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Examining the Relationship between Organizational Risk Attributes of U.S.

Defense
Companies and Corporate Hedging

Dissertation
Submitted to Northcentral University
Graduate Faculty of the School of Business and Technology Management
in Partial Fulfillment of the
Requirements for the Degree of

DOCTOR OF BUSINESS ADMINISTRATION

by
CHARLIE SHAO

Prescott Valley, Arizona


September 2012

UMI Number: 3534186

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Charlie Shao

APPROVAL PAGE

Examining the Relationship between Organizational Risk Attributes of U.S. Defense


Companies and Corporate Hedging
by
Charlie Shao
Approved by:

Chair: Steven Munkeby, D.M

U/-T/ao\a.
Date

Member: Roy Nafarrete, D.M.


Member: Becky Takeda-Tinker, Ph.D.

Certified by:

School Dean: A. Lee Smith, Ph.D.

vi / W / ? Date

Abstract
Corporate hedging had become a vital activity for success of United States (U.S.) defense
firms. As a result of corporate hedging in foreign exchange and currency risk
management, U.S. defense companies were exposed recently to financial risks resulting
in millions of dollars of lost profits. While research has shown organizational risk
attributes may be indicators of corporate hedging activities, the relationship between
organizational risk attributes and corporate hedging practices in U.S. defense industry has
not been studied. To ensure the success of corporate hedging, managers in the U.S.
defense companies need to be attentive to the organizational determinants that might
influence corporate hedging decisions. The purpose of this study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management. A linear regression model was
utilized to estimate the relationship between seven risk attributes and corporate hedging
for a random sample of 55 U.S. defense companies that were faced with foreign exchange
and currency risk exposures. Evidence indicated financial distress was not statistically
significant correlated with corporate hedging, t(53) = 1.18,/? > .05; tax benefits were
statistically significant and positively correlated with corporate hedging, t(53) = 6.64, p
< .05; underinvestment problems were positively correlated with corporate hedging, /(53)
= 2.44, p < .05; managerial incentives were not statistically significant correlated with
corporate hedging, /(53) = -1.92, p > .05; scale economies were statistically significant
and positively correlated with corporate hedging, r(53) = 4.54, p < .05; level of foreign
involvement was not statistically significant correlated with corporate hedging, f(53) =
1.45, p > .05; and revenues derived from U.S. government contracts were negatively

iv

correlated with corporate hedging, /(53) = -2.39, p < .05. Findings of this research
suggest tax benefits, underinvestment problems, scale economies, and revenues derived
from U.S. government contracts are important determinants of corporate hedging for U.S.
defense companies. Further research in assessment of the relationship between
organizational risk attributes of U.S. defense companies and corporate hedging is
recommended.

Acknowledgements
There is no way I could have written this dissertation manuscript without my
support team. I would like to take this opportunity to express my profound gratitude to
all who helped me complete this research study. Their comments and suggestions were
inestimably contributed to the success of the study. I am particularly grateful to my
committee chair, Dr. Steven Munkeby, who made specific comments and suggestions
that led to significant improvements of the study. The consistent counsel and guidance
provided by Dr. Munkeby have been invaluable. I would like to thank my committee
members, Dr. Roy Nafarrete and Dr. Becky Takeda-Tinker, for their wisdom and advices
as well. I also owe a word of appreciation to Dr. Bob Goldwasser, Dr. Catherine
Crocker, Dr. Emil Berendt, Dr. Carrie Williams, and Dr. John Caruso for their
encouragement and knowledge in my pursuit of this academic journey.
I would like to give a special thanks to the establishment of an employee scholar
program at United Technologies Corporation (UTC) and Computer Sciences Corporation
(CSC). I have been encouraged to develop additional skills and engage in lifelong
learning from the program. In particular, my thanks go out to my former and current
managers, Aksel Sidem, Barbara Nickels, and Daniel Hamernick, for their support of my
academic study along the way.
Most naturally, I want to say thanks to my wife Jenny and sons Jason and Tyler,
who gave me the time and quiet I needed to work and do research for the study. Without
their constant support and patience, the completion of this study would not have been
possible. I also appreciate my brother, Dr. Ruijin Shao, to let me learn from his

vi

knowledge and experience. As always, I would like to thank my parents and parents-inlaw for their love and prayers for me on the journey.

vii

Table of Contents
List of Tables

List of Figures

xi

Chapter 1: Introduction
Background
Problem Statement
Purpose of the Study
Theoretical Framework
Research Questions
Hypotheses
Nature of the Study
Significance of the Study
Definitions
Summary

1
2
4
4
6
11
12
14
17
18
24

Chapter 2: Literature Review


Overview
Financial Distress
Tax Benefits
Underinvestment Problems
Managerial Incentives
Scale Economies
Level of Foreign Involvement
Other Factors
Corporate Hedging in Foreign Exchange and Currency Risk Management
Summary

26
28
33
37
43
46
53
56
59
78
85

Chapter 3: Research Method


Research Design and Methods
Participants
Research Instruments
Operational Definition of Variables
Data Collection, Processing, and Analysis
Methodological Assumptions, Delimitations, and Limitations
Ethical Assurances
Summary

87
88
91
93
101
104
117
118
120

Chapter 4: Findings
Results
Evaluation of Findings
Summary

122
123
147
153

Chapter 5: Implications, Recommendations, and Conclusions

155

viii

Implications
Recommendations
Conclusions

156
167
169

References

174

Appendixes
194
AppendixA: Random Sampling Procedure
195
Appendix B: Determination of Sample Size with a Priori Power Analysis
196
Appendix C: Permission to Use the Diagram of Evaluating Secondary Data
199
Appendix D: Residual Plots for the Independent Variables
200
Appendix E: Normal Probability Plots of Residuals for the Dependent Variable ....204
Appendix F: Approval Letter for the Research Study from the University's IRB ...208

ix

List of Tables
Table 1 Summary of Independent Variable, Description and Data Type
102
Table 2 General Guidelines for Interpreting the Calculated Value of Durbin-Watson
Statistics (d)
113
Table 3 Frequencies and Percentages of Corporate Hedging in Foreign Exchange and
Currency Risk Management Markets
124
Table 4 Frequencies and Percentages for Financial Distress
125
Table 5 Frequencies and Percentages for Tax Benefits
126
Table 6 Frequencies and Percentages for Underinvestment Problems
127
Table 7 Frequencies and Percentages for Managerial Incentives
128
Table 8 Frequencies and Percentages for Scale Economies
129
Table 9 Frequencies and Percentages for Level of Foreign Involvement
130
Table 10 Frequencies and Percentages for Revenues Derivedfrom U.S. Government
Contracts
131
Table 11 Descriptive Statistics of the Risk Attributes of U.S. Defense Companies and
Corporate Hedging in Foreign Exchange and Currency Risk Management Markets.... 132
Table 12 The Calculated Value of Durbin-Watson Statistic (d) for Independent Variables
in the Analyzed Data Sets
135
Table 13 Results of Testing the Significance of the Linear Relationship between Financial
Distress and Corporate Hedging (n = 55)
137
Table 14 Results of Testing the Significance of the Linear Relationship between Tax
Benefits and Corporate Hedging (n = 55)
138
Table 15 Results of Testing the Significance of the Linear Relationship between
Underinvestment Problems and Corporate Hedging (n = 55)
140
Table 16 Results of Testing the Significance of the Linear Relationship between
Managerial Incentives and Corporate Hedging (n = 55)
141
Table 17 Results of Testing the Significance of the Linear Relationship between Scale
Economics and Corporate Hedging (n = 55)
143
Table 18 Results of Testing the Significance of the Linear Relationship between Level of
Foreign Involvement and Corporate Hedging (n = 55)
144
Table 19 Results of Testing the Significance of the Linear Relationship between Revenues
Derived from U.S. Government Contracts and Corporate Hedging (n = 55)
146

List of Figures
Figure 1. Tax benefits in corporate hedging
Figure 2. Evaluating secondary data

xi

38
107

Chapter 1: Introduction
With growing globalization and the global economic and financial crisis
beginning in 2008, the increased volatility of the financial markets has given rise to
increased financial risks faced by United States (U.S.) defense companies such as
Lockheed Martin Corporation and the Boeing Company (The Boeing Company, 2009;
Chance & Brooks, 2007; Gregory, 2010; Lockheed Martin Corporation, 2009). The
management of financial risks has become paramount for the survival of U.S. defense
companies in volatile financial markets (The Boeing Company, 2009; Chance & Brooks,
2007; Lockheed Martin Corporation, 2009; Whaley, 2006). In 2009, a survey from the
International Swaps and Derivatives Association (ISDA) indicated increased corporate
usage of financial derivatives. Representatives of more than 94% of the top 500 global
companies use derivative instruments to manage and hedge financial risks more
effectively (ISDA, 2009). As a means of reducing financial risk, corporate hedging with
derivatives is an integral part of corporate risk management among leading companies
worldwide (Chance & Brooks, 2007).
An introduction to the problem resulting from corporate hedging in risk
management is provided in this chapter. Background information is presented regarding
the importance of the problem caused by corporate hedging. The problem and the
purpose of the study are presented, followed by a discussion of the theoretical framework
of the study. Research questions and hypotheses are defined, and the nature and
significance of the study are described. Finally, definitions of key terms for the study are
given, followed by a summary of the chapter.

Background
A derivative is a financial instrument whose value is derived iBrom the value of
another underlying asset (Chance & Brooks, 2007; Hull, 2006; Stulz, 2003). The
derivatives used by representatives of a company to hedge financial risk include forward
contracts, future contracts, option, and swap (Hancock-Weise, 2011; Hull, 2006; Whaley,
2006). In general, corporate hedging with derivatives is defined as "a component of a
more general process called risk management, the alignment of the actual level of risk
with the desired level of risk" (Chance & Brooks, 2007, p. 355). There is a demonstrated
need for corporate hedging in foreign exchange and currency risk management (Eiteman,
Stonehill, & Moffett, 2007; Homaifar, 2004; Nguyen & Faff, 2010). Such evidence
points to the fact that companies benefit from corporate hedging (Froot, Scharfstein, &
Stein, 1993; Graham & Smith, 1999; Jensen & Meckling, 1976; Morellec & Smith, 2007;
Smith & Stulz, 1985; Shapiro, 2005). Corporate hedging with derivatives can be
designed to create a wide range of cash flows because derivatives are cheap and flexible
(Hancock-Weise, 2011; Nguyen & Faff, 2010; Whaley, 2006).
As documented in the annual financial reports, company representatives in the
U.S. defense industry perform corporate hedging in risk management on a regular basis
(The Boeing Company, 2009; Lockheed Martin Corporation, 2009). Corporate hedging
is important to ensure that U.S. defense companies gain reliable, timely, and affordable
access to materials needed to produce defense products and to protect the value of the
assets of a company against appreciation or depreciation in foreign currencies (The
Boeing Company, 2009; Eiteman et al., 2007; Stulz, 2003; Lockheed Martin Corporation,
2009; Watts, 2008). However, company representatives are reluctant to hedge against a

foreign exchange and its currency risks because corporate hedging may introduce risks
such as a buildup of a derivative position, which is an uncertainty in terms of the hedge
performance, counterparty risks, and possible high hedging costs (Chance & Brooks,
2007; Gregory, 2010; Hancock-Weise, 2011; Stulz, 2003; Whaley, 2006). Uncertainties
regarding global currency may result in increased costs and reduced profits for U.S.
defense companies while limiting the desire of representatives of these companies to
conduct business with foreign markets (The Boeing Company, 2009; Eiteman et al.,
2007; Homaifar, 2004; Lockheed Martin Corporation, 2009).
Researchers (e.g., Artez & Bartram, 2010; Stulz, 2003) have suggested a range of
theoretical determinants that might influence corporate hedging decisions at the
organizational level. The main explanations of corporate hedging focus on risk
management as a means to lessen the possibility of financial distress (Smith & Stulz,
1985), reduce expected taxes (Graham & Smith, 1999; Smith & Stulz, 1985), avoid
underinvestment (Froot et al., 1993), and maximize managers' own self-interest (Jensen &
Meckling, 1976; Shapiro, 2005; Stulz, 2003). However, the determinants of corporate
hedging in foreign exchange and currency risk management can differ across different
industry sectors and companies with different characteristics (Adam, Dasgupta, &
Titman, 2007; Bartram, Brown, & Fehle, 2009; Lei, 2006; Papaioannou, 2006; Reynolds,
Bhabra, & Boyle, 2009; Rogers, 2002). To improve the efficiency of corporate hedging
in risk management, managers in the U.S. defense companies need to be attentive to the
organizational determinants that might affect corporate hedge policies (Artez & Bartram,
2010; Stulz, 2003).

Problem Statement
The problem addressed in this study was that, as a result of corporate hedging
practices in foreign exchange and currency risk management markets, U.S. defense
companies are exposed to financial risks leading to a potential loss of millions of dollars
of profit (The Boeing Company, 2009; Chance & Brooks, 2007; Eiteman et al., 2007;
Gregory, 2010; Lockheed Martin Corporation, 2009; Stulz, 2003). As a U.S. government
contractor, the Boeing Company reported net losses of $92 and $101 million, in 2007 and
2008 respectively, associated with corporate hedging transactions (The Boeing Company,
2009). Derivatives used for defense contracts, with notional foreign exchange and
currency values of $1.9 billion in 2008 and $1.4 billion in 2009, were designated as
hedging instruments (Lockheed Martin Corporation, 2009). Although corporate hedging
in risk management is receiving increasing attention in the U.S. defense industry, whether
organizational risk factors relate to corporate hedging for U.S. defense companies is
unknown (Artez & Bartram, 2010). To ensure that company managers succeed in
performing corporate hedging in risk management, a need exists for empirical assessment
regarding the relationship between the risk attributes of U.S. defense companies and
corporate hedging (Artez & Bartram, 2010; Petersen & Thiagarajan, 2000; Stulz, 2003).
The relationship between the risk attributes of U.S. defense companies and corporate
hedging practices in foreign exchange and currency risk management markets has not
been examined in previous literature.
Purpose of the Study
The purpose of this quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging

in foreign exchange and currency risk management markets. A secondary data analysis
was used. The independent variables of the risk attributes of U.S. defense companies
were defined as financial distress, underinvestment problems, tax benefits, managerial
incentives, scale economies, level of foreign involvement, and revenues from U.S.
government contracts (Allayannis & Ofek, 2001; Bartram et al., 2009; Dolde & Mishra,
2007; Froot et al., 1993; Jensen & Meckling, 1976; Jorion, 1990; Smith & Stulz, 1985;
Stulz, 2003). The dependent variable was defined as corporate hedging in foreign
exchange and currency risk management markets. The population for the study consisted
of 194 U.S. defense companies in the National Automated Accounting Research System
(NAARS) database (American Institute of Certified Public Accountants, 2005). All 194
defense companies that conducted defense-related business from 2000 to 2010 in the U.S.
qualified for inclusion in the study. A random sample for the study was drawn from the
list of 194 U.S. defense companies. From this population, a sample size of 55 U.S.
defense companies was used to ensure statistical significance. All financial data were
collected from the annual financial report on Form 10-K and the annual proxy statement,
filed in the electronic data gathering and retrieval (EDGAR) database system of the U.S.
Securities and Exchange Commission (Securities and Exchange Commission [SEC],
2012). With the passage of the Sarbanes-Oxley Act of2002, corporate executives must
certify the financial statements are faithful representations of the financial positions and
results of operations of the company (Whittington & Pany, 2004). Because of the
improved disclosure requirements for the business and financial information of a
company, more empirical studies have been based on the use of the data contained in the
annual financial reports (Apostolou & Apostolou, 2008; Bartram et al., 2009; Carter,

Rogers, & Simkins, 2006; Hsu, Ko, Wu, Cheng, & Chen, 2009; Judge, 2006; Nguyen,
Mensah, & Faff, 2007; Ramirez, 2007; Reynolds et al., 2009; Schiozer & Saito, 2009;
Spano, 2008; SprCic, 2007).
Theoretical Framework
The underlying theoretical framework supporting this study is composed of
corporate hedging theories and empirical studies. To discuss the rationale for engaging in
corporate hedging and what the effects of corporate hedging can be, the two most
prevalent theories used by representatives of nonfinancial companies are shareholder
value maximization theory and managerial utility maximization theory. Empirical
research on corporate hedging in foreign exchange and currency risk management for
nonfinancial companies is relatively recent, and the results of the empirical studies are
varied (Allayannis & Weston, 2001; Bartram et al., 2009; Berkman, Bradbury, Hancockc,
& Innes, 2002; Brown, 2001; Carter et al., 2006; Davies, Eckberg, & Marshall, 2006;
Dolde & Mishra, 2007; Fabling & Grimes, 2008; Graham & Rogers, 2002; Hagelin,
2003; Judge, 2006; Kapitsinas, 2008; Lei, 2006; Luiz & Junior, 2011; Marsden &
Prevost, 2005; Menon & Viswanathan, 2005; Nguyen & Faff, 2003; Reynolds & Boyle,
2005; Schiozer & Saito, 2009; Spano, 2008). The current study was designed to confirm
whether the corporate hedging theories and the findings from empirical studies are
applicable to corporate hedging practices in the U.S. defense industry.
According to the shareholder value maximization theory, the exploitation of
inefficiencies in the perfect capital market is based on the assumption that corporate
hedging can add value by reducing various costs involved with future cash flows and
alleviating problems associated with these costs. Furthermore, financially distressed

companies face costs of default on debt obligations and costs of filing for bankruptcy
(Smith & Stulz, 1985). One of the most important benefits in effective risk management
is to reduce the costs associated with financial distress (Stulz, 2003). Given these costs,
company representatives have incentives to reduce the probability of financial distress.
When companies are subject to a progressive tax system, corporate hedging can reduce
expected tax liabilities (Graham & Smith, 1999; Smith & Stulz, 1985). As such, a greater
convexity in the tax functiorj will lead to a greater likelihood of corporate hedging.
Furthermore, when external financing is more costly to companies than are internally
generated funds, company representatives may tend to use derivative instruments (Froot
et al., 1993). In particular, the company representatives can hedge cash flows to avoid a
shortfall in internal funds so that costly external financing from the capital markets may
be prevented (Froot et al., 1993).
The primary theoretical alternative to the shareholder value maximization as a
corporate hedging theory is managerial utility maximization. From the perspective of the
managerial utility maximization theory, corporate hedging can have different effects on
shareholder value. Corporate hedging decisions may be the result of the aversion of
company managers to financial risks because, unlike shareholders, the company
managers have disproportionately large investments in the company, which cannot easily
diversify their risks (Morellec & Smith, 2007). When the objectives of shareholders and
company managers diverge, the managers can behave in their own self-interest rather
than in the best interests of the shareholders (Jenson & Meckling, 1976). Therefore,
company managers may seek to maximize their own self-interest and have incentives to
hedge their own private wealth at the expense of the shareholders (Jensen & Meckling,

