutson and Stevenson (2010); using a large international sample, they also find that mining firms are the most exposed, and utilities the least. Finally, consumer goods and consumer services firms are the greatest users of derivatives, with 85.6% and 73.3% of firms, respectively, hedging with FX derivatives.

Figure 1 depicts exposure and derivatives use for hedging purposes, by industry. In this figure, industries are sorted in ascending order on mean absolute FX exposure. The figure shows that at the industry level, the use of FX derivatives tends to be inversely related to exposure. This suggests that differences in industries’ FX exposure, found in studies such as Di Iorio and Faff (2000) and Hutson and Stevenson (2010), may be explained by divergences in derivatives hedging practices. Figure 1 also highlights the importance of controlling for industry in FX hedging and exposure studies.

Figure 1.

Derivatives use and absolute foreign exchange exposure by industry. This figure plots derivatives use and mean estimated foreign exchange exposure by industry. Industries are sorted on mean absolute foreign exchange exposure (|α_{2, i}|, with α_{2, i} estimated via equation (3)), from highest (basic minerals) to lowest (utilities).

Table 3 provides univariate tests of the relation between FX hedging, exposure and executive compensation. Panel A reports on derivatives use and FX exposure for firms that use versus those that do not use cash bonuses, shares and options as part of annual compensation. A t test reveals that firms that pay their executives a cash bonus are significantly more likely to hedge using derivatives (61%) relative to non-bonus paying firms, while firms that offer executives option-based compensation are significantly less likely to do so (47% vs. 58%).

Table 3.

Executive compensation, hedging and foreign exchange exposure.

Panel A: Executive compensation
	Bonus users			Bonus non-users		p value
% using derivatives	60.8			41.6		0.00
Median exposure	0.48			0.69		0.00
	Current share users			Current share non-users
% using derivatives	68.6			55.7		0.07
Median exposure	0.40			0.53		0.42
	Current option users			Current option non-users
% using derivatives	46.9			57.7		0.00
Median exposure	0.64			0.51		0.00
Panel B: Executive equity holdings by quintile
	Q1	Q2	Q3	Q4	Q5	Q5–Q1	Wilcoxon testp value
% using derivatives
By shareholdings	73.31	61.46	54.17	43.00	49.29	−24.02	(0.00)
By option holdings	55.22	65.93	45.59	41.35	32.31	−22.91	(0.00)
Median absolute foreign exchange exposure
By shareholdings	0.377	0.531	0.568	0.647	0.541	0.164	(0.00)
By option holdings	0.533	0.647	0.552	0.729	0.747	0.214	(0.00)

This table presents information on foreign exchange derivatives use and absolute foreign exchange exposure by type of executive compensation. Panel A shows – for firms that use and do not use cash bonuses, shares and options as part of annual remuneration packages – the percent using derivatives and median absolute foreign exchange exposure (estimated via equation (3)). We report p values for difference in proportion using derivatives among users and non-users, and Wilcoxon tests for difference in median exposure among users and non-users of each type of compensation. Panel B shows the percentage for firms that hedge their foreign exchange exposure with derivatives, and median foreign exchange exposure, across quintile groups of executive share and options holdings. Quintile 1 has the lowest executive share and option holdings, and quintile 5 the highest. Shareholdings and option holdings are the number of shares and options held by executives, scaled by total number of shares held by all executives. Bold and italics indicate statistical significance at the 5% and 10% levels, respectively.

Panel B in Table 3 separates the sample into quintiles based on managers’ share and option holdings, and reports for each quintile the proportion of firms that hedge FX risk and median absolute FX exposure; quintile 1 firms’ managers hold the lowest amount of equity or options, and the lowest exposure. In general, the greater the executives’ shareholdings, the less likely the firm is to use FX derivatives for hedging purposes, and the greater its exposure. The trend is similar for executives’ holdings of share options in their firm. There is, however, a potentially nonlinear relation between executive shareholdings and the use of FX derivatives, as well as FX exposure. In the case of the former, there is a possible U-shaped relation; as the number of shares held by executive increases at low levels of shareholdings, firms appear less likely to hedge using derivatives. However, at high levels of executive shareholdings – as managers’ wealth becomes increasingly dependent on firm value – hedging is more likely. A complementary inverse ‘U’ shaped (or ‘humped’) relation is apparent for the relation between executive shareholdings and exposure. There is also a possible nonlinearity in the relation between options holdings and derivatives use: as option holdings rise, firms are less likely to hedge with derivatives and are more exposed. In our multivariate analyses, we test for possible nonlinearities in these relations.

