“Eurozone firms’ derivatives usage: an empirical examination.”

In this study, I empirically examine the determinants of firms’ derivatives usage. Theory suggests that market exposure, manager-shareholder agency conflicts, and the threats of financial distress and underinvestment can all motivate derivatives usage. Most previous studies attempt to test these ‘theories of optimal derivatives usage’ empirically by regressing some measure of derivatives usage on a range of accounting proxies for these firm attributes. I use a similar approach in this study. However, since these theories do not discriminate between different categories of derivatives - foreign currency (FX), interest rate (IR) and commodity price (CP) - most previous studies examine either general derivatives usage or only one of these categories of derivatives. Instead, I separately examine what motivates firms’ binary (yes/no) decisions to use foreign currency (FX), interest rate (IR) and commodity price (CP) derivatives. Furthermore, owing to a lack of accessible data, most previous studies restrict the analysis to the binary usage decision. This study overcomes that limiation by assembling a unique dataset to examine whether what motivates firms’ binary usage decisions differs from what motivates the extent of their derivatives usage. Lastly, recent studies suggest that firms’ derivatives decisions are codetermined with other corporate financing policies. Hence, I also examine what motivates two of firms’ capital structure decisions: the level and the maturity of debt. Using a sample of 710 large, non-financial, Eurozone firms, I gather two years of data on firms’ FX, IR and CP notional derivatives usage from annual report disclosures. Many of the accounting measures, which are traditionally used as proxies for the firm attributes thought to motivate derivatives usage, are readily available on databases such as DataStream. However, I also manually gather a number of customized variables from annual report disclosures to ensure that the proxies used in this study are as close as possible to the firm attributes they are intended to represent. I use a Tobit model to model each category of derivatives usage as a singular decision and compare this to a two-step model similar to Cragg’s (1971), in which the derivatives decision is modeled as a two-step process: first, the decision to use and second, the decision of how much to use. In robustness tests, I attempt to control for sample selection bias using a Heckman (1976, 1979) model, omitted variables bias using a fixed effects model, and simultaneity bias using a two stage least squares (2SLS) model. I find that firms’ FX derivatives decisions are motivated by foreign currency exposure, economies of scale, and liquidity concerns. On the other hand, their IR derivatives decisions are motivated by underinvestment and financial distress costs, with particular emphasis on capital structure. This suggests that the theories of optimal derivatives usage need to be reimagined to incorporate the different motivations to use distinct categories of derivatives. I also find that what motivates a firm’s decision to use derivatives is different from what motivates the extent of its usage, again suggesting that a possible reconsideration of the theory is needed, which assumes both decisions are concurrent. With respect to the determinants of the level and the maturity of firms’ debt, I find further evidence of the strong linkages between capital structure and derivatives usage, with particular emphasis on IR derivatives. My findings therefore suggest that no examination of derivatives usage is complete without recognition of other corporate financing policies.