1976; Shapiro, 2005; Stulz, 2003). To ensure that company managers act to maximize
shareholder value and not just to advance their own private wealth, managerial
compensation policy can be designed to give the company managers incentives to select
corporate hedging that increase shareholder value (Jenson & Meckling, 1976; Shapiro,
2005; Stulz, 2003). Company managers may also be interested in protecting the
profitability of a company through corporate hedging in risk management because of a
possible change in corporate asset value (Shapiro, 2005).
In addition to the theoretical determinants of corporate hedging, some additional
factors are associated with the use of derivative instruments in company risk
management. These additional factors include scale economies (Allayannis & Ofek,
2001; Nance, Smith, & Smithson, 1993), firm value (Carter et al., 2006; Jin & Jorion,
2006), level of foreign involvement (Howton & Perfect, 1998; Menon & Viswanathan,
2005), foreign debt (Judge, 2009; Nguyen & Faff, 2006), asymmetric information
(Breeden & Viswanathan, 1996; DeMarzo & Duffie, 1991), board characteristics
(Borokhovich, Brunarski, Crutchley, & Simkins, 2004; Prevost, 2005), industry-specific
characteristics (Rogers, 2002; Schiozer & Saito, 2009), country-specific characteristics
(Lei, 2006; Marsden & Prevost, 2005), and accounting reporting methods (Sapra, 2002;
Supanvanij & Strauss, 2010).
Large companies are more likely to hedge than are small companies because the
large companies may have better access to external financing in capital markets
(Allayannis & Ofek, 2001). Smaller companies have been advised to hedge more than
larger ones because the smaller companies are likely to have a greater informational
asymmetric problem (Nance et al., 1993). Corporate hedging and firm value were

positively related in the U.S. airline industry (Carter et al., 2006). In contrast, corporate
hedging did not affect market values of companies in the U.S. oil and gas industry (Jin &
Jorion, 2006). Corporate hedging activities were significantly and positively related to
the extent of foreign involvement by U.S. multinational corporations (Menon &
Viswanathan, 2005). However, the relationship between the level of foreign involvement
and corporate hedging with currency derivatives was not strongly supported in another
study (Howton & Perfect, 1998). Corporate hedging was significantly related to the
existence of foreign debt in one study (Judge, 2009), but in a different study, the use of
foreign debt was found to be irrelevant to corporate hedging in foreign exchange and
currency risk management (Nguyen & Faff, 2006).
Corporate hedging decisions can be explained by the reputation of company
managers (Breeden & Viswanathan, 1996; Demarzo & Duffie, 1991). Board
composition was not related to the use of derivative instruments (Marsden & Prevost,
2005). Board size and the presence of corporate executives on the board were not found
to be determinants of corporate hedging (Borokhovich et al., 2004). Because regulated
industries operated in more stable environments (Smith & Watts, 1992), representatives
of companies in regulated industries used corporate hedging less than did representatives
of companies in unregulated industries (Rogers, 2002). Furthermore, company
representatives in regulated industries were less likely to use currency derivatives for
corporate hedging (Schiozer & Saito, 2009). Financial market developments, legal
environment, and macroeconomic characteristics of the country were considered to be
possible reasons for differences in corporate hedging practices (Lei, 2006; Marsden &
Prevost, 2005). Derivative reporting transparency is a significant determinant of

10

corporate hedging (Supanvanij & Strauss, 2010). Furthermore, increased reporting of


transparency resulting from the FAS 133 standard may induce company representatives
to take an excessive speculative position (Sapra, 2002).
From a theoretical perspective, companies benefit from corporate hedging in
foreign exchange and currency risk management because of shareholder value
maximization and managerial utility maximization (Froot et al., 1993; Graham & Smith,
1999; Jensen & Meckling, 1976; Morellec & Smith, 2007; Smith & Stulz, 1985; Shapiro,
2005). The theoretical framework presented in the study underscores the premise that
U.S. defense companies may benefit from corporate hedging in foreign exchange and
currency risk management. Recently, corporate hedging theories have been empirically
tested to examine if nonfinancial companies benefit from corporate hedging in foreign
exchange and currency risk management (Allayannis & Weston, 2001; Bartram et al.,
2009; Berkman et al., 2002; Brown, 2001; Carter et al., 2006; Davies, Eckberg, &
Marshall, 2006; Dolde & Mishra, 2007; Fabling & Grimes, 2008; Graham & Rogers,
2002; Hagelin, 2003; Judge, 2006; Kapitsinas, 2008; Lei, 2006; Luiz & Junior, 2011;
Marsden & Prevost, 2005; Menon & Viswanathan, 2005; Nguyen & Faff, 2003;
Reynolds & Boyle, 2005; Schiozer & Saito, 2009; Spano, 2008). However, the
conflicting findings from prior empirical studies remain because the conclusions from the
prior empirical studies are largely sample specific, and the measurement of the
determinants for corporate hedging is not consistent (Artez & Bartram, 2010; Nguyen &
Faff, 2010; Stulz, 2003).
Although the existing empirical studies on corporate hedging in foreign exchange
risk management by nonfinancial companies are diverse, in a recent review of the

11

literature, a gap in research studies on the relationship between the risk attributes of U.S.
defense companies and corporate hedging was identified. Therefore, additional research
to assess the relationship between the risk attributes of U.S. defense companies and
corporate hedging in foreign exchange and currency risk management markets is
warranted. Furthermore, an evaluation of the corporate hedging theories in light of the
findings from empirical studies was enabled by the current study. As such, the study can
be used to extend the body of knowledge on corporate hedging at an organizational level.
Research Questions
To broaden a view of corporate hedging in the U.S. defense industry with
discussions of risk management for a specific financial exposure to U.S. defense
companies, the following research questions directed the focus of the study:
Ql. To what extent, if any, is financial distress related to corporate hedging in
foreign exchange and currency risk management markets for U.S. defense companies?
Q2. To what extent, if any, are tax benefits related to corporate hedging in
foreign exchange and currency risk management markets for U.S. defense companies?
Q3. To what extent, if any, are underinvestment problems related to corporate
hedging in foreign exchange and currency risk management markets for U.S. defense
companies?
Q4. To what extent, if any, are managerial incentives related to corporate
hedging in foreign exchange and currency risk management markets for U.S. defense
companies?
Q5. To what extent, if any, are scale economies related to corporate hedging in
foreign exchange and currency risk management markets for U.S. defense companies?

12

Q6. To what extent, if any, is level of foreign involvement related to corporate


hedging in foreign exchange and currency risk management markets for U.S. defense
companies?
Q7. To what extent, if any, are revenues from U.S. government contracts related
to corporate hedging in foreign exchange and currency risk management markets for U.S.
defense companies?
Hypotheses
Based on the research questions and literature review presented in Chapter 2,
seven hypotheses about the relationship between the risk attributes of U.S. defense
companies and corporate hedging in foreign exchange and currency risk management
markets were developed for the study.
Hl0. Financial distress, as measured with debt ratio, is not correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
Hla. Financial distress, as measured with debt ratio, is correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
H2o. Tax benefits, as measured with income tax credit range, are not correlated to
corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.
H2. Tax benefits, as measured with income tax credit range, are correlated to
corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.

13

H3o. Underinvestment problems, as measured with research and development


(R&D) spending, are not correlated to corporate hedging in foreign exchange and
currency risk management markets, as measured with notional value of derivatives, for
U.S. defense companies.
H3a. Underinvestment problems, as measured with R&D spending, are correlated
to corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.
H4o. Managerial incentives, as measured with presence of corporate executives'
stock shares, are not correlated to corporate hedging in foreign exchange and currency
risk management markets, as measured with notional value of derivatives, for U.S.
defense companies.
H4. Managerial incentives, as measured with presence of corporate executives'
stock shares, are correlated to corporate hedging in foreign exchange and currency risk
management markets, as measured with notional value of derivatives, for U.S. defense
companies.
H5o- Scale economies, as measured with firm size, are not correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
H5a. Scale economies, as measured with firm size, are correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.

14

H6o. Level of foreign involvement, as measured with foreign sale ratio, is not
correlated to corporate hedging in foreign exchange and currency risk management
markets, as measured with notional value of derivatives, for U.S. defense companies.
H6a. Level of foreign involvement, as measured with foreign sale ratio, is
correlated to corporate hedging in foreign exchange and currency risk management
markets, as measured with notional value of derivatives, for U.S. defense companies.
H70. Revenues derived from U.S. government contracts, as measured with sales
to U.S. government, are not correlated to corporate hedging in foreign exchange and
currency risk management markets, as measured with notional value of derivatives, for
U.S. defense companies.
H7a. Revenues derived from U.S. government contracts, as measured with sales
to U.S. government, are correlated to corporate hedging in foreign exchange and currency
risk management markets, as measured with notional value of derivatives, for U.S.
defense companies.
Nature of the Study
The purpose of this quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. The design of the study was
based on an analysis of secondary source. The quantitative correlational study was
theoretically informed by related literature on corporate hedging. A positivistic view was
used to develop a focus on theory testing, wherein corporate hedging theories were first
adopted as the framework for developing and testing hypotheses in the research context
(Trochim & Donnelly, 2008). Therefore, a deductive orientation of the study was

15

emphasized in the study (Trochim & Donnelly, 2008). Given the nature of the research
purpose, the research questions, and the adequate availability of previous empirical
studies to formulate hypothesized relationships for examination, the research design for
the study was a quantitative correlational design.
The population for the study consisted of 194 U.S. defense companies listed in the
NAARS database (American Institute of Certified Public Accountants, 2005). All 194
defense companies that conducted defense-related business from 2000 to 2010 in the U.S.
qualified for inclusion in the study. From this population, 55 U.S. defense companies
were randomly selected to ensure statistical significance. Seven constructed independent
variables were defined to represent the risk attributes of U.S. defense companies: (a)
financial distress, (b) underinvestment problems, (c) tax benefits, (d) managerial
incentives, (e) scale economies, (f) level of foreign involvement, and (g) revenues from
U.S. government contracts. The instruments to measure the independent variables were
debt ratio, income tax credit range, R&D spending, presence of corporate executives'
(CEO) stock shares, firm size, foreign sale ratio, and sales to U.S. government. The
constructed dependent variable for the study was defined as corporate hedging in foreign
exchange and currency risk management markets. Corporate hedging was measured as
the notional value of derivatives. All data were collected from the annual financial report
on Form 10-K and the annual proxy statement in the EDGAR database system of the
SEC.
In prior empirical studies, the outcome of corporate hedging decisions was
considered to be a linear function of the independent variables, which are proxies of the
determinants of corporate hedging (Allayannis & Weston, 2001; Berrospide,

16

Purnanandam, & Rajan, 2007; Carter et al., 2006; Hagelin, 2003; Jin & Jorion, 2006;
Judge, 2006; Khediri, 2010; Lei, 2006; Nguyen et al., 2007; Nguyen & Faff, 2010;
Spano, 2008; SprCic, 2007). In the current study, the relationship between each
independent variable and the dependent variable was measured as a bivariate linear
regression, with corporate hedging in foreign exchange and currency risk management
markets as the dependent variable and a U.S. defense company-specific risk attribute as
the independent variable. Bivariate linear regression analyses were performed to address
the research questions for the study. Parametric methods to test the hypotheses were used
because the normality, independence of errors, and equal variance assumptions for
performing a bivariate linear regression were met (Allen, 2004, Weiers, 2002).
Parametric linear regressions were used in prior empirical studies to determine similar
relationships (Carter et al., 2006; Hagelin, 2003; Hsu et al., 2009; Jin & Jorion, 2006;
Judge, 2006; Khediri, 2010; Lei, 2006; Nguyen et al., 2007; Nguyen & Faff, 2010;
Reynolds, Bhabra, & Boyle, 2009; Spano, 2008; SprCic, 2007). The following steps were
taken for conducting hypothesis testing to address the research questions in the study:
state the hypothesis to be tested, analyze the assumptions of underlying linear regression,
select test statistic used for measures of association, and define decision criterion to either
accept or reject the hypothesis (Allen, 2004; Lind, Marchal, & Mason, 2005; Zikmund,
2003). To support the interpretation associated with correlation in bivariate linear
regression analysis, the coefficient of determination and sign of regression coefficients
indicated the strength and direction of the association between the risk attributes of U.S.
defense companies and corporate hedging in foreign exchange and currency risk
management markets.

17

Significance of the Study


To compete in global markets as well as competitive and regulated environments,
U.S. defense companies are exposed to financial risks resulting in a potential loss of
millions of dollars of profits as a result of corporate hedging practices in foreign
exchange and currency risk management (The Boeing Company, 2009; Chance &
Brooks, 2007; Eiteman et al., 2007; Gregory, 2010; Lockheed Martin Corporation, 2009;
Stulz, 2003). Identifying and measuring the determinants for corporate hedging becomes
a critical battle for company managers in U.S. defense companies. If the relationship
between the risk attributes of U.S. defense companies and corporate hedging in foreign
exchange and currency risk management markets is conclusively demonstrated, the study
may provide useful insight for corporate hedging to company managers in the U.S.
defense industry, and may help to improve the effectiveness of strategic thinking and
decision-making for corporate hedging by U.S. defense companies in foreign exchange
and currency risk management markets.
The contribution of this study to the literature regarding corporate hedging is
significant given that U.S. defense companies potentially lose millions of dollars of
profits as a result of corporate hedging practices in foreign exchange and currency risk
management. In addition, no prior research studies have been conducted on corporate
hedging in risk management in terms of the risk attributes of U.S. defense companies.
Therefore, research designed to examine the relationship between the risk attributes of
U.S. defense companies and corporate hedging in foreign exchange and currency risk
management markets is merited. The current study was applied to add to the
understanding of the determinants of corporate hedging in foreign exchange and currency

18

risk management at the organizational level. Furthermore, the results of the study have
the potential to trigger further research into this relationship.
Definitions
Agency costs. Agency costs are "costs caused by management's ability to pursue
its own interests at the expense of the firm's shareholders" (Stulz, 2003, p. 645).
Bankruptcy costs. Bankruptcy costs are "the costs incurred as a result of a
bankruptcy filing" (Stulz, 2003, p. 645).
Counterparty risks. Counterparty risks are "the risk that a counterparty fails to
deliver the promised payoff, either because of being financially unable to do so or for
other reasons" (Stulz, 2003, p. 647).
Convex function. According to Jensen's inequality (Azar, 2008), iff(x) is a
convex function and x is a random variable with nonzero variance, the expectation of the
transform of a random variable x by a convex function is larger than the transform of the
expectation of x, that is, E(/(x)) >y(E(x)) (Azar, 2008). A tax function for a given
company is a convex function (Smith & Stulz, 1985).
Convexity. A convexity is "a curve above a straight line connecting two end
points" (Harvey, n.d., p. 376). This curve is used to describe characteristics of a tax
function for a given company.
Corporate Hedging. Corporate hedging is "a component of a more general
process called risk management, the alignment of the actual level of risk with the desired
level of risk" in a company (Chance & Brooks, 2007, p. 355).

19

Currency risk. Currency risk is "the risk that currency exchange rates may
change adversely for a business that has exposure to foreign currency" (Stephens, 2001,
P- 8).
Default. Default is the failure to make interest and principal payments as agreed
to in a debt agreement based on the terms and at the designated time set (Penman, 2007).
Derivative. A derivative is "an instrument whose price depends on, or is derived
from, the price of another asset" (Hull, 2006, p. 747).
Economic risk. Economic risk is
The risk to the firm's present value of future operating cash flows from exchange
rate movements. In essence, economic risk concerns the effect of exchange rate
changes on revenues (domestic sales and exports) and operating expenses (cost of
domestic inputs and imports). Economic risk is usually applied to the present
value of future cash flow operations of a firm's parent company and foreign
subsidiaries. (Papaioannou, 2006, p. 131)
Empirical study. An empirical study is "a study using available market data and
observation to draw conclusion" (Hancock-Weise, 2011, p. 471).
Exchange rate. An exchange rate is "the rate at which a unit of one currency is
exchanged for another" (Whaley, 2006, p. 877).
Fair Value of Derivatives. Fair value of derivatives is recorded at market value
on the balance sheet, either an asset or liabilities (Penman, 2007).
Financial Accounting Standard No. 133 (FAS 133). FAS 133 is an accounting
standard that requires derivatives are reflected on the balance sheet at fair market value

20

for U.S. companies (Ramirez, 2007). FAS 133 was issued by the Financial Accounting
Standards Board (FASB).
Financial distress. Financial distress is "a low cash-flow state of the firm in
which it incurs deadweight losses without being insolvent" (Purnanandam, 2007, p. 706).
Financial leverage. Financial leverage is the degree to which a company funds
business operation and investment by debts (Chance & Brooks, 2007).
Financial risk. Financial risk is "the risk associated with changes in such factors
as interest rates, stock prices, commodity prices, and exchange rate" (Chance & Brooks,
2007, p. 627).
Foreign debt. Foreign debt is the debt denominated in foreign currency (Aabo,

2006).
Foreign exchange risk. Foreign exchange risk is
The likelihood that an unexpected change in exchange rates will alter the home
currency value of foreign currency cash payments expected from a foreign source.
Also, the likelihood that an unexpected change home currency needed to repay a
debt denominated in a foreign currency. (Eiteman et al., 2007, p. EM-37)
Foreign involvement. Foreign involvement ranges from simple import or export
activity to more complicated decisions including integrated global sourcing, production,
and competition (Eiteman et al., 2007).
Foreign tax credit. Foreign tax credit is "the amount by which a domestic firm
may reduce (credit) domestic income taxes for income tax payments to a foreign
government" (Eiteman et al., 2007, p. EM-37).

21

Form 10-K. Form 10-K is a report required by the U.S. SEC, in which a
comprehensive overview of a company's business and financial condition, including
audited financial statements, is provided (Penman, 2007).
Forward contract. Forward contract is "one party agrees to buy the underlying
from another party at maturity of the contract and pay for it then a price agreed upon
when the contract is originated with no cash changing hands before maturity" (Stulz,
2003, p. 648).
Future contract Future contract is "a contract traded on an exchange enabling
one party to buy for future delivery and another to sell for future delivery with gains and
losses settled daily" (Stulz, 2003, p. 649).
Hedge. Hedge is "a transaction in which an investor seeks to protect a position or
anticipated position in the spot market by using an opposite position in derivatives"
(Chance & Brooks, 2007, p. 628).
Hedge accounting. Hedge accounting is
A form of accounting for derivatives transactions in which certain transactions,
qualifying as hedges, are accounted for in such a manner that the gains or losses
from hedges are, to an extent, limited by specified rules, combined with gains and
losses from transactions they are designed to hedge, so as to minimize the impact
on reported earnings. (Chance & Brooks, 2007, p. 628-629)
Hedging costs. Hedging costs are "costs of putting on a hedge; examples include
transaction costs, monitoring costs, and design costs" (Stulz, 2003, p. 649).

22

Information asymmetry. When one party to a transaction has more or superior


knowledge and information, the other party does not. This informational disparity is
referred as information asymmetry (DaDalt, Gary, & Nam, 2002).
International Accounting Standard No. 39 (IAS 39). IAS 39 is an international
accounting standard that requires derivatives are reflected on the balance sheet at fair
market value for corporations (Ramirez, 2007). IAS 39 was issued by the International
Accounting Standard Board (IASB).
Managerial incentives. Managerial incentives are the variation in company
managers' total equity holdings as a result of increases in stock prices (Core, Guay, &
Larcker, 2003).
Marginal tax rate. Marginal tax rate is "the highest rate at which income is
taxed" (Penman, 2007, p. 313). In the U.S., "the marginal tax rate is usually the
maximum statutory tax rate for federal and state taxes combined" (Penman, 2007, p.
314).
Net operating loss (NOL) carryback. NOL carryback is an accounting
technique that applies the current year's net operating losses to past years' profits in order
to reduce tax liability (Penman, 2007)
NOL carryforward. NOL carryforward is an accounting technique that applies
the current year's net operating losses to future years' profits in order to reduce tax
liability (Penman, 2007).
Notional value of derivatives. Notional value of derivatives is "the quantity of
the underlying used to determine the payoff of the derivative" (Stulz, 2003, p. 650).