Table 4 presents Spearman rank correlations for our variables; correlation coefficients highlighted in bold are significant at the 5% level. We find a significant negative association between FX derivatives use with executives’ current options compensation, shareholdings and option holdings. There is also a negative relation between the use of FX derivatives and absolute exposure, implying that hedging with derivatives is associated with lower exposure.

Table 4.

Correlation matrix.

		(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)	(10)	(11)	(12)	(13)
(1)	Derivative use
(2)	Absolute exposure	−0.169
(3)	Salary	−0.188	0.130
(4)	Bonus	0.249	−0.193	−0.819
(5)	Current shares	0.048	−0.022	−0.158	−0.016
(6)	Current options	−0.078	0.072	−0.333	−0.128	0.034
(7)	Shareholdings	−0.044	0.042	0.103	−0.110	−0.021	−0.005
(8)	Option holdings	−0.190	0.164	−0.010	−0.108	−0.030	0.200	0.041
(9)	Total assets	0.441	−0.287	−0.361	0.420	0.071	−0.075	0.026	−0.114
(10)	Debt/assets	0.340	−0.140	−0.121	0.152	0.040	−0.056	0.120	−0.052	0.512
(11)	Quick ratio	−0.265	0.138	0.005	−0.078	−0.037	0.110	−0.021	0.069	−0.300	−0.334
(12)	Market-to-book	0.100	−0.175	−0.260	0.267	−0.048	0.015	0.135	−0.020	0.042	0.09	0.018
(13)	Foreign sales	0.042	0.033	−0.112	0.091	0.008	0.050	0.032	0.082	0.162	0.004	0.136	0.036
(14)	ABHK	0.137	−0.020	−0.200	0.229	0.018	−0.029	−0.025	−0.019	0.250	0.200	−0.001	0.068	0.298

This table presents Spearman rank correlations for the variables used in this study. Derivative use is a binary variable that takes the value of 1 if the firm hedges its foreign exchange exposure with derivatives, and 0 otherwise. Absolute exposure is the sample firms’ absolute foreign exchange exposure|α_{2, i}| estimated by equation (3). Salary, bonus, current shares and current options are the value of executives’ cash salary, cash bonus, share-based compensation and option-based compensation, respectively, as a proportion of their total compensation. Shareholdings and options holdings are the number of shares and options held by the executives, scaled by total number of shares held by all executives. Total assets is total assets in millions of dollars. Debt/assets is the ratio of firms’ total debt to total assets. Quick ratio is the ratio of firms’ cash and marketable securities to current liabilities. Market-to-book is the market value of ordinary shares outstanding scaled by the book value of shares outstanding. Foreign sales is the percentage of the firm’s sales that are made outside of Australia. ABHK is Aggarwal, Berrill, Hutson and Kearney’s (2011) classification system used as our measure firms’ operational hedging. It ranges between 1 (domestic firms) and 7 (global firms). Bold and italics indicate statistical significance at the 5% and 10% levels, respectively.

4.2. Multivariate results

4.2.1. Executive compensation and derivatives use

Table 5 presents the logit regression results of the relation between the current compensation of all executives, CEOs, CFOs and directors, and FX derivatives use (equation (1)) (columns 1–4), and between derivatives use and executives’ share and options holdings (equation (2)) (columns 5–10). Because the relation between derivatives use and share and options holdings may be nonlinear, as identified in Table 3, we include specifications in which squared share and options holdings terms are included (columns 6, 8 and 10).

Table 5.

Derivatives use, by executive type.