23

Option. Option is "a contract granting the right to buy or sell an asset, currency,
or futures at a fixed price for a specific time period" (Chance & Brooks, 2007, p. 633).
Progressive tax function. A progressive tax function is a convex function that
indicates marginal tax rates are increasing in taxable income, in which "the tax on the
average of two possible outcomes is less than the average of the tax reckoned on each
outcome individually" (Brennan, 2010, p. 2).
Risk aversion. Risk aversion is "the characteristic referring to an investor who
dislike risk and will not assume more risk without an additional return" (Chance &
Brooks, 2007, p. 636).
Risk management. Risk management is "the practice of identifying the risk
level a firm desires, identifying the risk level it currently has, and using derivative or
another financial instruments to adjust the actual risk level to the desired risk level"
(Chance & Brooks, 2007, p. 636).
Scale economies. Scale economies "constitute the relationship between the size
of a firm (or plant) and its costs of production in the broadest sense" (Stigler, 1983, p.
67).
Swap. Swap is "an agreement to exchange cash flows in the future according to a
prearranged formula" (Hull, 2006, p. 757).
Tax benefit. Tax benefit is an allowable deduction on a taxpayer's tax liability
(Penman, 2007).
Transaction risk. Transaction risk is
Cash flow risk and deals with the effect of exchange rate moves on transactional
account exposure related to receivables (export contracts), payables (import

24

contracts) or repatriation of dividends. An exchange rate change in the currency


of denomination of any such contract will result in a direct transaction exchange
rate risk to the firm. (Papaioannou, 2006, p. 131)
Translation risk. Translation risk is "balance sheet exchange rate risk and
relates exchange rate moves to the valuation of a foreign subsidiary and, in turn, to the
consolidation of a foreign subsidiary to the parent company's balance sheet"
(Papaioannou, 2006, p. 131).
Underinvestment problem. Underinvestment problem is characterized by "the
instances wherein companies are unable to fund profitable investments projects due to the
lack of adequate financing" (Salvary, 2005, p. 89).
Summary
The U.S. defense companies are exposed to financial risks resulting in millions of
dollars of lost profits as a result of corporate hedging practices in foreign exchange and
currency risk management markets. The purpose of this quantitative correlational study
was to examine the relationship between the risk attributes of U.S. defense companies
and corporate hedging in foreign exchange and currency risk management markets. The
seven constructed independent variables for the study were defined as (a) financial
distress, (b) underinvestment problems, (c) tax benefits, (d) managerial incentives, (e)
scale economies, (f) level of foreign involvement, and (g) revenues from U.S.
government contracts. The constructed dependent variable for the study was defined as
corporate hedging in foreign exchange and currency risk management markets. A
correlational design was used. The instruments to measure the independent variables
were debt ratio, income tax credit range, R&D spending, presence of corporate

25

executives' stock shares, firm size, foreign sale ratio, and sales to U.S. government. The
instrument for the dependent variable was the notional value of derivatives. The outcome
of the study was a contribution to the understanding of corporate hedging for the U.S.
defense companies and may be employed to help improve the effectiveness of strategic
thinking and decision-making for corporate hedging among U.S. defense companies in
foreign exchange and currency risk management markets. The need and purpose for the
study was established within this chapter; the theoretical framework, research questions,
hypotheses, research methods, nature of the study, and significance were summarized;
and definitions of key terms were provided.

26

Chapter 2: Literature Review


Company managers in the U.S. defense industry perform corporate hedging in
risk management on a regular basis, as documented in the annual financial reports (The
Boeing Company, 2009; Lockheed Martin Corporation, 2009). The problem addressed
within the study was that U.S. defense companies are exposed to financial risks resulting
in millions of dollars of lost profits as a result of corporate hedging practices in foreign
exchange and currency risk management markets (The Boeing Company, 2009; Chance
& Brooks, 2007; Eiteman et al., 2007; Gregory, 2010; Lockheed Martin Corporation,
2009; Stulz, 2003). Although the theoretical consideration and empirical evidence
indicated a range of factors that might influence corporate hedging, the relationship
between the risk attributes of U.S. defense companies and corporate hedging in foreign
exchange and currency risk management is not clear. The quantitative correlational study
was used to examine the relationship between the risk attributes of U.S. defense
companies and corporate hedging in foreign exchange and currency risk management
markets.
The literature search on corporate hedging in foreign exchange and currency risk
management was a significant step in the research process for the study. Since whether a
particular source would be cited in the literature review for the study was unknown, a
complete record of all of the bibliographic information from sources was developed for
the study. Search strategies for the study were to locate books that are currently accepted
reference texts in corporate hedging and find out who has cited the books in recent years
and to search original (seminal) journal papers and identify who has cited the papers in
recent years. Once information related to corporate hedging in foreign exchange and

27

currency risk management was located, the following step was to summarize the
information into a coherent literature review section for the study. To identify which
sources were applicable to the study and in what context sources were related to the
subject of the study, Booth, Colomb, and Williams (1995) suggested to become familiar
with the geography of the source, locate the point of the argument, identify key subpoints, identify key themes, and skim paragraphs. Finally, literature material relevant to
corporate hedging in foreign exchange and currency risk management were focused
without spending time on the literature material that was at best only marginally related.
Most of references cited in the study are from books and peer-reviewed journals.
To assess the relationship between risk attributes and corporate hedging using
derivative instruments is a complex task (Artez & Bartram, 2010; Nguyen & Faff, 2010).
To measure the theoretical risk attributes as determinants of corporate hedging in foreign
exchange and currency risk management is difficult (Nguyen & Faff, 2010; Stulz, 2003).
The determinants of corporate hedging in foreign exchange and currency risk
management can differ across different industry sectors and companies with different
characteristics (Adam et al., 2007; Bartram et al., 2009; Lei, 2006; Papaioannou, 2006;
Rogers, 2002). Therefore, the theoretical discussions, the information from prior
empirical evidence, and the discussion of specific characteristics of the U.S. defense
industry were a theoretical framework upon which the study was built on.
In this chapter, the literature review begins with the importance of identifying
determinants of corporate hedging in risk management followed by the theoretical and
empirical research on corporate hedging in risk management pertaining to the constructs
for the study. In the literature review, theoretical discussions relevant to these constructs

28

are organized into sections to create a context for comprehension of the theoretical
rationale of corporate hedging and to help readers understand the study. In the final
review of literature, specific information and studies on corporate hedging in foreign
exchange and currency risk management are highlighted and followed by a summary of
the chapter.
Overview
Corporate hedging is the process that is used to reduce risk of loss against
negative outcomes within the capital market (Chance & Brooks, 2007). Corporate
hedging policy is a controversial subject in risk management (Stulz, 2003). By
facilitating the access of U.S. companies to international capital markets and enabling
U.S. companies to lower the cost of funds while diversifying the funding sources,
corporate hedging improves the position of U.S. companies in an expanding, competitive,
and global economy (Eiteman et al., 2007). However, the dramatic growth of corporate
hedging activities in risk management coupled with the derivatives-related losses has
resulted in millions of dollars of lost profits in U.S. companies (The Boeing Company,
2009; Chance & Brooks, 2007; Eiteman et al., 2007; Gregory, 2010; Lockheed Martin
Corporation, 2009; Stulz, 2003). The recent economic and financial crisis has further
accentuated the importance of understanding the incentives of corporate hedging
practices for U.S. companies. Identifying corporate hedging becomes an essential
component of corporate hedging strategy in risk management (Artez & Bartram, 2010;
Petersen & Thiagarajan, 2000; Stulz, 2003).
Theoretical and empirical researchers of corporate hedging in risk management
have focused on the question of what factors are used to justify corporate hedging

29

decisions when companies hedge a given risk (Artez & Bartram, 2010; Petersen &
Thiagarajan, 2000; Stulz, 2003). Viewed from a finance theory developed by Modigliani
and Miller (1958), corporate hedging policy is irrelevant in shareholder value creation.
However, characterized by corporate hedging theories, companies have incentives to
hedge (Artez & Bartram, 2010; Stulz, 2003). In the absence of capital market
perfections, the Modigliani and Miller (1958) framework does not hold (Eiteman et al.,
2007). Therefore, research studies, based on corporate hedging theories, were developed
to empirically test various factors to explain corporate hedging behavior in risk
management (Artez & Bartram, 2010; Stulz 2003). Despite extensive empirical research
studies in corporate hedging, the actual determinants of corporate hedging at the
organizational level remain uncertain (Artez & Bartram, 2010; Nguyen & Faff, 2010;
Stulz, 2003).
According to the Modigliani and Miller (1958) framework, perfect capital market
assumptions are no taxes, no transaction costs, no symmetric information between
company managers and shareholders, rational investors and markets, no costs of
bankruptcy, and aligned interests between company managers and shareholders. Under
these assumptions, corporate financing policy cannot be attributed to the shareholder
value creation because shareholders manage their own financial risks by holding welldiversified portfolios (Modigliani & Miller, 1958). Corporate hedging policy is a
component of corporate financing policy because financial claims using derivative
instruments against a firm are involved (Stulz, 2003). Therefore, the Modigliani and
Miller (1958) framework can be extended to the application of corporate hedging
(Stiglitz, 1974). Under the perfect capital market assumptions defined by Modigliani and

Miller (1958), corporate hedging in foreign exchange and currency risk management is
irrelevant in value creation (Stiglitz, 1974). However, since the capital market is
imperfect, corporate hedging does matter in foreign exchange and currency risk
management (Artez & Bartram, 2010; Stulz 2003). Corporate hedging theories, based on
shareholder value maximization and managerial utility maximization, are utilized to
explain the reasons companies may require corporate hedging in a real financial world.
From the shareholder maximization theory, corporate hedging can be used to
reduce the various costs involved with future cash flows including costs of financial
distress, external financing, taxes, and underinvestment costs (Froot et al., 1993; Graham
& Smith, 1999; Smith & Stulz, 1985). First, corporate hedging can reduce the expected
transaction costs of financial distress by reducing the probability of incurring these costs
(Smith & Stulz, 1985). Second, since corporate tax expenses are a progressive tax
function to the taxable income of a company, corporate hedging can reduce the variability
of taxable income and the expected value of taxes (Graham & Smith, 1999; Smith &
Stulz, 1985). Third, corporate hedging ensures companies have sufficient internal funds
that enable the companies to mitigate unnecessary fluctuations in either investment
spending or costly external financing (Froot et al., 1993).
The primary theoretical alternative to the shareholder value maximization as a
corporate hedging theory is managerial utility maximization. From the managerial utility
maximization theory, company managers may seek to maximize their own self-interest at
the expense of shareholders because the company managers understand better than the
shareholders if the company's objectives the shareholders consider important can be met
(Jensen & Meckling, 1976). Furthermore, the company managers have the capability to

31

behave in their own self-interest rather than in the best interests of the shareholders
(Jensen & Meckling, 1976). Stulz (2003) indicated company managers have an incentive
to hedge their own wealth, which is aligned with the job performance at the expense of
the shareholders. Jensen and Meckling (1976) suggested the managerial compensation
policy can be "designed to give the manager incentives to select and implement actions
that increase shareholder wealth" (p. 226). Company managers may be interested in
protecting the company's profitability through corporate hedging in risk management
because of a possible change in corporate asset value (Shapiro, 2005). In addition,
company managers may have different risk preferences. The company managers are
essentially willing to consider risk-free prospects in financial decisions (Morellec &
Smith, 2007; Shapiro, 2005). Therefore, the company managers may be likely to be riskaverse under uncertainty (Morellec & Smith, 2007; Shapiro, 2005).
Other possible justifications explore additional factors not well explained by the
corporate hedging theories. Jorion (1990) found the degree of foreign exchange and
currency risk exposure varies directly with the degree of foreign involvement and the
fluctuations of foreign exchange rate. Corporate hedging with financial derivatives was
found by Brown (2001) to depend on accounting reporting methods and foreign exchange
volatility. Judge (2006) indicated the level of foreign debt and foreign currency sales are
related to corporate hedging decisions.
According to Allayannis and Ofek (2001), large companies are more likely to
hedge than small companies. Market values of companies for derivative users are higher
than for non-users (Allayannis & Ofek, 2001). However, it was posited by Nance et al.
(1993) that smaller companies should hedge more than larger ones. Dolde and Mishra

(2007) argued the extent of information asymmetry about exposures of financial risks
between company managers and shareholders influences the likelihood of corporate
hedging. Firm value and corporate hedging have been reported to be significantly related
(Kapitsinas, 2008). Changes in reporting corporate hedging activities were documented
by Supanvanij and Strauss (2010) as having influenced the relationship between
executive compensation packages and use of financial derivatives. Furthermore, Adam,
Dasgupta, and Titman (2007) stated corporate hedging in financial risks depends on
industry-specific characteristics. Corporate governance mechanisms were demonstrated
by Lei (2006) and Marsden and Prevost (2005) as having an impact on the use of
financial derivatives in risk management. Finally, Bartram et al. (2009) and Marsden and
Prevost (2005) substantiated the legal support involvement in corporate hedging
decisions.
In summary, the theoretical area of interest for the study is determinants of
corporate hedging in risk management. Corporate hedging theories and empirical studies
of additional risk factors associated with corporate hedging are the foundation of the
study of the organizational determinants of hedging (Stulz 2003). The existing corporate
hedging literature indicated a range of factors that might influence corporate hedging
decisions in risk management (Artez & Bartram, 2010; Stulz 2003). If these factors do
matter in corporate hedging decisions, and if company managers could determine which
factors are critical to corporate hedging, the reduction of risks associated with corporate
hedging practices would be significant (Nguyen & Faff, 2010; Stulz, 2003).
Two main classes of theoretical explanations of why company managers engage
in corporate hedging practices are shareholder value maximization and managerial utility

33

maximization. Empirical studies have been applied in the exploration of additional


factors associated with corporate hedging in risk management, such as scale economies,
firm value, information asymmetry, level of foreign involvement, foreign debt, industryspecific characteristics, country-specific characteristics, and account reporting methods
(Artez & Bartram, 2010; Stulz, 2003). Among the various company-specific factors
associated with corporate hedging in foreign exchange and currency risk management,
emphasis has been placed on financial distress, tax benefits, underinvestment problems,
managerial incentives, scale economies, and level of foreign involvement (Allayannis &
Ofek, 2001; Stulz, 2003). In spite of the fact that the theoretical and empirical evidence
on these company-specific determinants of corporate hedging are available, much
controversy remains about the effects of these company-specific determinants on
corporate hedging (Artez & Bartram, 2010; Nguyen & Faff, 2010; Stulz, 2003). In this
chapter, each of the company-specific determinants on corporate hedging in foreign
exchange and currency risk management will be presented with special reference to
corporate hedging in the U.S. defense industry, which applies to the study.
Financial Distress
Financial distress can impose significant costs on a company (Andrede & Kaplan,
1998; Korteweg, 2006). Companies that are significantly exposed to the exchange rate
fluctuations would derive benefits from corporate hedging because corporate hedging
reduces the costs of financial distress such as default and bankruptcy costs (Smith &
Stulz, 1985). Shareholders will be interested in corporate hedging to reduce the
probability of financial distress (Stulz, 2003). The costs of financial distress include not
only litigation expenses such as lawyer's and court fees and direct bankruptcy costs

(Andrede & Kaplan, 1998; Warner, 1977; Weiss, 1990), but less quantifiable effects of
financial trouble such as damage to the company's reputation, the loss of key employees
and customers, and the loss of value from foregone investment opportunities (Andrede &
Kaplan, 1998; Korteweg, 2006).
Warner (1977) and Weiss (1990) estimated the direct costs of litigation fees and
bankruptcy to be about 3 to 5% of total firm value at the time of financial distress.
However, a far greater consequence is the costs stemming from customers who are
reluctant to buy from a distressed company, high-quality employees who leave, company
managers who are distracted from running the business because of financing distress, and
potential investment opportunities that are missed because of insufficient capital funds
(Andrede & Kaplan, 1998; Korteweg, 2006). Andrede and Kaplan (1998) found the total
loss in firm value attributable to financial distress in the range of 10 to 23% of predistress firm value. Korteweg (2006) stated the costs of financial distress are 31% of firm
value on average across industries if companies are at bankruptcy and the equity of a
company is zero. Since financial distress is costly to a company, a company has an
incentive to hedge the exposure of financial risks by reducing the costs of financial
distress. As such, "firms with a high probability of default and/or high financial distress
costs should be more likely to engage in corporate hedging" (Artez & Bartram, 2010, p.
348).
The magnitude of the costs of financial distress can be defined by the size and
exposure of a company's financial leverage (Geczy, Minton, & Schrand, 1997). A
company's financial leverage is the degree to which a company funds business operation
and investment by debts (Chance & Brooks, 2007). As payments of debts and interest

35

constitute obligations the debtholders are legally entitled to, debts put pressure on the
company. A distressed company more likely experiences difficulties of the payments of
debts and interest (Smith & Stulz, 1985). If the company does not meet the financial
obligations in time, financial distress occurs, followed by default and bankruptcy.
Therefore, the higher levered company with debts might have a strong incentive to hedge
(Geczy et al., 1997; Smith & Stulz, 1985).
Graham and Rogers (2002) illustrated companies with higher financial leverage in
long-term debt will typically hedge with foreign currency derivatives. Corporate hedging
may increase debt capacity and the present value of the tax benefits (Graham & Rogers,
2002). However, a large amount of debt may also increase the degree of financial
distress and probability of default and bankruptcy, which in turn may increase the
incentive for companies to hedge (Graham & Rogers, 2002). Nguyen and Faff (2003)
analyzed a sample of469 Australian nonfinancial companies and confirmed companies
with debts in the capital structure are more likely to hedge foreign currency risk
exposure. From a sample of 493 U.S. nonfinancial companies with sales exceeding $1
billion, Dolde and Mishra (2007) supported a strong positive relationship between
financial leverage and use of derivative instruments exists at the corporate level in
foreign exchange and currency risk management. Spano (2008) collected annual
financial data from 443 nonfinancial companies in United Kingdom and affirmed the
higher levered companies intend to hedge. The findings from these empirical studies are
consistent with Smith and Stulz's (1985) theory.
However, empirical results on costs of financial distress and corporate hedging
are varied. A large number of recent empirical studies confirmed financial leverage is

36

significantly positive related to corporate hedging (Bartram et al., 2009; Berkman, 2002;
Berrospide et al., 2007; Dolde & Mishra, 2007; Graham & Rogers, 2002; Haushalter,
2000; Lei, 2006; Nguyen & Faff, 2003; Reynolds et al., 2009; Schiozer & Saito, 2009;
Spand, 2008). In contrast, Allayannis and Ofek (2001) suggested the relationship
between financial leverage and corporate hedging is positively insignificant. Davies et al.
(2006) and SprCic (2007) indicated no evidence is found to support financial leverage is
an explanatory factor for corporate hedging. Hagelin (2003) and Hagelin, Holmen,
Knopf, and Pramborg (2007) stated financial leverage is negatively associated with
corporate hedging. Judge (2006) further acknowledged financial leverage with the level
of debt is not a good measure for costs of financial distress.
According to the Standard & Poor's industry survey for aerospace and defense
industries, a 30-year average debt ratio is about 60% in the defense industry, and the debt
ratio is widely varied among U.S. defense companies (Tortoriello, 2011). The U.S.
defense companies with foreign subsidiaries or U.S. defense companies that hold foreign
debts or foreign currencies are more susceptible to financial distress because of high
financial leverage. As a result, financial leverage may vary directly with corporate
hedging in U.S. defense industry.
Financial distress is one of the key elements in shareholder value maximization
theory used to explain corporate hedging (Smith & Stulz, 1985). Both theoretically and
empirically, financial distress can impose significant costs on a company (Andrede &
Kaplan, 1998; Korteweg, 2006; Warner, 1977; Weiss, 1990). Companies that face
greater risk of financial distress with the implicit and explicit costs contained may benefit
from corporate hedging (Artez & Bartram, 2010). Through corporate hedging, reduction

37

in the probability of financial distress will result in improvement of a company's ability


to increase financial leverage (Graham & Rogers, 2002). However, high financial
leverage increases the degree of financial distress and probability of default and
bankruptcy, which in turn increases the incentive for companies to hedge (Smith & Stulz,
1985).
Despite the theoretical analysis of financial distress, empirical results on the
relationship between costs of financial distress and corporate hedging are not without
ambiguity. Highly levered U.S. companies are more susceptible to financial distress.
Therefore, financial leverage in U.S. defense companies may be directly related to
corporate hedging decisions in foreign exchange and currency risk management (Geczy
et al. 1997; Graham & Rogers, 2002; Smith & Stulz, 1985).
While high debt capacity for a company increases, a degree of financial distress
and probability of default and bankruptcy increases (Graham & Rogers, 2002). Debts
also have tax advantages because the interest payments are made from pre-tax earnings
(Penman, 2007; Smith & Stulz, 1985). As such, the question exists whether tax benefits
are related to corporate hedging decisions in risk management situations.
Tax Benefits
A progressive tax is convex (Smith & Stulz, 1985). The principle of progressivity
is reflected in much of the U.S. tax system (Graham & Smith, 1999; Smith & Stulz,
1985). Corporate marginal tax rates vary as a convex function of the level of taxable
income in the U.S. (Graham & Smith, 1999; Smith & Stulz, 1985). Companies pay a
higher corporate marginal tax rate at higher levels of total taxable income. Therefore, the
U.S. tax system has significant convexity (Graham & Smith, 1999; Smith & Stulz, 1985).

38

Companies face nonlinear tax schedules in which varying corporate marginal tax
rates introduce a company-specific source of risk. The issue of nonlinear taxation is
commonly referred to as the tax convexity problem (Smith & Stulz, 1985). When a
company's tax liabilities increase more than proportionally with the level of expected
taxable income, the demand for corporate hedging may increase (Smith & Stulz, 1985)
because corporate hedging can stabilize the level of expected taxable income, and thus
lower corporate marginal tax rates. The benefits of corporate hedging are illustrated in
Figure 1. The minimum and maximum limits of pre-tax income of a company are
denoted with Xi or XH, respectively. The possible pre-tax incomes are ordered from

Y(X)
Y'(Xo)
u

Y(Xo)

XL

Pre-Tax Income

Figure 1. Tax benefits in corporate hedging.

39

state Xl to state Xh- The possible post-tax incomes of a company are given a convex
solid line, which exhibits progressive tax liabilities. According to Jensen's inequality
(Azar, 2008), the convex transformation of a mean is less than or equal to the mean after
convex transformation. If a company's tax liabilities are a convex function of the pre-tax
income, the expected tax liabilities will be smaller at the average pre-tax income level Xo
than what the tax liabilities will be if the company has increases and decreases in pre-tax
income around the average income level Xo (Gagnon, Khoury, & Landry, 2010; Smith &
Stulz, 1985). As such, the expected post-tax income at the average pre-tax income level
X0 will be higher (Gagnon et al., 2010; Smith & Stulz, 1985). Therefore, stabilizing pre
tax income through corporate hedging is beneficial to the company (Smith & Stulz,
1985).
The theoretical analysis of the impact of tax convexity on corporate hedging was
provided by Smith and Stulz (1985). For a given company, the convexity of progressive
tax function depends upon the schedule of marginal tax rates, but also upon a number of
tax preference items such as NOL carrybacks, NOL carryforwards, investment tax
credits, and foreign tax credits (Smith & Stulz, 1985). The corporate income tax in the
U.S. provides only limited tax relief to companies that report a net operating loss
(Penman, 2007). Companies that have paid positive taxes during the three years prior to
the loss year may carry back the net operating loss and receive a tax refund (Graham &
Rogers, 2002; Smith & Stulz, 1985). The total of the tax refund cannot exceed the total
tax payments in the three years (Penman, 2007). If a company exhausts the net operating
loss carrybacks, the company may carry the net operating loss forward to corporate
income for 20 future years (Penman, 2007). However, the NOL carryforwards can only

40

be applied if pre-tax earnings are positive (Penman, 2007). If a company faces lower
earnings prospects for the near future, the present discounted tax benefits associated with
accumulated NOL carryforwards positively vary with pre-tax earnings due to the time
value of money (money in hand today is worth more than money that is expected to be
received in the future) and possible time limits on the use of NOL carryforwards (Graham
& Smith, 1999; Penman, 2007; Smith & Stulz, 1985). A similar reasoning applies for
any other tax preference items that can only be counted against positive earnings and
have a time limitation on the use of any other tax preference items such as investment tax
credits and foreign tax credits. To increase the probability of taking advantage of tax
preference items, companies with more tax preference items have benefits to intensify
corporate hedging activities (Graham & Smith, 1999; Smith & Stulz, 1985). Therefore, a
more significant convexity of progressive tax function will lead to a likelihood of
corporate hedging (Graham & Smith, 1999; Smith & Stulz, 1985).
Graham and Smith (1999) provided the empirical evidence on the potential tax
benefits to companies from corporate hedging by looking at the tax structures of U.S.
companies. Graham and Smith (1999) estimated about 50% of all U.S. companies face
convex tax functions where corporate tax rates increase with corporate taxable income.
Graham and Smith (1999) evaluated the potential tax savings to the U.S. companies and
concluded tax savings are substantial for 20% of the U.S. companies with convex tax
rates. In some cases, the tax savings amounted to more than 40% of the overall tax
liability. In agreement, Gagnon et al. (2010) indicated the potential tax savings through
corporate hedging is significant. The potential tax savings resulting from NOL
carryforwards were 16.5 to 33% of the tax liabilities to Canadian nonfinancial companies

41

(Gagnon et al., 2010). Furthermore, Berrospide, Purnanandam, and Rajan (2007) studied
167 Brazilian nonfinancial companies and found the companies hedge to increase debt
capacity, and therefore higher tax benefits. The findings from these empirical studies are
consistent with the expectations of Smith and Stulz (1985).
However, empirical evidence on the relationship between tax benefits and
corporate hedging is mixed. Berrospide et al. (2007), Gagnon et al. (2010), Graham and
Smith (1999), and Lin and Smith (2007) confirmed tax convexity and corporate hedging
are positively and significantly related while Spano (2008) found the relationship
between tax convexity and corporate hedging is positively weak. In contrast, Benson and
Oliver (2004), Carter et al. (2006), Jalilvand (2009), Ramlall (2009), and Sprdic (2007)
suggested tax convexity is not associated with corporate hedging. Knopf, Nam, and
Thornton (2002) indicated tax convexity is insignificantly and negatively related to
corporate hedging activities. Graham and Rogers (2002) and Purnanandam (2007)
concluded companies with higher tax convexity hedge less than others.
In theory, U.S. defense companies pay a 35% marginal tax rate on the profits the
U.S. defense companies earn (Graham & Rogers, 2002; Penman, 2007). Tax benefits
received by U.S. defense companies were documented in the annual financial reports
such as R&D tax credits (The Boeing Company, 2009; Lockheed Martin Corporation,
2009). However, whether a convexity of progressive tax function relates to corporate
hedging for U.S. defense companies is unknown.
The development of tax benefits in shareholder value maximization theory has
attracted as much scholarly attention as has the theoretical and empirical relationship
between tax benefits and corporate hedging in risk management (Graham & Smith, 1999;

42

Smith & Stulz, 1985). At a theoretical level, companies benefit from corporate hedging
due to tax incentives (Graham & Smith, 1999; Smith & Stulz, 1985). When a company's
tax liabilities increase more than proportionally with the level of expected taxable
income, corporate hedging can stabilize the level of expected taxable income (Graham &
Smith, 1999; Smith & Stulz, 1985) and lower corporate marginal tax rates. Furthermore,
Smith and Stulz (1985) indicated for a given company, the convexity of progressive tax
function depends upon the schedule of marginal tax rates, but also upon a number of tax
preference items including NOL carrybacks, NOL carryforwards, investment tax credits,
and foreign tax credits (Smith & Stulz, 1985).
The theoretical tax incentives on corporate hedging are partly supported by
empirical testing. Empirical evidence on the relationship between tax benefits and
corporate hedging is inconclusive. Given the conflicting results of empirical testing,
whether the relationship between tax benefits and corporate hedging for U.S. defense
companies exists is not clear.
With decreases in costs of financial distress and increases in tax benefits through
corporate hedging, funds can be effectively committed to R&D investment projects for
companies with abundant growth opportunities (Froot et al., 1993). Furthermore, costly
external financing for these R&D investment projects can be avoided (Froot et al., 1993).
For company managers to ensure companies are financed at the lowest possible costs,
providing an answer to a question of whether underinvestment problems are associated
with corporate hedging decisions becomes important in risk management (Froot et al.,
1993; Stulz, 2003).

43

Underinvestment Problems
A company's growth opportunities affect investment decisions (Eiteman et al.,
2007; Stulz, 2003). Because a company's growth opportunities require sizable outlays of
funds that commit a company to a given course of action (Eiteman et al., 2007; Froot et
al., 1993), a company with abundant growth opportunities may have underinvestment
problems to the extent the positive net present value (NPV) investments in growth
opportunities available are not chosen (Eiteman et al., 2007; Froot et al., 1993; Stulz,
2003). Therefore, guarding against underinvestment problems becomes an important
reason to hedge (Froot et al., 1993; Stulz, 2003).
Underinvestment problems, as described by Froot et al. (1993), are important to a
company with high R&D investment opportunities for reasons. First, faced with R&D
investment opportunities, company managers often raise capital through both internal
funds and external financing. When external financing costs more than internal funds,
and investment spending is cut because internally generated cash flows are not sufficient
to finance the R&D investment opportunities, corporate hedging can reduce the
variability of the internal funds to make sure the company has sufficient internal funds
required by the R&D investment opportunities, and thus the costs of underinvestment
are reduced (Froot et al., 1993). Next, company value is related to the anticipated future
cash flows. Foreign exchange rate movements can reduce the future cash flows and
lower a company's ability to invest in other profitable R&D projects (Graham & Rogers,
2000). Finally, R&D investment expenditure is used to indicate the intensity of R&D
investment opportunities within a company. Because of the uncertainty of the payoff
from R&D investment expenditures, the value of the R&D investment opportunities are

44

unlikely to be fully recognized in bankruptcy (Froot et al., 1993). Therefore, to alleviate


underinvestment problems, companies with high investment opportunities should
increase corporate hedging (Froot et al., 1993).
Carter et al. (2006) investigated jet fuel and hedging policies in the U.S. airline
industry and found capital expenditures exhibit a positive relationship with the amount of
corporate hedging. Graham and Rogers (2000) analyzed 531 companies' financial data
in annual reports and found corporate hedging with derivatives is positively related to
measures of the company's investment opportunity represented by R&D expenditures.
Graham and Rogers' (2000) empirical results showed the use of derivative instruments is
driven by the need to avoid potential underinvestment problems. By sampling 364
nonfinancial companies from 34 countries, Lei's (2006) empirical evidence indicated the
companies with high investment opportunities hedge more with derivative instruments.
Hsu et al. (2009) studied 624 nonfinancial companies in Taiwan and confirmed
companies with more growth investment opportunities will use more derivative
instruments for corporate hedging. These empirical results are consistent with the
predictions of Froot et al. (1993).
However, empirical studies on relationship between underinvestment problems
and corporate hedging have produced mixed results. Carter et al. (2006), Crabb (2006),
Graham and Rogers (2000), Hsu et al. (2009), Lei (2006), Mseddi and Abid (2010),
Sprdic (2007), and Schiozer and Saito (2009) reported a significantly positive relationship
between investment opportunities and corporate hedging while Spano's (2008) results
were mixed. However, Purnanandam (2007) pointed out a positive relationship between
R&D investment expenditure and corporate hedging was not supported. Bartram et al.

45

(2009), Dolde and Mishra (2007), Geczy et al. (1997), and Lin and Smith (2007)
suggested a significantly negative relationship between investment opportunities and
corporate hedging.
R&D investment opportunities have been pointed out as a major engine of growth
in the U.S. defense industry (The Boeing Company, 2009; Lockheed Martin Corporation,
2009; Watts, 2008). Significant amounts of funds in R&D for U.S. government programs
and weapon systems have been spent within U.S. defense companies (Arnold, Harmon,
Tyson, Fasana, & Wait, 2009; Tortoriello, 2011). The U.S. defense companies with
R&D investment opportunities have greater potential for future profitability and sales
growth (Froot et al., 1993). However, R&D investment expenditure in U.S. defense
companies may be limited due to the foreign exchange and currency risk (The Boeing
Company, 2009; Lockheed Martin Corporation, 2009). Therefore, underinvestment
problems described by Froot et al. (1993) are critical to U.S. defense companies with
more investment opportunities. Nevertheless, whether underinvestment problems are
positively associated with corporate hedging in the U.S. defense industry is unclear.
In order to reduce underinvestment problems, investment opportunities related to
corporate hedging have been subjected to intense theoretical and empirical investigation
(Froot et al., 1993; Stulz, 2003). In theory, investment opportunities of a company
demand for sufficient cash flows, and the cash flows impact of a company's investment
decision matters (Froot et al., 1993). All growth companies with low levels of internally
generated funds may be vulnerable to underinvestment problems (Eiteman et al., 2007;
Froot et al., 1993; Stulz, 2003). To alleviate underinvestment problems, companies with
R&D investment opportunities will hedge to reduce the variability of the internal funds so

46

the companies have adequate internal funds to finance the R&D investment opportunities
(Froot et al., 1993).
The empirical support for the linkage between underinvestment problems and
corporate hedging is documented. However, different conclusions concerning this
relationship are made in the empirical testing. Although the reduction of
underinvestment problems is important to U.S. defense companies with abundant
investment opportunities (The Boeing Company, 2009; Froot et al., 1993; Lockheed
Martin Corporation, 2009), further documentation of the relationship between
underinvestment problems and corporate hedging in U.S. defense industry is lacking.
Since growth companies with low levels of internally generated funds may be
subjected to underinvestment problems (Eiteman et al., 2007; Froot et al., 1993; Stulz,
2003), high growth opportunities may exacerbate conflicts between company managers
and shareholders due to the wider latitude company managers have in investment
decisions (Jensen & Meckling, 1976; Shapiro, 2005). These investment decisions are
especially difficult for shareholders to monitor (Shapiro, 2005). As such, managerial
incentives may relate to corporate hedging in risk management for growth companies
through reduction of the agency costs of the company manager-shareholder relationship
(Jensen & Meckling, 1976; Smith & Stulz, 1985; Tufano, 1996).
Managerial Incentives
The conflicts of interest in the company manager-shareholder relationship can
predict strategic managerial behaviors of company managers (Jensen & Meckling, 1976;
Shapiro, 2005). Jensen and Meckling (1976) defined an agency relationship as "a
contract under which one or more persons-the principal(s)-engage another person-the

47

agent-to perform some service on their behalf that involves delegating some decision
making authority to the agent" (p. 378). Within a mutually agreed-upon contractual
relationship, a principal will delegate some or all of the decision-making power to an
agent. For instance, shareholders (principals) grant the decision-making power to
managers (agents) of a company. The decision-making power is acknowledged in the
belief the agent can effectively take the responsibilities due to the agent's specialized and
professional expertise (Jensen & Meckling, 1976; Shapiro, 2005). Within the mutually
agreed-upon contractual relationship, compensation incentives for the agent, distribution
of responsibilities, appropriation of corporate ownership rights, and information systems
monitoring the agents' behaviors are defined (Jensen & Meckling, 1976; Shapiro, 2005).
When shareholders (principals) employ company managers (agents) to act on the
shareholders' behalf, the prosperity of the shareholders is affected by the decisions of the
company managers (Jensen & Meckling, 1976; Shapiro, 2005). Potential conflicts of
interest may arise, which result from the divergence of the company's objectives between
shareholders and company managers (Jensen & Meckling, 1976; Shapiro, 2005). Such
conflicts of interest between shareholders and company managers do not lead to
maximization of shareholders' value. As such, the potential conflicts of interest in the
company manager-shareholder relationship must always be considered in corporate
hedging behavior analysis (Jensen & Meckling, 1976; Smith & Stulz, 1985; Tufano,
1996). As stated by Lambert (2001), the impact of the conflicts of interest between
shareholders and company managers should be examined because of differential risk
preferences of company managers and shareholders, the delegation of decision-making

48

power from shareholders to company managers, and allocation of resources by company


managers for their own benefits.
Shareholders are considered to be risk-neutral in the preference of risk
management for financial decisions since the shareholders can efficiently diversify the
shareholdings of many different securities from several collective companies (Morellec &
Smith, 2007). In contrast, risk-averse company managers have limited ability to
capitalize the employment status and to diversify the financial risks for the private wealth
because the company managers' compensation incentives and employment status are
inevitably attached to the company (Shapiro, 2005; Stulz, 2003). As a result, the
company managers are essentially willing to consider risk-free prospects in corporate
hedging decisions (Morellec & Smith, 2007; Shapiro, 2005; Stulz, 2003) so that
exposures of the company managers' private wealth are reduced.
Because of the delegation of decision-making power from shareholders to
company managers, the possibility of the divergence of company objectives between
shareholders and company managers is created (Jensen & Meckling, 1976; Shapiro,
2005). Larger companies and the more diverse shareholders will indicate the divergence
of company objectives between shareholders and company managers more likely exists
(Jensen & Meckling, 1976; Shapiro, 2005). Company managers may seek to maximize
their own self-interest and have incentives to hedge their private wealth at the expense of
the shareholders (Jensen & Meckling, 1976; Shapiro, 2005; Stulz, 2003).
From an organizational perspective, company managers might not adequately
support the interests of shareholders due to moral hazard (Jensen & Meckling, 1976;
Shapiro, 2005). Moral hazard is defined as the tendency among agents to abuse the