	(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)	(10)
	All	CEO	CFO	Director	CEO		CFO		Director
Bonus	0.091	0.045	0.046	0.026
Bonus	(0.47)	(0.65)	(0.70)	(0.81)
Current shares	0.128	0.082	0.410	0.076
Current shares	(0.78)	(0.82)	(0.40)	(0.83)
Current options	−0.058	−0.317	−0.035	−0.041
Current options	(0.74)	(0.05)	(0.85)	(0.79)
Shareholdings					−0.106	3.255	1.037	2.335	−0.187	2.016
Shareholdings					(0.76)	(0.00)	(0.53)	(0.43)	(0.69)	(0.27)
Shareholdings²						−5.988		−4.158		−2.916
Shareholdings²						(0.00)		(0.68)		(0.21)
Option holdings					−0.842	−3.550	3.083	1.363	−1.828	−0.866
Option holdings					(0.24)	(0.06)	(0.29)	(0.82)	(0.01)	(0.67)
Option holdings²						6.248		9.718		−3.286
Option holdings²						(0.19)		(0.77)		(0.46)
Total assets	0.121	0.123	0.105	0.130	0.557	0.551	0.552	0.550	0.555	0.548
Total assets	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)
Debt/assets	0.196	0.213	0.178	0.249	0.710	0.830	0.781	0.788	0.687	0.744
Debt/assets	(0.15)	(0.13)	(0.19)	(0.08)	(0.24)	(0.16)	(0.20)	(0.20)	(0.26)	(0.23)
Quick ratio	−0.027	−0.035	−0.022	−0.024	−0.114	−0.136	−0.114	−0.113	−0.118	−0.116
Quick ratio	(0.17)	(0.09)	(0.28)	(0.23)	(0.15)	(0.09)	(0.15)	(0.15)	(0.14)	(0.15)
Market-to-book	0.045	0.052	0.046	0.049	0.191	0.176	0.193	0.192	0.189	0.174
Market-to-book	(0.02)	(0.01)	(0.02)	(0.02)	(0.03)	(0.05)	(0.03)	(0.03)	(0.03)	(0.05)
Foreign sales	0.051	0.080	0.109	0.045	0.094	0.104	0.116	0.114	0.117	0.159
Foreign sales	(0.30)	(0.12)	(0.03)	(0.37)	(0.66)	(0.62)	(0.59)	(0.59)	(0.59)	(0.46)
ABHK	−0.044	−0.041	0.006	−0.048	−0.183	−0.177	−0.187	−0.184	−0.159	−0.151
ABHK	(0.26)	(0.31)	(0.87)	(0.23)	(0.27)	(0.29)	(0.26)	(0.26)	(0.34)	(0.37)
ABHK²	0.090	0.009	0.002	0.090	0.040	0.039	0.040	0.040	0.037	0.036
ABHK²	(0.10)	(0.10)	(0.14)	(0.10)	(0.09)	(0.10)	(0.08)	(0.08)	(0.12)	(0.13)
Industry Dummies	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Year Dummies	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Pseudo R²	0.25	0.26	0.26	0.26	0.25	0.26	0.25	0.25	0.26	0.26

This table presents logit regression results where the dependent variable Derivatives dummy is a binary variable that takes the value of 1 if the firm uses foreign currency derivatives for hedging purposes, and 0 otherwise. Bonus, current shares and current options is the value of executives’ cash bonus, share-based compensation and option-based compensation, respectively, as a proportion of their total compensation. Shareholdings and options holdings are the number of shares and options held by the executive, scaled by total number of shares held by all executives. Total assets is total assets in millions of dollars. Debt/assets is the ratio of firms’ total debt to total assets. Quick ratio is the ratio of firms’ cash and marketable securities to current liabilities. Market-to-book is the market value of ordinary shares outstanding over the book value of shares outstanding. Foreign sales is the percentage of firms’ sales that are made outside of Australia. ABHK refers to the Aggarwal, Berrill, Hutson and Kearney’s (2011) classification system that we use as a proxy for the extent of the firms’ operational hedging; it ranges from 1 (domestic firms) to 7 (global firms). The p values are shown in brackets below the coefficients; bold and italics indicate statistical significance at the 5% and 10% levels, respectively.