49

resource allocation authorities delegated to them through the agency contract to


maximize their own welfare and establish their positions within the company (e.g.,
acquisition decisions and luxury spending) even if these actions lead to de-optimizing the
best interests of principals (Heath, 2009). To reduce the moral hazard from an
organizational perspective, shareholders (principals) have to oversee company managers'
(agents') actions and reward the company managers when the company's objectives the
shareholders consider important are met (Eisenhardt, 1989; Jensen & Meckling, 1976;
Shapiro, 2005; Smith & Stulz, 1985; Tufano, 1996).
To prevent company managers to act in advancing their own private wealth at the
expense of the shareholders, managerial compensation policy must be designed and
aimed at inducing company managers to act in the best interest of shareholders by
maximizing the value of the company (Coles, Daniel, & Naveen, 2004; Jensen &
Meckling, 1976; Perry & Zenner, 2000; Smith & Stulz, 1985; Tufano, 1996). By making
managerial compensation policy a convex function of company performance,
shareholders can discourage "managers from devoting excessive resources to hedging"
(Smith & Stulz, 1985, p. 401). Higher levels of such managerial compensation policy
should ultimately lead to higher company performance (Jensen & Meckling, 1976).
Therefore, including stock and option holdings, elements in managerial compensation
policy may "better align the interests of managers and shareholders" (Lei, 2006, p. 21)
and mitigate the tendency for risk-averse company managers to hedge (Smith & Stulz,
1985; Tufano, 1996).
The use of stock and option holdings in managerial compensation policy is
generally one of the most effective means of aligning the interests of company managers

50

and shareholders because the stock and option holdings are seen as an increase of
managerial ownership (Coles et al., 2004; Perry & Zenner, 2000; Smith & Stulz, 1985).
Such stock and option holdings give company managers the right to buy company stock
at a fixed price in the future. When the market value of the company increases, the value
of the stock and option holdings also increases (Eiteman et al., 2007). Company
managers can exercise the stock and option holdings to make more profits. As a result,
the company managers are motivated to improve the company's financial performance
for increase of firm value (Jensen & Meckling, 1976; Smith & Stulz, 1985).
At the same time, incorporating stock and option holdings into managerial
compensation policy may also have the desired effect of motivating company managers
to invest in higher risk investment opportunities than would be possible otherwise
(Rogers, 2002; Smith & Stulz, 1985). The reason is shareholders receive the benefits of
positive stock price developments when the shareholders have a call-option like provision
on the company's assets (Merton, 1974). According to option theory, the shareholders
will be interested in the upside and the volatility, since the volatility increases the value
of the option (Chance & Brooks, 2007). Therefore, when company managers act in the
interest of the shareholders to choose investment opportunities with different levels of
risks, the company managers have incentives to choose investment opportunities with
high risks (Rogers, 2002; Smith & Stulz, 1985).
Although the managerial utility maximization theory provides a useful theoretical
foundation for the study of the role of managerial compensation incentives in corporate
hedging, empirical studies on the relationship between managerial incentives and
corporate hedging have produced conflicting results. Managerial compensation has been

51

applied to explain corporate hedging, and increases in executive stock holdings and
corporate hedging have been reported to be positively and significantly related
(Gonzalez, Bua, Lopez, & Santomil, 2010; Marsden & Prevost, 2005; Purnanandam,
2007; Rogers, 2002; Sprdic, 2007; Supanvanij & Strauss, 2010). Lei (2006) asserted,
"The link between managerial incentives and corporate hedging in strongly governed
companies is insignificant" (p. 21). The sensitivity of the company managers' stock and
option holdings to a stock price of a company is positively related to corporate hedging
activities (Knopf et al., 2002). In agreement, Graham and Rogers (2000) affirmed
managerial stock and option holdings are positively related to corporate hedging
activities. Interestingly, Tufano (1996) and Wang and Fan (2011) found evidence
supporting corporate hedging increases with managerial stock holdings and decreases
with managerial option holdings. However, a significantly positive link between
managerial option holdings and corporate hedging exists in foreign exchange and
currency risk management (Boubaker, Mefteh, & Shaikh, 2010; Hagelin, 2003; Hagelin
et al., 2007; Haushalter, 2000).
Conversely, Adam, Fernando, and Salas (2008) and Kapitsinas (2008) stated no
evidence was found to support company managers' engagement in corporate hedging for
their own benefits. Adam et al. (2008) argued managerial stock and option holdings are
negatively related to corporate hedging in the U.S. gold mining industry. Evidence was
supplied by Dolde and Mishra (2007) and Smith and Stulz (1985) to support managerial
option holdings and corporate hedging are negatively related. Similarly, Jalilvand
(2009), Reynolds and Boyle (2005), and Spano (2008) claimed managerial ownership
does not directly affect the likelihood of corporate hedging. In conclusion, no evidence

52

has indicated shareholders benefit from corporate hedging practices (Brown, Crabb, &
Haushalter, 2006). Further evidence was cited by Kruse (1991) to support the concept
that employees might be willing to accept greater variability in the managerial
compensation in exchange for more stable employment, which indicates job security is an
important factor in managerial utility maximization. Among U.S. defense companies, the
prevalence of managerial incentives incorporating managerial stock and option holdings
exists (The Boeing Company, 2009; Lockheed Martin Corporation, 2009). Therefore, the
managerial incentives and corporate hedging might be related in the U.S. defense
industry (Graham & Rogers, 2000; Marsden & Prevost, 2005; Tufano, 1996).
The important thought of managerial utility maximization theory is managerial
incentives are the key determinant of corporate hedging (Jensen & Meckling, 1976; Stulz,
2003). Due to the divergence of company objectives between shareholders and company
managers in a company (Jensen & Meckling, 1976; Shapiro, 2005), potential conflicts of
interest arise. Such conflicts of interest between company managers and shareholders
can predict managerial behaviors of company managers (Jensen & Meckling, 1976;
Shapiro, 2005). The conflicts of interest between shareholders and company managers
will not lead to maximization of shareholders' value (Jensen & Meckling, 1976). In
addition, company managers may seek to maximize their own self-interest and have
incentives to hedge their private wealth on the expense of the shareholders (Jensen &
Meckling, 1976; Shapiro, 2005; Stulz, 2003). The important method of aligning
company managers and shareholder interests regarding value maximization is with an
appropriately structured managerial compensation package including stock and option
holdings (Jensen & Meckling, 1976; Smith & Stulz, 1985; Tufano, 1996).

53

Although the managerial utility maximization theory provides a theoretical


explanation for the study of the role of managerial compensation incentives in corporate
hedging (Jensen & Meckling, 1976; Shapiro, 2005; Smith & Stulz, 1985; Tufano, 1996),
no clear answers are available in the empirical texts. Even though there is lack of
conclusive evidence, managerial incentives and corporate hedging may be related in the
U.S. defense industry because among U.S. defense companies, the prevalence of
managerial incentives incorporating managerial stock and option holdings is reflected in
a company's annual financial reports (The Boeing Company, 2009; Lockheed Martin
Corporation, 2009).
Shareholder value maximization and managerial utility maximization theories
may be applied to explain corporate hedging decisions within the imperfect capital
markets in which companies operate (Froot et al., 1993; Graham & Smith, 1999; Jensen
& Meckling, 1976; Smith & Stulz, 1985; Shapiro, 2005). At the same time, other lines of
reasoning on corporate hedging behaviors have received considerable attention in the
literature and provoked vigorous debate (Artez & Bartram, 2010; Stulz, 2003). The
question of whether scale economies matter for corporate hedging in risk management is
significant (Allayannis & Ofek, 2001).
Scale Economies
Scale economies represented by firm size are related to the magnitude of financial
losses (Shih, Samad-Khan, & Medapa, 2000). Corporate hedging can be used to reduce
risk of loss against negative outcomes in the imperfect capital markets (Chance &
Brooks, 2007). Empirical studies show scales economies and corporate hedging in risk
management are related (Allayannis & Ofek, 2001; Bartram et al., 2009; Berrospide et

54

al., 2007; Hagelin et al., 2007; Reynolds et al., 2009; Schiozer & Saito, 2009; Spand,
2008; Smith & Stulz, 1985). However, competing arguments for either a positive or
negative relationship between firm size and corporate hedging exist, and will be viewed
in light of each of the following dimensions.
Large companies are more likely to hedge than small companies because the large
companies may have better access to external financing in capital markets (Allayannis &
Ofek, 2001). First, corporate hedging with sophisticated derivative instruments has high
fixed costs such as initial set-up costs, ongoing consulting costs, and costs of monitoring
and operating corporate hedging strategies. Only large companies are able to bear the
high fixed costs (Allayannis & Ofek, 2001). Second, large companies are more
internationally oriented and exposed to the foreign exchange and currency risk than small
companies, and thus have a greater need to hedge (Jong, Ligterink, & Macrae, 2006).
Third, large companies often have expert staff to identify and analyze possible financial
loss exposures (Eugene & Houston, 2009). Therefore, the large companies are at a
distinct advantage in corporate hedging for mitigation of financial risks (Allayannis &
Ofek, 2001; Jong et al., 2006).
Although large companies may be more likely to hedge than small companies,
smaller companies might have a greater likelihood of financial distress and face more
severe financial constraints (Nance et al., 1993; Smith & Stulz, 1985), which in turn may
increase the small companies' likelihood to hedge. According to Nance et al. (1993) and
Smith and Stulz (1985), smaller companies are also subject to costly external financing
because the smaller companies are likely to have a greater informational asymmetry
problem (Nance et al., 1993) and the costs of corporate hedging are proportional to firm

55

size (Smith & Stulz, 1985). These valid arguments support the hypothesis that corporate
hedging should be more prevalent among small companies.
Empirical evidence indicating the effect of firm size on corporate hedging is not
without controversy. In most empirical studies, the positive relationship between firm
size and corporate hedging supports the hypothesis that corporate hedging exhibits
scale economies (Bartram et al., 2009; Berrospide et al., 2007; Carter et al., 2006; Davies
et al., 2006; Guay & Kothari, 2003; Hagelin et al., 2007; Haushalter, 2000; Hsu et al.,
2009; Jong et al., 2006; Judge, 2006; Klimczak, 2008; Lei, 2006; Mseddi & Abid, 2010;
Nguyen et al., 2007; Purnanandam, 2007; Reynolds et al., 2009; Schiozer & Saito, 2009;
Spand, 2008). However, Adam et al. (2008) and Reynolds et al. (2009) concluded
corporate hedging with derivative use is essentially driven by the small companies.
Similarly, Gagnon et al. (2010) indicated small and medium-sized companies are more
likely to hedge than large companies in the Canadian context. However, Dolde and
Mishra (2007) and SprCic (2007) argued no evidence is found to support firm size is a
determinant for corporate hedging. As such, whether there is a relationship between firm
size and corporate hedging for U.S. defense companies is uncertain.
The compelling theoretical explanations of a relationship between firm size and
corporate hedging differ (Allayannis & Ofek, 2001; Nance et al., 1993; Smith & Stulz,
1985). The positive relationship between firm size and corporate hedging indicated large
companies are more likely to hedge because the large companies have better access to
external financing in capital markets (Allayannis & Ofek, 2001). On the other hand,
small companies have a greater incentive to hedge because small companies are also
faced with greater information asymmetries and high costs of corporate hedging (Nance

56

et al., 1993; Smith & Stulz, 1985), which are likely to make external financing more
expensive for smaller companies, and therefore corporate hedging is more likely.
The U.S. defense industry base includes small, medium, and large private
enterprises for U.S. defense related contracts (Watts, 2008). The conflicting theoretical
predictions about the effect of firm size on corporate hedging have not been resolved.
Therefore, firm size effect on corporate hedging for U.S. defense companies is uncertain.
Also noted is the issue that global operations of small and large companies are expanding
(Eiteman et al., 2007; Pope, 2002). Due to an unexpected change in the exchange rate,
the impact of these companies on corporate hedging in risk management has made the
companies' foreign involvement a topic of significant interest. As a result, the level of
foreign involvement and its relationship to corporate hedging in risk management has
become a major issue in foreign exchange and currency risk management (Jorion, 1990).
Level of Foreign Involvement
The U.S. defense companies have recognized substantial foreign exchange and
currency risk as a constant financial risk to business operations because changes in
exchange rates drive changes in cash flows, and ultimately the value of U.S. defense
companies (Allayannis & Ofek, 2001; The Boeing Company, 2009; Jorion, 1990;
Lockheed Martin Corporation, 2009). The exposures to foreign exchange and currency
risk are influenced by a company's foreign involvement such as the level of foreign sales
and the extent of foreign subsidiaries (Jorion, 1990). Companies are more exposed to
foreign exchange and currency risk from foreign sales, foreign income, and foreign
assets. Corporate hedging can lessen the foreign exchange and currency risk (Chance &
Brooks, 2007; Stulz, 2003). Since the magnitude and significance of a company's

57

foreign exchange and currency risk exposures are measured by the level of foreign
involvement, at the corporate level, companies with the greater level of foreign
involvement have greater benefits from corporate hedging (Jorion, 1990). Therefore,
these companies are typically known to hedge a greater proportion of the exposures to the
foreign exchange and currency risk (Allayannis & Ofek, 2001; Jorion, 1990).
By examining the relationship between determinants of corporate hedging and the
use of foreign currency derivatives in a sample of U.S. nonfinancial companies,
Allayannis and Olek (2001) reported the use of corporate hedging instruments reduced
the exposure to the foreign exchange and currency risk, and confirmed foreign sales were
significantly and positively correlated with the corporate hedging decisions. Using
survey data from 441 nonfinancial companies in the United Kingdom, Judge (2006)
found companies with higher foreign sales were more likely to hedge foreign exchange
and currency risk. Menon and Viswanathan (2005) examined how U.S. multinational
corporations used foreign exchange derivatives from 1995 to 2000 and affirmed a
significantly positive relationship between the extent of foreign involvement by U.S.
multinational corporations and corporate hedging activities. By analyzing 81 companies
from nine industry sectors categorized by the Oslo Stock Exchange, Davies et al. (2006)
reported the extent of international operations is a significant determinant of corporate
hedging. The empirical evidence from these studies is consistent with Jorion's (1990)
proposition.
However, the outcome of empirical studies in view of the level of foreign
involvement and corporate hedging is not conclusive. Allayannis and Ofek (2001),
Bartram et al. (2009), Clark and Mefteh (2011), Dolde and Mishra (2007), Davies et al.

58

(2006), Jong et al. (2006), Jorion (1990), Judge (2006), Menon and Viswanathan (2005),
and Pantzalis, Betty, and Laux (2001) found the level of foreign involvement and
corporate hedging are positively related. In contrast, Howton and Perfect (1998)
indicated the relationship between the level of foreign involvement and corporate
hedging with currency derivatives is not supported in a random sample of 461 U.S.
nonfinancial companies. The level of foreign involvement was indicated by Nguyen and
Faff (2006) and Nydahl (1999) as being negatively related to corporate hedging.
Evidence indicating derivative instruments for corporate hedging have a significant and
negative relationship with the existence of foreign assets was provided by Judge (2009).
By analyzing 102 U.S. oil and gas companies, Wang and Fan (2011) concluded the extent
of international operations is negatively related to corporate hedging.
The level of foreign involvement in U.S. defense companies is high. The U.S.
defense industry is responsible for 7% of exports and is the largest net exporting industry
to the U.S. economy in 2010 (Deloitte Development LLC, 2012). According to the
Defense Security Cooperation Agency (DSCA), the U.S. defense companies sold more
than $30 billion in weapons systems and other defense products to the allies of the U.S. in
2010 (Murray, 2010). However, no previous studies have been conducted to assess the
relationship between the level of foreign involvement for U.S. defense companies and
corporate hedging.
The level of foreign involvement, a key measure to the magnitude and
significance of a company's foreign exchange and currency risk exposures, is considered
in corporate hedging decisions (Allayannis & Ofek, 2001; Jorion, 1990). At the
corporate level, companies with a greater level of foreign involvement have greater

59

benefits from corporate hedging (Jorion, 1990) and typically hedge a greater proportion
of the exposures to foreign exchange and currency risk (Allayannis & Ofek, 2001).
However, the outcome of empirical studies addressing the level of foreign involvement
and corporate hedging is not clear. Although the level of foreign involvement in the U.S.
defense companies is high, the question of whether a relationship exists between the level
of foreign involvement for U.S. defense companies and corporate hedging remains
unanswered.
The six key determinants of corporate hedging discussed previously may
influence corporate hedging decisions in risk management within the imperfect capital
markets (Allayannis & Ofek, 2001; Froot et al., 1993; Graham & Smith, 1999; Jensen &
Meckling, 1976; Jorion, 1990; Nance et al., 1993; Smith & Stulz, 1985; Shapiro, 2005;
Stulz, 2003). Other theoretical extensions justifying corporate hedging with derivatives
at the organizational level have been developed in recent studies. Additional corporate
hedging factors in risk management include firm value (Allayannis & Ofek, 2001),
foreign debt (Kelohaiju & Niskanen, 2001), asymmetric information (Breeden &
Viswanathan, 1996; DeMarzo & Duffie, 1991; Raposo, 1997; Tufano, 1996), board
characteristics (Whidbee & Wohar, 1999), industry-specific characteristics (Jorion,
1991), country-specific characteristics (Gebhardt, 1999), and accounting reporting
methods (Melumad, Weyns, & Ziv, 1999; Sapra, 2002). The key empirical studies of the
exploration of each of the additional factors are cited and discussed below. A review of
critical findings from these empirical studies is emphasized.
Other Factors
Firm value. Company managers should make all decisions so as "to increase the

60

total long run market value of the company. Total value of the sum of the value of all
financial claims on the company including equity, debt, preferred stock, and warrants"
(Jensen, 2001, p. 298). In an imperfect capital market, corporate hedging is a means to
increase firm value to the benefit of shareholders (Jensen, 2001; Jensen & Meckling,
1976; Shapiro, 2005). Therefore, maximization of firm value is a primary motive for
corporate hedging in risk management (Allayannis & Ofek, 2001).
The findings of empirical evidence indicating the relationship between firm value
and corporate hedging are debatable. Bartram et al. (2009), Berrospide et al. (2007), and
Kapitsinas (2008) supported the impact of corporate hedging on firm value is significant.
Evidence supporting both corporate hedging and firm value are positively related in the
U.S. airline industry was provided by Carter et al. (2006). A large cross section of 442
nonfinancial companies was examined by Graham and Rogers (2002), and they
concluded corporate hedging with currency derivatives increases firm value by 1.1%.
Firm value increases when transaction risk is hedged with currency derivatives, according
to Hagelin (2003).
In contrast, Guay and Kothari (2003) demonstrated corporate hedging has a
positively insignificant affect on firm value. It was concluded by Nguyen and Faff
(2006) that firm value was not related to corporate hedging in 428 Austrian nonfinancial
companies. Corporate hedging decisions were determined to have no impact on company
valuations in 250 French nonfinancial companies (Khediri, 2010). Jin and Jorion (2006)
indicated corporate hedging did not affect companies' market values in the U.S. oil and
gas industry. Lastly, Spr5ic (2007) suggested the primary reasons for corporate hedging,

61

such as the reduction of taxes and costs of financial distress, were not supported in
foreign exchange and currency risk management practices.
As Allayannis and Ofek (2001) indicated, corporate hedging may be positively
related to an increase in firm value for U.S. defense companies. However, the mix of
empirical results from previous studies does not indicate whether the existing corporate
hedging theories apply to U.S. defense companies. Furthermore, an estimate of firm
value is provided by the market capitalization of the company's equity and debt (Koller,
Goedhart, & Wessels, 2005). The market value of assets and debts is difficult to
estimate, which may lead to inaccurate findings. Therefore, firm value, as a determinant
of corporate hedging, was not included in the study.
Foreign debt. Financial derivatives are not the only corporate hedging
instruments. Foreign debt can act as an important alternative of corporate hedging
instruments for companies whose cash flow is more sensitive to exchange rate
fluctuations (Aabo, 2006; Allayannis, Brown, & Klapper, 2003; Judge, 2009; Kelohaiju
& Niskanen, 2001). If companies have liabilities in the same currency as the assets, the
amount of foreign currency translation is reduced, and the overall effect of exchange rate
volatility on cash flow and earnings is reduced (Allayannis et al., 2003). Therefore,
companies with more foreign debts may relate to higher corporate hedging activities in
reduction of exposures to foreign exchange and currency risk (Aabo, 2006; Allayannis et
al., 2003; Gonzalez et al., 2010; Judge, 2009; Kelohaiju & Niskanen, 2001).
The companies that select foreign debt as a corporate hedging instrument could be
exporters (Judge, 2009), companies with foreign subsidiaries, or companies that hold
foreign currency debt (Kelohaiju & Niskanen, 2001). The main reasons for companies to

62

select foreign debt as a corporate hedging instrument are when foreign debt is cheaper
than domestic debt (Allayannis et al., 2003; Berrospide et al., 2007; Gonzalez et al.,
2010; Kelohaiju & Niskanen, 2001), companies with liabilities destined to repaying the
principal and interest of the foreign debt would be compensated by income in the foreign
currency generated by foreign operations (Gonzalez et al., 2010; Judge, 2009), and
companies with revenue in foreign currency might issue debt denominated in foreign
currency to avoid mismatches in the balance sheets (Judge, 2009; Kelohaiju & Niskanen,
2001).
Berrospide et al. (2007) indicated companies using corporate hedging in foreign
exchange and currency risk management have significantly higher proportions of foreign
debt. Aabo (2006) analyzed the determinants of foreign debt compared to derivative
instruments for corporate hedging in foreign exchange and currency risk. Aabo showed
the importance of foreign debt in corporate hedging is positively related to the exposures
to foreign exchange and currency risk. Allayannis and Ofek (2001) asserted American
exporters with higher foreign exchange and currency risk exposure are more likely to use
foreign debt in corporate hedging. Using a sample of nonfinancial companies traded on
the U.S. exchanges in the four most developed Latin American countries, Schiozer and
Saito (2009) reported the size of currency derivative portfolios held by a company is
positively influenced by foreign debt.
Judge (2009) illustrated the likelihood of using derivative instruments and the
existence of foreign debts is significantly and positively related. Judge further suggested
foreign debt is a complementary rather than a competing strategy to hedge the exposures
to foreign exchange and currency risk. Gathering a sample of Finnish nonfinancial

63

companies, Kelohaiju and Niskanen (2001) found companies raise foreign debt in order
to hedge the exposure to foreign exchange and currency risk. Kelohaiju and Niskanen
detected larger companies have better access to international financial markets, and thus,
companies typically use foreign debt for corporate hedging. Using a data set of East
Asian nonfinancial companies, Allayannis et al. (2003) indicated direct costs of debt
issuance are an important factor of corporate hedging using foreign debt. Gonzalez et al.
(2010) suggested company managers are more inclined to hedge using foreign debt
because of managerial risk aversion. Clark and Judge (2009) analyzed the joint use of
derivative instruments and foreign debt to test the hypothesis that corporate hedging
reduces the costs of financial distress. However, empirical results on the relationship
between foreign debt and corporate hedging are not stable. Nguyen and Faff (2006)
detected no relationship between the use of foreign debt and the exposures to foreign
exchange and currency risk. Evidence was supplied by Schiozer and Saito (2009) to
support the use of currency derivative are not influenced by the level of foreign debt.
With globalization, the trend of U.S. defense companies is to extend the
international operations that enhance economic competitiveness (Arnold et al., 2009). As
such, U.S. defense companies are increasingly exposed to the foreign exchange and
currency risk. However, whether foreign debt is used to hedge the foreign exchange and
currency risk exposure in the U.S. defense industry is unknown. Because direct data
indicating whether foreign debt is used in corporate hedging for U.S. defense companies
is not available, foreign debt, as a determinant of corporate hedging, was excluded in the
study.

64

Asymmetric information. Asymmetric information signifies a situation in which


one party involved in a transaction with another has more or superior knowledge and
information than the other (DaDalt et al., 2002; Hillairet, & Jiao, 2010). In an imperfect
capital market, prohibitive dissemination, expense, and competitive safeguarding of
proprietary information prevent companies from delivering sufficient data to shareholders
to manage their portions of the exposures to foreign exchange and currency risk
(DeMarzo & Duffie, 1991; Dolde & Mishra, 2007). As such, company managers would
have superior information regarding the foreign exchange and currency risk that could be
hedged. If a company's volatile earnings are provided, shareholders cannot tell whether the
fluctuations of earnings are due to the foreign exchange and currency risk that could be
hedged or whether the variability is caused by managerial incompetence (DaDalt et al.,
2002). Under these circumstances, company managers could decide to hedge. Evidence
indicating asymmetric information is an important determinant for corporate hedging in
foreign exchange and currency risk management was provided by Dolde and Mishra
(2007).
A different explanation of corporate hedging behaviors, based on asymmetric
information, was presented by Breeden and Viswanathan (1996) and DeMarzo and
Duffie (1995) who focused on managers' reputations. Breeden and Viswanathan and
DeMarzo and Duffie argued company managers may prefer to engage in risk
management activities to communicate their skills to the labor market. Both teams of
researchers found younger executives and company managers with shorter tenures have
less developed reputations than older or longer-tenured company managers (Breeden &
Viswanathan, 1996; DeMarzo & Duffie, 1991). Therefore, young executives and

65

company managers with shorter tenures are more willing to embrace risk management.
Although an executive's age and the extent of risk management activity are not related,
Tufano (1996) argued companies whose executives have fewer years in the current job
are more likely to engage in higher risk management activities. Tufano confirmed young
executives are more willing to engage in risk management activities than are their older
colleagues. Therefore, the results are consistent with Breeden and Viswanathan's (1996)
and DeMarzo and Duffie's (1995) theory.
Raposo (1997) addressed the interaction between the disclosure of corporate
hedging positions and company manager's hedging strategies. Assuming the risk
exposure of the company is not known, the disclosure of corporate hedging positions is
not desirable (Raposo, 1997). Disclosing the value of derivative instruments for corporate
hedging can destroy company manager's incentive to hedge because corporate hedging
can reveal more information about the company manager's ability, and thereby make the
future compensation more risky (Raposo, 1997). However, if profits from corporate
hedging are aggregated with other revenues, company managers will be encouraged to
hedge to reduce the volatility of earnings, and thus reduce the employment risk (Raposo,
1997).
The empirical evidence needed to support the relationship between asymmetric
information and corporate hedging is limited. Human resource information of U.S.
defense companies is not publicly available. As a result, asymmetric information as a
determinant of corporate hedging was not included in the study.
Board characteristics. Another potential determinant of corporate hedging,
based on the conflicts of interest argument in an agency relationship, is the board

66

characteristics (Borokhovich et al., 2004; Marsden & Prevost, 2005; Whidbee & Wohar,
1999). Corporate statutes describing the affairs of the company are managed by or under
the direction of a board of directors (Fama & Jensen, 1983). Shareholders contribute
capital and retain ownership interests. Company managers make decisions regarding
corporate operations, including strategic planning, risk management, and financial
reporting. The board is composed largely of independent directors, who oversee
company managers' performance on the behalf of the shareholders. The board monitors
such performance and intervenes to remedy deficient management operations (Fama &
Jensen, 1983). Through the risk oversight role, independent directors evaluate the risk
management policies and procedures designed and implemented by corporate executives
and ensure company managers' actions are consistent with the corporate strategy and risk
plan (Fama & Jensen, 1983). Therefore, the board characteristics such as board
independence, board size, board composition, and directors' characteristics may influence
corporate hedging practices at the organizational level in risk management (Borokhovich
et al., 2004; Marsden & Prevost, 2005; Whidbee & Wohar, 1999).
Empirical studies supported the relationship between board characteristics and
corporate hedging (Borokhovich et al., 2004; Marsden & Prevost, 2005; Triki, 2005;
Whidbee & Wohar, 1999). Whidbee and Wohar (1999) explored the relationship
between use of derivative instruments and the board independence, which is measured by
the proportion of outside directors within the board. Whidbee and Wohar (1999)
suggested corporate hedging activities are influenced by outside directors' presence at
low levels of insiders' share holdings only. Company managers who own a small
fraction of the company's share holdings are more likely to be disciplined if the company

67

managers' performance is poor (Whidbee & Wohar, 1999). To minimize the financial
risk of the private wealth, the company managers will be encouraged to hedge more.
Borokhovich et al. (2004) found corporate hedging activities cannot be explained
by the board size and the presence of corporate executives on the board. Dionne and
Triki (2005) suggested the financial education of the board and the audit committee
impact corporate hedging practices. An examination of the relationship between board
composition and use of derivative instruments was conducted by Marsden and Prevost
(2005), and they concluded the board composition does not systematically affect the
decisions to use derivative instruments.
While recent studies indicating board characteristics influence corporate hedging
have been documented, the results of empirical testing are not conclusively supported.
Research on the board characteristics, as a determinant of corporate hedging, is still
developing. Since board of directors' data in the U.S. defense industry is limited, the
board characteristics were not examined for the study.
Industry-specific characteristics. Foreign exchange and currency risk
exposures are largely determined at the industry level (Marston, 2001). Recent empirical
studies supported a hypothesized relationship between corporate hedging and industryspecific characteristics, which are not directly related to the corporate hedging theories.
To understand if the industry-specific characteristics are related to corporate hedging in
foreign exchange and currency risk management is important for the following reasons.
First, to meet competitive challenges from international trading partners, the
optimization of target specific industries is needed (Westphal, 1990). The importance of
foreign exchange and currency risk management and its impact on the industries has been

68

a topic of significant interest in the optimization (Eiteman et al., 2007; Homaifar, 2004).
If foreign exchange and currency risk exposures differ systematically between industries,
industry-level corporate hedging in foreign exchange and currency risk management
would be more relevant to company managers in these industries. Second, according to
the corporate hedging hypothesis, effective corporate hedging eliminates foreign
exchange and currency risk premium in industry returns (Jorion, 1991). If foreign
exchange and currency risk is priced at the stock market level, and currency and stock
markets are imperfectly integrated, corporate hedging can reduce industry cost of capital
by eliminating the foreign exchange and currency risk premium (Jorion, 1991). Third,
foreign exchange and currency risk is economically more important for U.S. industries
(Bartram et al., 2009; Francis, Hason, & Hunter, 2008). Corporate hedging in industrylevel foreign exchange and currency risk management adds to the discussion U.S.
investors can obtain benefits of international diversification for their investment
portfolios (Errunza et al., 1999). Therefore, industry-specific characteristics may
influence corporate hedging decisions at the organizational level (Jorion, 1991).
Empirical results representing industry-specific characteristics and corporate
hedging are not consistent. Adam et al. (2007) stated, "Industry characteristics, such as
on the number of firms in the industry, the elasticity of demand, the convexity of
production costs, and the relative market shares of each firm" (p. 2445) are associated
with corporate hedging. To protect against the rises in oil price, the U.S. airline industry
hedges jet fuel costs (Carter et al., 2006) because corporate hedging is an important part
of business for the successful airlines because fuel is an airline's second highest cost

69

(after labor). Jin and Jorion (2006) reported companies with higher production costs are
less likely to hedge in the U.S. oil and natural gas industry.
Reynolds et al. (2009) argued derivative instruments are significant across
industry sectors in New Zealand. Brailsford, Heaney, and Oliver (2005) stated, "It is not
expected that value maximizing incentives generally applicable to the private sector will
also be critical in explaining derivative use in the public sector" (p.63). However, Adam
et al. (2008) studied 92 U.S. gold mining companies, a homogeneous industry group, and
found payoffs of corporate hedging activities are not economically significant.
Comparing a sample of Australian industrial companies and Australian mining
companies, Berkman et al. (2002) concluded financial advantage and derivative uses are
more significant and positively related in industrial companies than in mining companies.
Evidence was supplied by Hsu et al. (2009) to support the electronics, electric machinery,
and machinery industries are more influential on corporate hedging than other industries.
However, from a sample of 150 Polish companies listed on the Warsaw Stock Exchange,
no evidence was found to support the differences in corporate hedging between industries
(Klimczak, 2008).
Companies in regulated industries provide company managers with few
opportunities for discretion in corporate investment and financing decisions (Smith &
Watts, 1992). Therefore, if regulated companies face tighter scrutiny and lower
contracting costs, company representatives are less likely to use derivative instruments to
hedge (Mian, 1996; Rogers, 2002). Furthermore, companies in regulated industries do
not have the same growth opportunities as companies in unregulated industries (Smith &
Watts, 1992). As such, operated in more stable environments, companies in regulated

70

industries have a lower demand for corporate hedging than companies in unregulated
industries (Fabling & Grimes, 2008). By analyzing a sample of nonfinancial companies
traded on the U.S. exchanges in the four most developed Latin American countries,
Schiozer and Saito (2009) confirmed company managers in regulated industries are less
likely to use currency derivatives for corporate hedging.
The U.S. defense industry is regulated by the Federal Government of the U.S.
Demand in the U.S. defense industry is driven by the U.S. Government (Deloitte
Development LLC, 2012). One of the key U.S. defense industry-specific characteristics
is to conduct business with the U.S. Government (Watts, 2008). After what kinds of
systems and weapon that will be built are decided, a defense company, based on price
and performance, will be chosen. The U.S. defense companies typically bid for U.S.
government contracts by submitting proposals for development of specific systems and
weapons programs funded by the Department of Defense (DoD) (Arnold et al., 2009;
Tortoriello, 2011). The U.S. government contracts have unique risks to U.S. defense
companies because the U.S. defense companies are subject to regulations, audits,
inquiries, and investigations by U.S. government agencies (The Boeing Company, 2009;
Eiteman et al., 2007; Lockheed Martin Corporation, 2009) and due to U.S. government
budget cuts, funding the development of specific systems and weapons programs in the
U.S. defense industry would be impacted (Arnold et al., 2009; Deloitte Development
LLC, 2012; Tortoriello, 2011; Watts, 2008). Therefore, given the heightened risks to
U.S. defense companies because of U.S. government policies, regulations, and budget
cuts, the U.S. defense companies may be pressured to restrict corporate hedging to shift
financial risks and contend for U.S. government contracts (Mian, 1996; Rogers, 2002).

71

Revenues derived from U.S. government contracts, as an industry-specific attribute of


U.S. defense companies, were presented in the study.
Country-specific characteristics. Financial markets differ in different countries
(Eiteman et al., 2007). Although corporate hedging in emerging financial markets is the
same conceptually as in developed financial markets, the corporate hedging decisions are
more complex in practice (Whaley, 2006). Financial expertise in corporate hedging
within different countries also develops over time (Bartram et al., 2009; Eiteman et al.,
2007). Investors are asked to decide on factors normally taken for granted in the
developed financial markets, such as location of counterparty, application of hedge, and
convertibility restrictions (Whaley, 2006). Furthermore, institutional and legal
environment are diverse across countries (Allayannis, Lei, & Miller, 2012; Bartram et al.,
2009; Bodnar, De Jong & Macrae, 2003; Lei, 2006; Marsden & Prevost, 2005).
Corporate reporting standards are country-specific and legal requirements on reporting
are not the same in every country (Naylor & Greenwood, 2008). Therefore, corporate
hedging practices vary in different countries, and country-specific characteristics may
play an important role in corporate hedging decisions at the organizational level
(Allayannis et al., 2012; Bartram et al., 2009; Bodnar, De Jong & Macrae, 2003; Lei,
2006; Marsden & Prevost, 2005).
Lei (2006) and Marsden and Prevost (2005) considered financial market
developments, legal environment, and macroeconomic characteristics of the country as
possible reasons for differences in corporate hedging practices. Lei (2006) argued
companies in emerging economies expose higher macroeconomic risks, and thus are
more likely to use derivative instruments in corporate hedging. Evidence provided by

72

Allayannis et al. (2012) indicated companies within an English legal origin engage in
significantly more corporate hedging activities than companies within a non-English legal
origin. Financial distress cost factors are more important for U.K. companies than U.S.
companies due to differences in the bankruptcy codes in the two countries, which result
in higher expected costs of financial distress for the U.K. companies (Judge, 2006).
By analyzing a sample of 7,319 nonfinancial companies from 50 countries,
Bartram et al. (2009) suggested companies using derivative instruments are more often
located in countries with larger derivatives markets and higher gross domestic product
(GDP) per capita and are Organization for Economic Co-operation and Development
(OECD) members. Bodnar et al. (2003) indicated Dutch companies might be more
exposed to foreign currency risk than U.S. counterparts because of differences in
economy orientation and the presence of legal structure. After applying a matchedindustry procedure, Gebhardt (1999) concluded German companies hedge more with
derivative instruments than U.S companies. Surveying a sample of companies in Sweden
and Korea, Pramborg (2004) compared the use of hedging instruments to manage foreign
exchange and currency risk and found similarities between companies in the both
countries. However, with notable exception, the aim of hedging activity differed between
companies in the countries. Swedish companies favored minimizing fluctuations of
earnings or protecting the appearance of the balance sheet, while Korean companies were
focused more on minimizing the fluctuations of cash-flows (Pramborg, 2004). The
proportion of companies that use derivative instruments is significantly lower in the
Korean sample than in the Swedish sample, which suggested the Korean derivative
markets are not easily accessible because of strict government regulations and is also less

73

sophisticated than the Swedish market (Pramborg, 2004). Naylor and Greenwood's
(2008) results showed the usage of derivative instruments in New Zealand, Swedish, and
Asian companies was higher than in the U.S., Dutch, and German companies of
comparable size. Corporate hedging generally aims to accounting objectives such as
ensuring a company's budget outcomes are met.
The comparative studies examining the relationship between country-specific
characteristics and corporate hedging are not widely available. The results of the prior
studies were varied. Furthermore, the participants of the study are U.S. defense
companies only, therefore, the country-specific characteristics, as a determinant of
corporate hedging, were excluded in the study.
Accounting reporting methods. Explanations of corporate hedging, based upon
accounting reporting methods in derivative instruments, are provided since the FASB
issued FAS 133 on accounting for derivative financial instruments and hedging activities.
According to U.S. FAS 133 and internationally as IAS 39 standards, companies are
required to report fair value and related carrying value of derivative instruments in annual
financial reports and specify if the derivative instruments are used for trading or other
purposes (Apostolou & Apostolou, 2008; Chance & Brooks, 2007; Power, 2010;
Ramirez, 2007). The fair value is defined as the exchange price that "would be received
to sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the date of measurement" (Power, 2010, p. 199). The FAS 133 standard is
a significant departure from earlier standards and accounting traditions. Financial
instruments, except in a few defined exceptions, are accounted for at the historical
(amortized) cost. Therefore, a distinction between derivative instruments (at fair value)

74

versus financial instruments (amortized cost) exists when derivative instruments are
reported in the company's annual financial reports (Apostolou & Apostolou, 2008;
Chance & Brooks, 2007; Power, 2010; Ramirez, 2007).
The FAS 133 standard has been intensely debated both theoretically and
empirically. At a theoretically level, the controversy about the FAS 133 standard centers
on how disclosing information about derivatives and hedging activities affects a
company's risk-management practices (Apostolou & Apostolou, 2008; Chance &
Brooks, 2007; Power, 2010; Ramirez, 2007). At an empirical level, researchers
supported disclosures of derivatives and hedging activities focus on earnings volatility
rather than the companies' real actions in risk management practices (Apostolou &
Apostolou, 2008; Power, 2010; Ramirez, 2007). Proponents of the FAS 133 standard
argue income fluctuations using derivative instruments in corporate hedging are created
because gains or losses in the values of derivative instruments are not appropriately
disclosed or recognized under historical cost accounting (Apostolou & Apostolou, 2008;
Chance & Brooks, 2007; Power, 2010). Since corporate hedging is designed to reduce
financial risk, increase in a level of income volatility would lead to the exact opposite
impression (Chance & Brooks, 2007). Fair value recognition defined in the FAS 133
makes the use of derivative instruments more transparent. Therefore, a company's
prudent risk management is encouraged (Apostolou & Apostolou, 2008; Power, 2010).
Opponents of the FAS 133 standard insist companies use derivative instruments to hedge
the inherent business risk, and fair value accounting induces higher short-term volatility
in the financial statements. As such, the legitimate use of derivative instruments for

75

hedging purposes is deterred (Sapra, 2002). Therefore, the accounting reporting methods
may affect corporate hedging activities in risk management (Brown, 2001).
Empirical evidence indicating the relationship between accounting reporting
methods and corporate hedging is various. Glaum and Klocker (2011) studied 114
nonfinancial companies in German and Switzerland and found companies applying the
hedge accounting rules have more frequently used derivative instruments for hedging.
They concluded the application of hedge accounting rules influence corporate hedging
behaviors (Glaum & Klocker, 2011). Lins, Servaes, and Tamayo (2010) indicated the
risk management activities of more than 42% of the 229 sample companies are affected
by the FAS 133 standard. Since the fair value of derivative instruments reveals
quantitative information about the level of corporate risk management and a company's
underlying risk exposure, Nguyen et al. (2007) suggested using fair value of derivative
instruments makes tests of hypotheses on the determinants of the volume of corporate
hedging in the foreign exchange and currency risk management markets possible.
Melumad et al. (1999) illustrated derivative accounting with fair value measurement
reveals a company's underlying risk exposure, and thereby keeps to have the best
derivative instruments selected, as in a setting with no asymmetric information. Lins et
al. (2010) found the accounting reporting methods of derivative instruments are more
likely to affect companies that take active derivative positions, companies that write
earnings based contracts, and companies that consider reducing earnings volatility to be
important. Supanvanij and Strauss (2010) concluded derivative reporting transparency is
a significant factor in determining the use of corporate hedging.