For the current executive compensation variables – cash bonuses, and shares and options awarded as part of executives’ annual compensation package – our only significant result is for annual grant of options to CEOs: the greater the value of options granted, the less likely the firm is to use FX derivatives for hedging. This is consistent with the notion that CEOs with convex compensation contracts like the cash flow volatility associated with not hedging because the value of their options is enhanced, and it suggests a downside to the use of option-based remuneration. This finding is consistent with prior empirical studies (Allayannis and Ofek, 2001; Géczy et al., 1997; Nguyen and Faff, 2002). Our weak findings in general for the current compensation variables are likely due to annual compensation does not constitute a material proportion of executives’ wealth.

Accumulated shares or options – that is, executives’ holdings of shares or options in the firm – plausibly constitute a more sizable element of their overall wealth, and is therefore more likely to influence behaviour. Our findings are indeed stronger when using the shares and options holding variables (equation (2), columns (5) to (10) of Table 5). We find an inverse U-shaped relation between CEO’s shareholding and the likelihood of hedging with derivatives. At low levels of CEO shareholding, a rise in shareholding is associated with a greater likelihood of derivatives hedging. This finding is consistent with Rogers (2002) and Coles et al. (2006). At higher levels of CEO shareholdings, firms are less likely to use FX derivatives for hedging purposes as shareholdings rise.

We also find a significant inverse relation between directors’ option holdings and the likelihood that firm hedges with derivatives. This is consistent with the theory of Stulz (1984) and Smith and Stulz (1985) – that convex compensation contracts can discourage managers from hedging because their wealth is an increasing function of firm volatility. It is also consistent with Nguyen and Faff (2002) for Australian executives in general. Finally, we do not find any significant relation between CFOs’ equity-linked holdings and derivative use. We leave a more in-depth discussion of these findings to the next section, in which we examine the relation between executive and director remuneration and FX exposure.

For the control variables, firm size (total assets) is positive and significant at the 1% level in all specifications, implying large firms are more likely to hedge with derivatives. This is evidence for the economies of scale argument that large firms are more likely to have the human capital and financial resources available to implement a hedging programme. The market-to-book ratio is positive and universally significant, suggesting that firms with more growth options in their investment opportunity set face a greater incentive to hedge since they face higher underinvestment costs (Froot et al., 1993).

4.2.2. Executive compensation and FX exposure

Table 6 reports the panel fixed effects regression results in which the dependent variable is the square root of absolute FX exposure estimated from equation (3). The table is structured similarly to Table 5 in that columns 1–4 contain the specifications in which we include current shares and current options (equation (4)) and columns 5–10 repeat the analysis with equity and options holdings (equation (5)), and including squared terms. We find that neither current shares nor current options is related to FX exposure across any of the specifications in columns (1) to (4), and again, this is likely due to any particular year’s share and option grants are a small proportion of executives’ overall wealth.

Table 6.

Foreign exchange exposure, by executive type.