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Sapra (2002) investigated the opposing effects of fair value accounting from the
capital market valuation perspective and showed an extreme position in the derivative
market signals favorable private information about the future spot price which, in turn,
leads to a higher capital market price. Sapra suggested increased reporting transparency
resulting from the FAS 133 standard may induce a company to take an excessive
speculative position. From a sample of Fortune 500 derivative users, Singh (2004)
indicated no significant change in earnings volatility, cash flow volatility, or the notional
amount of the derivatives after the adoption of the FAS 133 standard. Singh concluded
the impact of the FAS 133 standard might not be as significant as claimed. Using a
sample of U.S. companies whose annual revenues were between $1 and $5 billion in
2001, survey results showed only 25% of the respondents believed the FAS 133 standard
imposes a beneficial discipline on a company's risk management activities (Association
of Financial Professional, 2002).
Overall, the empirical evidence indicating the impact of accounting reporting
methods on corporate hedging in risk management is not certain. No studies assessing
the relationship between accounting reporting methods and corporate hedging have been
performed using data from U.S. defense companies. However, due to unavailability of
direct data in accounting reporting methods from U.S. defense companies, accounting
reporting methods, as a determinant of corporate hedging, were not chosen for
examination in the study.
The comprehensive review shows the key determinants from corporate hedging
theories may lead to corporate hedging decisions at the organizational level (Froot et al.,
1993; Graham & Smith, 1999; Jensen & Meckling, 1976; Smith & Stulz, 1985; Shapiro,

77

2005). However, other rationales of corporate hedging with derivatives are equally
important to explain corporate hedging behaviors for nonfinancial companies (Adam et
al., 2007; Judge, 2006). Numerous researchers have pointed out real blind spots
corporate hedging theories cannot explain (Allayannis & Ofek, 2001; Borokhovich et al.,
2004; Breeden & Viswanathan, 1996; DeMarzo & Duffie, 1991; Gebhardt, 1999; Jorion,
1990; Kelohaxju & Niskanen, 2001; Lins et al., 2010; Melumad et al., 1999; Raposo,
1997; Rogers, 2002; Sapra, 2002; Tufano, 1996; Whidbee & Wohar, 1999). For
example, Borokhovich et al. (2004), Marsden and Prevost (2005), and Whidbee and
Wohar (1999) indicated the board characteristics such as board independence, board size,
board composition, and directors' characteristics may influence corporate hedging
decisions in risk management. Rogers (2002) suggested companies in regulated
industries use corporate hedging less than companies in unregulated industries. Since
regulated companies face tighter scrutiny and have lower contracting costs, company
managers are less likely to hedge in risk management. Lins et al.'s (2010) empirical
evidence indicated the accounting reporting methods of derivative instruments are more
likely to affect companies that take active derivative positions.
However, the empirical evidence on these additional corporate hedging factors
using organizational data still reigns challenged, and much remains debatable about the
impact of these additional determinants on corporate hedging in risk management (Artez
& Bartram, 2010; Nguyen & Faff, 2010; Stulz, 2003). "The effect of some variables on
risk management is more complex than typically considered, and a detailed
understanding of the underlying structural parameters is required to capture these effects
properly in empirical analyses" (Artez & Bartram, 2010, p. 366). Therefore, further

78

research on these additional determinants of corporate hedging in risk management will


be needed.
As a highly regulated industry in the U.S., one of the U.S. defense industryspecific characteristics is to conduct business with U.S. Government through bidding
contracts (Watts, 2008). Given the heightened risks to U.S. defense companies because
of U.S. government policies, regulations, and budget cuts, the U.S. defense companies
might restrict corporate hedging practices. Therefore, revenues from U.S. government
contracts, as an industry-specific attribute of U.S. defense companies, were included for
examination in the study. Other additional corporate hedging factors discussed in this
section were not selected for the study due to unavailability of direct data.
Corporate Hedging in Foreign Exchange and Currency Risk Management
Within the framework of corporate hedging in risk management, foreign
exchange rate movement is one major source of risk for companies (The Boeing
Company, 2009; Eiteman et al., 2007; Homaifar, 2004; Lockheed Martin Corporation,
2009). In effect, foreign exchange and currency risk management has become an
essential part of the companies' corporate hedging decisions against foreign exchange
rate risk (Papaioannou, 2006). To hedge exposures to foreign exchange and currency
risk, knowing the types of foreign exchange and currency risk companies expose to and
deciding whether to hedge these risks are fundamental to company managers (Eiteman et
al., 2007; Stulz, 2003).
Companies operating in the global marketplace have significant exposure to
changes in foreign exchange and currency risk in the various countries where the
companies conduct business (Eiteman et al., 2007; Homaifar, 2004). Foreign exchange

and currency risk is the effect that unanticipated foreign exchange rate changes have on
the value of the company (Eiteman et al., 2007; Fabling & Grimes, 2008). The exposure
to foreign exchange and currency risk may limit the company's production and capital
investment such as R&D investment projects (Eiteman et al., 2007). Therefore, to
manage foreign exchange and currency risk, understanding the types of foreign exchange
and currency risk companies are exposed to is important.
Generally, companies are exposed to three types of foreign exchange and
currency risk: (a) translation risk, (b) transaction risk, and (c) economic risk (Eiteman et
al., 2007; Homaifar, 2004; Papaioannou, 2006). Translation risk is the potential for
change from translation of account balances recorded in foreign currencies to an entity's
reporting currency due to fluctuations in foreign exchange rates (Eiteman et al., 2007;
Papaioannou, 2006). Company managers should not manage the translation risk
exposure for the following reasons: the translation risk focuses on accounting flows
rather than cash flows, is important from the narrow standpoint of reported earnings and
balance sheet values, and does not have any meaningful impact on future cash flows
(Hagelin, 2003). Moreover, if exchange rates do not move in the anticipated direction,
hedging translation risk may cause either cash flow or earnings volatility (Papaioannou,
2006). Research has shown evidence that does not indicate support of the value of
reporting translation adjustment in financial statements. Hagelin (2003) indicated the
reported earnings could be poor estimators of real changes in the market value of a
company, which suggests hedging translation risk is also inefficient in reducing the stock
price volatility. Dhaliwal, Subramanyam, and Trezevant (1999) argued the translation
adjustments do not provide meaningful information. According to Louis (2003), the

80

translation adjustment provides misleading information about companies with foreign


manufacturing operations.
Transaction risk is the most identifiable form of foreign exchange and currency
risk exposure (Eiteman et al., 2007). Because of fluctuations in foreign exchange rates,
transaction risk rises when a company involved in international trade executes a sale or
purchases at one point in time, but the transfer of funds takes place at a different point in
time, which results in an uncertainty about the amount of revenue or expenditure
involved in the transaction in the company's home currency (Eiteman et al., 2007;
Papaioannou, 2006). Transaction risk that concentrates on contractual commitments,
which involve the actual conversion of currencies, can be hedged using derivative
instruments. The transaction risk is usually short term in nature. Most MNCs estimate
the transaction risk and take steps to hedge and control the risk (Eiteman et al., 2007;
Hagelin, 2003; Papaioannou, 2006).
Economic risk is the potential for foreign exchange rate fluctuations to affect a
company's long-term competitive position, such as future cash flows and discount rates,
in domestic and international product markets (Eiteman et al., 2007; Papaioannou, 2006).
If a company has competitors from other countries with a cost base in a foreign currency
because of foreign productions, foreign exchange and currency changes can potentially
influence future cash flows. Unlike the former two risks, economic risk can be managed
through long-term strategic decisions (Papaioannou, 2006; Whaley, 2006). For the study,
the determinants that represent the rationales for corporate hedging in foreign exchange
and currency risk management can be expected to be related to the usage of derivative

81

instruments aimed to hedge transaction risk and economic risk, rather than translation
risk.
To mitigate the impact of foreign exchange and currency risk exposure, corporate
hedging, as a means of reducing financial risk, becomes one of the key components of the
overall corporate financial risk management perspective (Chance & Brooks, 2007;
Papaioannou, 2006). Corporate hedging in foreign exchange and currency risk
management refers to the ability to manage the financial risk exposure to an extent that
makes the financial risk bearable (Chance & Brooks, 2007; Whaley, 2006). The
objective of corporate hedge in foreign exchange and currency risk management should
be to help companies achieve the optimal risk profile that balances the benefits of
protection against the costs of corporate hedging (Chance & Brooks, 2007; Nguyen &
Faff, 2010; Papaioannou, 2006). The derivative instruments used by company managers
to hedge the foreign exchange and currency risk exposure include forward contracts,
future contracts, option, and swap (Hancock-Weise, 2011; Hull, 2006; Whaley, 2006).
Empirical studies showed foreign debt can be used as an alternative of derivative
instruments to hedge the foreign exchange and currency risk exposure (Aabo, 2006;
Allayannis et al., 2003; Clark & Judge, 2009; Judge, 2009; Kelohaiju & Niskanen, 2001;
Lei, 2006; Luiz & Junior, 2011; Schiozer & Saito, 2009).
Theoretically, companies benefit from corporate hedging in foreign exchange and
currency risk management because of shareholder value maximization and managerial
utility maximization (Froot et al., 1993; Graham & Smith, 1999; Jensen & Meckling,
1976; Morellec & Smith, 2007; Smith & Stulz, 1985; Shapiro, 2005). Corporate hedging
theories have been empirically tested to examine if nonfinancial companies benefited

82

from corporate hedging in foreign exchange and currency risk management (Allayannis
& Weston, 2001; Bartram et al., 2009; Berkman et al., 2002; Brown, 2001; Carter et al.,
2006; Davies et al., 2006; Dolde & Mishra, 2007; Fabling & Grimes, 2008; Graham &
Rogers, 2002; Hagelin, 2003; Judge, 2006; Kapitsinas, 2008; Lei, 2006; Luiz & Junior,
2011; Marsden & Prevost, 2005; Menon & Viswanathan, 2005; Nguyen & Faff, 2003;
Reynolds & Boyle, 2005; Schiozer & Saito, 2009; Spano, 2008). Some of the empirical
researchers used survey data while others relied on the availability of quantitative data in
commercial databases or annual financial reports made possible by the FAS 133 or IAS
39 standards (Bartram et al., 2009; Hagelin, 2003; Judge, 2006; Kapitsinas, 2008; Luiz &
Junior, 2011; Nguyen & Faff, 2003; Reynolds & Boyle, 2005; Schiozer & Saito, 2009;
Spano, 2008). In these empirical studies, researchers tried to determine why nonfinancial
companies use derivative instruments or foreign debt to hedge the foreign exchange and
currency risk exposure (Bartram et al., 2009; Hagelin, 2003; Judge, 2006; Kapitsinas,
2008; Luiz & Junior, 2011; Nguyen & Faff, 2003; Reynolds & Boyle, 2005; Schiozer &
Saito, 2009; Spano, 2008). However, the existing empirical validation of the corporate
hedging theories has been confronted with the sample specific interpretations of
empirical results and the unavailability of reliable data on corporate hedging activities
(Artez & Bartram, 2010; Nguyen & Faff, 2010; Stulz, 2003).
For a successful validation of corporate hedging theories, provision of a valid
measure for corporate hedging in foreign exchange and currency risk management is a
basic requirement and depends on the data availability of corporate hedging activities
(Artez & Bartram, 2010; Judge, 2006). In the prior empirical studies, the most common
measure for corporate hedging in foreign exchange and currency risk management was to

83

use a dummy variable indicating if the company uses derivative instruments for corporate
hedging (Allayannis & Weston, 2001; Bartram et al., 2009; Carter et al., 2006; Davies et
al., 2006; Hagelin, 2003; Judge, 2006; Luiz & Junior, 2011; Nguyen & Faff, 2003;
Reynolds & Boyle, 2005; Schiozer & Saito, 2009; Spand, 2008). However, the major
disadvantage of using the dummy variable is the lack of quantitative information about
the corporate hedging level in a company.
According to the FAS 133 and IAS 39 standards, the derivative instruments are
required to be booked and adjusted to fair value in the company's financial statements.
Therefore, using fair value of derivative instruments makes hypothesis testing on
corporate hedging determinants in foreign exchange and currency risk management
possible. As such, the fair value of the derivative instrument scaled by the market value
of the company was proposed in prior empirical studies (Howton & Perfect, 1998;
Mardsen & Prevost, 2005; Reynolds & Boyle, 2005). However, Graham and Rogers
(2002) argued the fair value of derivatives provides "information on the extent of price
movements in derivative contracts, rather than in the amount of derivatives held" (p.
837). Therefore, the fair value of derivatives does not present a reliable estimate of the
usage of derivative instruments (Graham & Rogers, 2002).
Another quantitative approach to measure corporate hedging in foreign exchange
and currency risk management is a notional value of derivative instruments, which was
proposed in the existing empirical studies (Allayannis & Weston, 2001; Graham &
Rogers, 2002; Lei, 2006; Luiz & Junior, 2011; Menon & Viswanathan, 2005; Nguyen &
Faff, 2003; Reynolds & Boyle, 2005; Rogers, 2002; Schiozer & Saito, 2009). According
to the FAS 133 standard, companies are required to disclose the notional value of

84

derivative instruments in their annual financial reports. The size of a risk exposure for a
financial transaction using derivative instruments can be characterized by the notional
value of derivative instruments (Chance & Brooks, 2007). As such, like the fair value of
derivative instruments, the notional value of derivative instruments has an advantage over
the dummy variable. However, the notional value of derivative instruments has a limit.
The notional value of derivative instruments may overestimate the corporate hedging
activities in a company (Allayannis & Ofek, 2001). Overall, none of these three
measures is appropriate for all situations.
In today's 21st century global economy, companies are exposed to foreign
exchange and currency risk if foreign exchange rate changes are not fully anticipated
(Eiteman et al., 2007; Homaifar, 2004). To reduce the impact of foreign exchange and
currency risk exposure, identifying the type of risk for corporate hedging practices
becomes necessary (Eiteman et al., 2007; Stulz, 2003). The exposure to foreign
exchange and currency risk can be classified into three types: (a) translation risk, (b)
transaction risk, and (c) economic risk. Since company managers should not manage the
exposure to translation risk (Hagelin, 2003; Papaioannou, 2006), hedging transaction risk
and economic risk at the corporate level was the focus of the study in terms of corporate
hedging practices in foreign exchange and currency risk management.
While corporate hedging theories and additional factors have been empirically
tested to examine if nonfinancial companies could benefit from corporate hedging in
foreign exchange and currency risk management, in these empirical studies, researchers
tried to determine the decisive factors for nonfinancial companies to hedge the foreign
exchange and currency risk exposure (Allayannis & Weston, 2001; Bartram et al., 2009;

85

Berkman et al., 2002; Brown, 2001; Carter et al., 2006; Davies et al., 2006; Dolde &
Mishra, 2007; Fabling & Grimes, 2008; Graham & Rogers, 2002; Hagelin, 2003; Judge,
2006; Kapitsinas, 2008; Lei, 2006; Luiz & Junior, 2011; Marsden & Prevost, 2005;
Menon & Viswanathan, 2005; Nguyen & Faff, 2003; Reynolds & Boyle, 2005; Schiozer
& Saito, 2009; Spand, 2008). Furthermore, in these empirical studies three measures of
corporate hedging in foreign exchange and currency risk management were deployed: (a)
a dummy variable indicating derivative uses, (b) fair value of derivative instruments, and
(c) notional value of derivative instruments. However, each of these three measures is
limited.
Summary
For the study, the theoretical area of interest is corporate hedging determinants in
risk management. To improve corporate hedging practices, the proper identification of
the theoretical determinants on corporate hedging yields value-enhancing risk
management decisions (Artez & Bartram, 2010; Petersen & Thiagarajan, 2000; Stulz,
2003). Therefore, the theoretical and empirical literature in corporate hedging was
presented.
The most important consideration of financial research in risk management has
been to develop theoretically sound corporate hedging theories. The two leading
theoretical explanations on corporate hedging, shareholder value maximization and
managerial utility maximization, have been subjected to rigorous empirical testing for
more than 10 years (Artez & Bartram, 2010). From the shareholder value maximization
theory, due to inefficiencies in the perfect capital market, corporate hedging can add
value by reducing various costs involved with future cash flows and alleviating problems

86

associated with these costs. Corporate hedging decisions are influenced by a company's
financial distress (Smith & Stulz, 1985), tax benefits (Graham & Smith, 1999; Smith &
Stulz, 1985), and underinvestment problems (Froot et al., 1993). From the managerial
utility maximization theory, company managers might pursue a corporate hedging policy
that is in their own best interest, rather than a company's shareholders (Jensen &
Meckling, 1976; Shaprio, 2005; Stulz, 2003).
While the effects of key determinants on hedging must be understood to survive
in corporate hedging theories, empirically studying additional factors associated with
companies' usage of derivative instruments in risk management is equally vital to explain
corporate hedging behaviors (Adam et al., 2007; Judge, 2006). A review of each of these
additional factors related to corporate hedging at the organizational level was addressed.
In spite of the voluminous research, the effect of additional corporate hedging factors for
nonfinancial companies remains as ambiguous as key determinants of corporate hedging
theories. The conclusions of the existing empirical assessments are largely sample
specific, and the measurement of these determinants for corporate hedging is not
consistent (Artez & Bartram, 2010; Nguyen & Faff, 2010; Stulz, 2003). Finally, a
discussion of the types of foreign exchange and currency risk exposure, an examination
of the relationship between the risk attributes of U.S. defense companies and corporate
hedging in foreign exchange and currency risk management markets was presented, and a
description of three measures of corporate hedging in foreign exchange and currency risk
management was discussed.