	(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)	(10)
	All	CEO	CFO	Director	CEO		CFO		Director
Bonus	−0.064	−0.067	0.063	−0.032
Bonus	(0.41)	(0.27)	(0.43)	(0.62)
Current shares	0.206	0.057	0.342	0.141
Current shares	(0.45)	(0.77)	(0.27)	(0.44)
Current options	0.113	0.086	0.066	0.141
Current options	(0.29)	(0.39)	(0.60)	(0.14)
Shareholdings					0.098	0.113	0.113	0.945	−0.026	0.744
Shareholdings					(0.06)	(0.51)	(0.55)	(0.01)	(0.69)	(0.00)
Shareholdings²						−0.028		−2.451		−0.987
Shareholdings²						(0.92)		(0.01)		(0.00)
Option holdings					0.136	0.323	0.365	1.575	0.155	0.097
Option holdings					(0.14)	(0.20)	(0.32)	(0.02)	(0.11)	(0.71)
Option holdings²						−0.507		−8.222		−0.094
Option holdings²						(0.39)		(0.07)		(0.86)
Total assets	−0.073	−0.072	−0.084	−0.071	−0.078	−0.078	−0.077	−0.079	−0.077	−0.081
Total assets	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)
Debt/assets	0.335	0.334	0.371	0.342	0.337	0.337	0.341	0.350	0.340	0.357
Debt/assets	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)
Quick ratio	0.001	0.007	0.008	0.001	0.002	0.003	0.002	0.004	0.003	0.003
Quick ratio	(0.94)	(0.62)	(0.59)	(0.94)	(0.87)	(0.83)	(0.88)	(0.72)	(0.79)	(0.78)
Market-to-book	−0.078	−0.082	−0.084	−0.081	−0.080	−0.081	−0.079	−0.080	−0.078	−0.082
Market-to-book	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)
Foreign sales	0.019	0.011	0.030	0.021	0.018	0.019	0.018	0.018	0.012	0.020
Foreign sales	(0.57)	(0.74)	(0.43)	(0.55)	(0.58)	(0.57)	(0.59)	(0.58)	(0.70)	(0.54)
ABHK	0.038	0.034	0.033	0.031	0.033	0.032	0.035	0.033	0.033	0.037
ABHK	(0.12)	(0.18)	(0.24)	(0.21)	(0.19)	(0.20)	(0.16)	(0.18)	(0.18)	(0.14)
ABHK²	−0.004	−0.003	−0.003	−0.003	−0.003	−0.003	−0.003	−0.003	−0.003	−0.004
ABHK²	(0.25)	(0.33)	(0.49)	(0.34)	(0.33)	(0.34)	(0.31)	(0.33)	(0.34)	(0.26)
Derivative dummy	−0.013	−0.012	−0.024	−0.020	−0.012	−0.012	−0.015	−0.015	−0.009	−0.010
Derivative dummy	(0.63)	(0.66)	(0.39)	(0.44)	(0.64)	(0.65)	(0.56)	(0.55)	(0.72)	(0.69)
Intercept	2.271	2.153	2.47	2.231	2.283	2.214	2.271	2.222	2.290	2.208
Intercept	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)
Industry Dummies	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Year Dummies	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Adjusted R²	0.18	0.18	0.18	0.18	0.16	0.16	0.16	0.17	0.16	0.17

This table presents panel fixed effects regression results where the dependent variable is the square root of the firms’ absolute foreign exchange exposure (to the trade-weighted exchange rate index)|α_2,i| estimated by equation (3). Bonus, current shares and current options is the value of executives’ cash bonus, share-based compensation and option-based compensation, respectively, as a proportion of their total compensation. Shareholdings and options holdings are the number of shares and options held by the executive, scaled by total number of shares held by all executives. Total assets is total assets in millions of dollars. Debt/assets is the ratio of firms’ total debt to total assets. Quick ratio is the ratio of firms’ cash and marketable securities to current liabilities. Market-to-book is the market value of ordinary shares outstanding over the book value of shares outstanding. Foreign sales is the percentage of firms’ sales that are made outside of Australia. ABHK refers to the Aggarwal, Berrill, Hutson and Kearney’s (2011) classification system that we use as a proxy for the extent of the firms’ operational hedging; it ranges from 1 (domestic firms) to 7 (global firms). Derivatives dummy is a binary variable that takes the value of 1 if the firm hedges its foreign exchange exposure with derivatives, and 0 otherwise. The p values are shown in brackets below the coefficients; bold and italics indicate statistical significance at the 5% and 10% levels, respectively.

Our findings are stronger for the holdings metrics (column (5)–(10)). In the CEO subsample, shareholdings is positive, although only weakly significant (p = 0.06). As seen in section 4.2.1 and Table 5, CEOs with substantial shareholdings seemingly prefer not to hedge with FX derivatives; our exposure findings show that this leads to greater FX exposure. This finding can be attributed to hedging that reduces expected future cash flows volatility, which increases the value of a levered firm’s equity (Jensen and Meckling, 1976). An alternative explanation is that large shareholdings can be associated with managerial entrenchment (Shleifer and Vishny, 1986), and entrenched CEOs may neglect to ensure that appropriate hedging activities are undertaken. Irrespective of the explanation, it is clear that when CEOs’ shareholdings are substantial, firms neglect to hedge, resulting in greater FX exposure.

For CFOs, we find an inverse U-shaped relation between FX exposure and their shareholdings as well as their option holdings, although the finding for shareholdings is statistically stronger, if smaller in magnitude. At high levels of holdings, exposure falls as shareholdings rise; that is, when the CFOs’ share and option holdings is substantial, a rise in their holdings is associated with lower exposure. At low levels of CFO share and options holdings, in contrast, an increase in the CFO’s holdings is associated with a rise in the firm’s FX exposure – implying that, similar to our finding relating to exposure and the shareholdings of CEOs, the incentive is not to hedge, or to hedge incompletely. Recall that we found no significant relation between the CFO’s holdings of equity-linked securities and derivatives use, and as we discussed in the literature review, the use of derivatives constitutes only a small part of firms’ hedging programmes. Where holdings of shares and options are more modest, CFOs appear to be faced with the incentive to not hedge optimally – perhaps because they like the enhancement of share and option value that results from high cash flow volatility.

However, CFOs with substantial share and options holdings appear to be ensuring via other hedging approaches such as using foreign currency debt or swaps, or possibly by advising the firm on optimal operational hedging, that the firm acts to manage its FX risk. Where CFOs’ holdings of equity-linked securities are higher, firms see the alignment of their interests with those of shareholders.

In the director subsample, we find an inverse U-shaped relation between FX exposure and directors’ shareholdings. Our conclusions are therefore the same as for CFOs: where directors have substantial shareholdings, the firm experiences lower FX exposure. This is evidence in favour of the notion that where directors have substantial ‘skin in the game’, they effectively monitor the firm’s managers to ensure that they act in shareholders’ interests and hedge FX exposure. At lower levels of shareholdings, however, directors appear to be incentivised to turn a blind eye to sub-optimal hedging, or somehow prevent the firm from engaging in best practice FX hedging. We find no significant relation between directors’ option holdings and exposure. So, whereas we found that option holdings are associated with reduced FX hedging with derivatives, this does not flow through to greater FX exposure.

The control variables in the exposure regressions of Table 6 are mostly as expected. The market-to-book ratio is significant and negative, reflecting that firms with a greater investment opportunity set and hence greater expected underinvestment costs have more hedging incentive (Froot et al., 1993). Total assets is negative and significant, as expected. Debt-to-assets is highly significant across all specifications, and positive. Hutson and Stevenson (2010) find the same relation, and suggest that this stems from levered firms failing to hedge or hedging sub-optimally; in such cases, debt heightens the likelihood that the firm encounters financial distress.

5. Robustness tests

5.1. Endogeneity

One concern about statistical inference using ordinary least squares (OLS) in the exposure regressions is the possibility that FX exposure and executive compensation contracts are endogenous. Endogeneity, in the form of reverse causality, may be a concern in our study since theory suggests that executive compensation is likely to be set in response to the risk and investment opportunity set of the firm (Smith and Stulz, 1985). We control for endogeneity using two-stage least squares (2SLS). In the first stage, the executive compensation and equity holdings variables are estimated using 1 year lagged compensation and equity holdings variables as instrumental variables. Lagged compensation variables are likely to meet the requisite criteria for instrumental variables under the 2SLS approach, because they are likely to be correlated with current year compensation variables and uncorrelated with the residuals in the structural equation. This is a reasonable assumption given that shareholders are unlikely to set managers’ compensation structure to mitigate long-term FX risk. In the second stage, estimated compensation variables are used as explanatory variables in the FX exposure regressions.

In the interests of brevity, we omit the full tabulated findings for all robustness tests; they are available from the authors on request. Our findings that firms whose CEOs have a high level of shareholdings are more exposed to FX movements is also robust to the 2SLS approach, albeit slightly more weakly (p = 0.08). We again find a strong inverse U-shape for the relation between shareholdings and exposure in the directors’ subsample. For CFOs, we no longer find the inverse U-shaped relation between their shareholdings and FX exposure. We do, however, find a strong positive linear relation between options holdings and exposure, implying that CFOs like the risk that ensues when the firm fails to hedge optimally – because the value of their options holdings is enhanced.

5.2. Exposure to bilateral exchange rates

We re-estimate equation (3) using bilateral exchange rates between Australia and three of its major trading partners – the United States (USD), Japan (JPY) and China (RMB) – to estimate the firms’ FX exposure. Equations (4) and (5) are re-estimated using these alternative measures of exposure. In general, our findings on share and option holdings are reasonably robust to exposure to the three bilateral exchange rates. The main exception is that across all three bilateral exchange rate specifications, we find no significant effects of share and option holdings in the CEO subsample on exposure. The relation between director shareholdings and FX exposure remain significant in each of the three bilateral exchange rate specifications, and the relation between CFO shareholdings and option holdings remain significant in the USD and RMB regressions. Particularly for the CFO and directors subsample, our findings are remarkably robust when we examine exposure to the bilateral exchange rates of Australia’s major trading partners rather than the trade-weighted exchange rate.

5.3. Sub-period analysis

During our 6-year sample period, the Australian dollar (on a trade-weighted basis) went through two distinct phases. The first 3 years (2009–2011) was a time of strong Australian dollar appreciation against all major currencies – following its sharp depreciation in the wake of the financial crisis in late 2008. During the second phase, 2012–2014, the Australian dollar was flat initially, followed by a downwards trend. In order to test the robustness of our findings in these two quite different regimes, we re-run our exposure analysis for the two sub-periods separately. Firms may operate different hedging programmes in diverse FX regimes, and likewise, remuneration-related incentives may have operated differently during the two periods.

Our findings for derivatives hedging are remarkably similar to our original findings over both periods. An interesting exception is that the relation between CFO shareholdings and derivatives use is significantly positive in the 2009–2011 period, implying that derivative hedging is more likely the greater the CFO’s shareholding. This finding is accompanied by an inverse relation between CFO shareholding and FX exposure for the same period; CFOs with higher shareholdings encouraged more hedging during this period of strong Australian dollar appreciation, resulting in improved exposure outcomes. Furthermore, in contrast to the later period (2012–2014), in which our findings are in general robust, in the strong appreciation phase of 2009–2011, CEOs’ and directors’ share and options holdings have no significant effect on the firm’s exposure outcome. It seems that during this period of an unusually strong rise in the Australian dollar – creating considerable stress for exporters – the risk-reducing incentive effect of CFOs’ equity-linked securities holdings dominated. Overall, our findings for the CFO subsample have remained highly robust and, in general, point to the conclusion that the incentives faced by CFOs holding equity-linked securities are the dominant force in the firm’s FX hedging decisions.

6. Concluding comments

This article investigates the role of equity-linked executive compensation on firms’ use of FX derivatives and their exposure to exchange rate movements, for a sample of 268 Australian firms. While theoretical and empirical studies show that equity-linked compensation provides an effective incentive mechanism for ameliorating issues surrounding managers’ unwillingness to take on high business risk projects, our findings show that it has a critical downside: substantial CEO share and options holdings and directors option holdings are associated with a lower likelihood that the firm hedges its FX risk with derivatives. Higher FX exposure is also found when CFOs have low levels of shareholdings and option holdings. As financial risk management enhances firm value, executives’ holdings of shares and options may have the effect of undoing the business risk-taking incentive benefits of equity-linked executive remuneration. The much stronger and more robust finding of this article, however, is that CFOs, where they hold a substantial quantity of shares and options in the firm, have the incentive to ensure effective FX hedging is undertaken. The outcome is that CFOs’ interests are aligned with those of shareholders.

Footnotes

Final transcript accepted 27 December 2018 by Barry Oliver (AE Finance).

Funding

The author(s) received no financial support for the research, authorship, and/or publication of this article.

Notes

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