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Chapter 3: Research Method


In the previous chapters, an introduction for the quantitative correlation study was
presented including background, problem statement, purpose of the study, and seven
research questions and corresponding hypotheses. In addition, a foundation of theoretical
support to this quantitative correlation study was established through a review of relevant
literature including corporate hedging theories and previous empirical studies. The
introduction of the study served to direct the research design and data analysis. The
problem addressed within the study was that the U.S. defense companies are exposed to
financial risks resulting in a potential loss of millions of dollars of profits as a result of
corporate hedging practices in foreign exchange and currency risk management markets.
The purpose of the study was to examine the relationship between the risk attributes of
U.S. defense companies and corporate hedging in foreign exchange and currency risk
management markets. The overarching research question for the study was: To what
extent, if any, is each of the seven risk attributes of U.S. defense companies related to
corporate hedging in foreign exchange and currency risk management markets? The
findings of the study could be used to add to the body of knowledge regarding the
organizational determinants of corporate hedging in foreign exchange and currency risk
management.
In the current chapter, the methodology used to achieve the purpose of the study
is discussed. Included in this chapter will be a description of research design and
method; participants; research instruments; operational definition of variables; data
collection; data analysis; methodological assumptions; delimitations, and limitations; and

88

ethical assurances. The chapter ends with a summary of the key components of the
methodology.
Research Design and Methods
A quantitative correlational method was most appropriate for the study because
the statistical relationship between the risk attributes of U.S. defense companies and
corporate hedging in foreign exchange and currency risk management markets was the
focus. Quantitative research is based on the positivistic research philosophy (Creswell,
2003). A positivistic researcher generalizes results to the larger population using the
deductive approach (Creswell, 2003; Trochim & Donnelly, 2008). In the positivistic,
deductive research approach, theory must be first generated and then tested by empirical
observations. If theory is falsified, it has to be rejected, and a new one formulated to
replace it (Creswell, 2003; Trochim & Donnelly, 2008). By adopting a positivistic view,
the study was used to test the tenet of corporate hedging theory that risk attributes are
related to corporate hedging in foreign exchange and currency risk management markets
is clearly warranted. Therefore, a positivistic, deductive orientation was appropriate for
this study, making the choice of a quantitative research design appropriate (Creswell,
2003; Trochim & Donnelly, 2008).
Quantitative research methods work with data in numerical form collected from a
representative sample and analyzed usually through statistical methods (Zikmund &
Babin, 2010). Johnson and Onwuegbuzie (2004) indicated that quantitative methods are
most appropriate when identifying the factors that might influence a specific outcome or
when testing a particular theory, which was precisely the purpose of the study. A
correlation design for the study was most appropriate because the predictor variable

89

cannot be manipulated (Creswell, 2003; Zikmund & Babin, 2010). Financial data
collected for the study were used to capture a measurement of the current level of the risk
attributes of U.S. defense companies and corporate hedging in foreign exchange and
currency risk management markets. Given the nature of the research purpose, the
research questions, and the adequate availability of previous empirical studies to
formulate hypothesized relationships for examination, a quantitative correlational method
was employed in the study.
For the study, the quantitative variables examined included the independent
variables of the risk attributes of U.S. defense companies and the dependent variable of
corporate hedging in foreign exchange and currency risk management markets. Designed
for variables in ratio scale of measurement, bivariate linear regression analyses were
performed to assess the relationship between seven constructed risk attributes and
corporate hedging for a random sample of U.S. defense companies that are faced with
foreign exchange and currency risk exposures. To support the interpretation of
correlation for the study, the correlation metric for measurement included the direction
and strength of the linear relationship between the risk attributes of U.S. defense
companies and corporate hedging in foreign exchange and currency risk management
markets (Weiers, 2002). A sign of regression coefficients was used to indicate either a
positive or a negative relationship between each of the risk attributes of U.S. defense
companies and corporate hedging (Allen, 2004; Weiers, 2002). A coefficient of
determination was used to determine the strength of the relationship between each of the
risk attributes of U.S. defense companies and corporate hedging (Allen, 2004; Weiers,
2002). By testing the relationship through defined and operationalized variables,

90

sampling strategies, study design, and statistical analysis, the outcome of the study may
be utilized to provide useful insight for corporate hedging to company managers in the
U.S. defense industry, and improve the effectiveness of strategic thinking and decision
making for U.S. defense companies' corporate hedging in foreign exchange and currency
risk management markets.
Validity and reliability are important concepts in quantitative research, reflecting
the rigor of research methodology and the replicability of the results, respectively
(Creswell, 2003; Trochim & Donnelly, 2008; Zikmund, 2003). Therefore, steps were
taken in the study to ensure that validity and reliability were maintained. To achieve
internal and external validity in studies of groups of subjects, the primary methods used
are random selection and assignment and the use of a research design and statistical
analysis that are appropriate to the types of data collected and the questions the researcher
tries to answer (Golafshani, 2003; Zikmund, 2003). A quantitative correlational method
was employed in the study because the purpose of the study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. The review of literature for
the study was an important step in identifying the relevant variables of inquiry in the
quantitative study. Therefore, to establish content validity, the relevant variables of the
concept were identified, and the test adequately reflected those variables were
demonstrated (Creswell, 2003; Trochim & Donnelly, 2008; Zikmund, 2003). When a
proxy for the risk attributes of U.S. defense companies was used to measure a variable,
the logic behind the selection was sound and well-documented by the researcher from
literature reviews. Furthermore, to increase confidence in the validity of the findings of

91

the secondary researches for the study, redundant patterns that cut across different
sources and studies were examined (Zikmund & Babin, 2010). Reliability was also
addressed through the use of instrumentation and procedures that allow for the
identification of relationships through random variation or irrelevant events (Allen, 2004;
Weiers, 2002; Zikmund, 2003).
Participants
The purpose of the quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. The population being
addressed in the study consisted of U.S. defense companies that met the following three
criteria: (a) U.S. based defense companies that conducted defense-related business from
2000 to 2010, (b) U.S. defense companies that must disclose financial information about
the use of financial derivatives for hedging in the annual financial report on Form 10-K,
and (c) either a multinational or a domestic U.S. defense company that is exposed to
foreign exchange and currency risk as a result of global competition. The sample was
obtained via a random selection from this population. The narrative market risk
disclosure for U.S. defense companies can be found from Item 7A in the annual financial
report on Form 10-K. Currently, there were 194 defense companies operating in the U.S.
as indicated in the NAARS database (American Institute of Certified Public Accountants,
2005).
For the study, the U. S. defense companies in the population were sampled by a
random process using a random number generator (Zikmund, 2003; Zikmund & Babin,
2010), so that each U.S. defense company remaining in the population had the same

probability of being selected for the sample (Zikmund, 2003; Zikmund & Babin, 2010).
A random sample for the study was drawn from the list of 194 U.S. defense companies.
The procedure of selecting a random sample of U.S defense companies is described in
Appendix A.
To generalize from a sample, the sample must be representative of the population
(Golafshani, 2003; Trochim & Donnelly, 2008; Zikmund, 2003). To ensure findings
from the data analysis can be generalizeable to all U.S. defense companies, a random
sample of the population was used for the study. The objective of a random sample was
to make sure that every U.S. defense company of the population had an equal chance of
being selected (Zikmund, 2003; Zikmund & Babin, 2010). The necessary sample size
was determined using a simple random sampling technique. Since the U.S. defense
companies selected for inclusion in the sample were chosen using probabilistic methods,
the simple random sampling allowed the researcher to make generalizations from the
sample to the population. Such generalizations are more likely to be considered to have
external validity (Golafshani, 2003; Trochim & Donnelly, 2008; Zikmund, 2003). The
researcher also considered whether a sample for U.S. defense companies were
representative of the rest of the population of all U.S. defense companies following U.S.
FAS 133 and IAS 39 standards, especially when the companies are from one industry. If
systematically filtering out some potential U.S. defense companies from the sample was
necessary, the study would have disclosed the filter used.
A power analysis was used to determine the proper sample size necessary to
confirm meaningful effects about the research hypotheses in the study (Cohen, 1989;
Zikmund & Babin, 2010). Sample size determinations depend on three parameters in a

93

power analysis: (a) the desired level of statistical power, set at .80 for the study; (b) the
alpha level (i.e., acceptable Type I error rate), which will be set at .05 for the study; and
(c) the effect size (Allen, 2004; Cohen, 1989; Weiers, 2002; Zikmund, 2003). Cohen
(1989) proposed that a medium effect size off2 = .15 for regression analysis because this
would be able to approximate the average size of observed effects in various fields.
Therefore, the effect size was set at/2 = .15 for the study. An a priori power analysis
was performed using G*Power 3.1 software (see Appendix B), and the sample size
necessary for the study was determined to be 55 U.S. defense companies.
Research Instruments
The purpose of the quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. Variables were developed
theoretically and abstractly in the mind of the researcher (Zikmund, 2003). For the study,
the researcher drew on corporate hedging theories and prior empirical evidence of
corporate hedging to identify and specify the variables. This section includes a
description and justification of the selected dependent and independent variables for the
study.
In the study, eight instruments were employed to measure eight constructs (seven
independent variables and one dependent variable). The seven independent variables
were (a) financial distress, (b) tax benefits, (c) underinvestment problems, (d) managerial
incentives, (e) scale economies, (f) level of foreign involvement, and (g) revenues
derived from U.S. government defense contracts. The dependent variable was corporate
hedging by U.S. defense companies in foreign exchange and currency risk management

94

markets. All of financial data about each U.S. defense company were collected from
annual financial report on Form 10-K and the annual proxy statement, which had been
filed in the EDGAR database system of the SEC.
The interpretations of the results of the study were tempered by an awareness of
the difficulties involved in measuring these selected constructs (Nguyen & Faff, 2010;
Stulz, 2003). As such, for this quantitative correlational study, choosing measurements
of the eight constructs was proceeded with the words of caution in mind. A justification
of each selected instrument is explained below.
Measurement of financial distress. To examine the costs of financial distress
(see hypothesis 1), financial leverage that is measured by a debt ratio (an independent
variable) represents financial distress of a U.S. defense company in the study. Suggested
by Allayannis and Ofek (2001) and also used by Bartram et al. (2009), Berkman et al.
(2002), Graham and Rogers (2002), Hagelin (2003), Hagelin et al. (2007), Haushalter
(2000), Lei (2006), Reynolds et al. (2009), Spand, (2008), a debt ratio provides an
indication of financial strength and the probability of financial distress for a company. A
company with a high debt ratio is more likely experiencing financial difficulties in
honoring the debt payments in the future and will be more financially distressed (Smith &
Stulz, 1985). Therefore, the greater the debt ratio, the greater financially distressed is the
company, and the more incentives the company has to hedge (Allayannis & Ofek, 2001;
Bartram et al., 2009; Berkman, 2002). The internal and predictive validity underlying
this independent variable have been demonstrated to be high in existing empirical studies
of corporate hedging in foreign exchange and currency risk management (Bartram et al.,
2009; Berkman et al., 2002; Graham & Rogers, 2002; Hagelin, 2003; Hagelin et al.,

95

2007; Haushalter, 2000; Lei, 2006; Reynolds et al., 2009; Spano, 2008). As such,
financial leverage measured by a debt ratio was appropriate for use to identify financial
distress of a U.S. defense company in the study.
Measurement of tax benefits. To examine the benefits of expected taxes (see
hypothesis 2), income tax credit range (an independent variable) represents tax benefits
of a U.S. defense company in the study. A company's tax liability is a convex function
of a company's taxable income (Graham & Smith, 1999; Stulz, 2003). Income tax credit
can affect the convexity of the company's taxable income and may reduce a company's
expected tax payments (Graham & Smith, 1999; Stulz, 2003). To use the income tax
credit, a company must have a sufficiently large taxable income (Graham & Rogers,
2002). If the company does not hedge, the company's taxable income may be too low to
use the income tax credit in some years, and so the company will lose the tax benefits.
As such, the company might have incentives to hedge (Graham & Smith, 1999; Stulz,
2003) and increase the probability of taking advantage of the income tax credit. The
internal and predictive validity underlying this independent variable have been
demonstrated to be high in existing empirical studies of corporate hedging in foreign
exchange and currency risk management. Allayannis and Ofek (2001), Mardsen and
Prevost (2005), and Lin and Smith (2007) suggested by reducing the probability of low
taxable income, corporate hedging increases the probability of using tax preference items
and thus the expected tax benefits increase. A sample of 7,319 nonfinancial companies
from 50 countries was examined by Bartram et al. (2009), and they concluded income tax
credit to measure tax incentives is an explanatory factor of corporate hedging with

96

derivative uses. Therefore, income tax credit range was appropriate for use to pinpoint
tax benefits of a U.S. defense company in the study.
Measurement of underinvestment problems. To examine underinvestment
problems (see hypothesis 3), R&D spending that is measured by a ratio of R&D expenses
to net sales or revenues (an independent variable) represents underinvestment problems
of a U.S. defense company in the study. Used by Froot et al., 1993, Bartram et al. (2009),
Carter et al. (2006), Dolde and Mishra (2007), Graham and Rogers (2000), Klimczak
(2008), Lei (2006), Lin and Smith (2007), Mseddi and Abid (2010), Schiozer and Saito
(2009), and Spano (2008), a ratio of R&D expenses to net sales or revenues reflects a
company's needs of internal funds and external financing and the future for where the
company's revenue or earnings might come from. To ensure the availability of internal
funds and external financing for a company's investment opportunities, the company with
higher R&D spending might have stronger incentives to hedge (Froot et al., 1993). The
internal and predictive validity underlying this independent variable have been
demonstrated to be high in existing empirical studies of corporate hedging in foreign
exchange and currency risk management. Graham and Rogers (2000), Lei's (2006), and
Mseddi and Abid (2010) reported investment opportunities measured by the R&D
spending are positively related to usages of derivative instruments in foreign exchange
and currency risk management. In other studies, investment opportunities measured by
the R&D spending were negatively related to corporate hedging, according to Bartram et
al. (2009) and Dolde and Mishra (2007). Therefore, the R&D spending measured by a
ratio of R&D expenses to net sales or revenues was appropriate for use to evaluate
underinvestment problems of a U.S. defense company in the study.

97

Measurement of managerial incentives. To examine managerial risk aversion


(see hypothesis 4), presence of CEO stock shares that is measured by a ratio of a
company's stock shares held by the corporate executives to total stock shares on issues
(an independent variable) represents managerial incentives of a U.S. defense company in
the study. When company managers own more stock shares of a U.S. defense company,
the company managers have greater incentives and capacity to hedge in order to reduce
their own personal wealth portfolio's risk since the company managers are overinvested
in their own U.S. defense company (Coles et al., 2004; Jensen & Meckling, 1976; Perry
& Zenner, 2000; Shapiro, 2005; Smith & Stulz, 1985; Stulz, 2003; Tufano, 1996). The
higher the ratio of a company's outstanding stock shares held by the corporate executives
to total stock shares on issues for a company, the greater the degree of preference of
corporate hedging to which company managers' actions are subjected (Marsden &
Prevost, 2005). The internal and predictive validity underlying this independent variable
have been demonstrated to be high in existing empirical studies of corporate hedging in
foreign exchange and currency risk management. Marsden and Prevost (2005) used the
ratio of a company's outstanding stock shares held by the corporate executives to total
stock shares on issues with a sample of 97 companies in 1991 and 91 companies in 1997
listed in New Zealand Stock Exchange and found a significantly positive relationship
between managerial incentives and corporate hedging. Supanvanij and Strauss (2010)
confirmed increases in executive's stock shares are significant related to corporate
hedging. "A $1 increase in CEO equity compensation results in additional $1.26 in
corporate risk activities" (Supanvanij & Strauss, 2010, p. 175). Therefore, the ratio of a

98

company's outstanding stock shares held by the corporate executives to total stock shares
on issues was appropriate for use to valuate managerial incentives in the study.
Measurement of scale economies. To examine scale economies (see hypothesis
5), firm size is measured by a natural logarithm of a company's book value of total assets
(an independent variable) and represents scale economies of a U.S. defense company in
the study. Allayannis and Ofek (2001) and Graham and Rogers (2002) attributed the
predictive power of the natural logarithm of a company's book value of total assets for
firm size to corporate hedging. Given the evident positive skewness in firm size, the
natural logarithm of a company's book value of total assets is the most effective
representation for firm size in many existing empirical studies (Bartram et al., 2009;
Berrospide et al., 2007; Carter et al., 2006; Davies et al., 2006; Guay & Kothari, 2003;
Hagelin et al., 2007; Haushalter, 2000; Hsu et al., 2009; Jong et al., 2006; Judge, 2006;
Kelohaiju & Niskanen, 2001; Lei, 2006; Mseddi & Abid, 2010; Nguyen et al., 2007;
Reynolds et al., 2009; Spano, 2008). The internal and predictive validity underlying this
independent variable have been demonstrated to be high in existing empirical studies of
corporate hedging in foreign exchange and currency risk management (Carter et al.,
2006; Jong et al., 2006; Judge, 2006; Lei, 2006; Nguyen et al., 2007; Spano, 2008). The
researchers of the existing empirical studies concluded firm size is significantly and
positively related to corporate hedging with derivative instruments (Berrospide et al.,
2007; Carter et al., 2006; Davies et al., 2006; Guay & Kothari, 2003; Hagelin et al., 2007;
Haushalter, 2000; Hsu et al., 2009; Jong et al., 2006; Judge, 2006; Klimczak, 2008; Lei,
2006; Mseddi & Abid, 2010; Nguyen et al., 2007; Spano, 2008). Therefore, the natural

99

logarithm of a company's book value of total assets was appropriate for use to estimate
scale economies in the study.
Measurement of level of foreign involvement. To examine the U.S. defense
company's extent of foreign involvement (see hypothesis 6), foreign sales ratio is a ratio
of international sales to net sales or revenues (an independent variable) and represents
level of foreign involvement of a U.S. defense company in the study. Level of foreign
involvement is a potential determinant of corporate hedging (Jorion, 1990). To
appropriately measure a company's foreign involvement, the researchers have primarily
relied upon one accounting number, namely foreign sales ratio (Allayannis & Ofek, 2001;
Bartram et al., 2009; Clark, & Mefteh, 2011; Dolde & Mishra, 2007; Jong et al., 2006;
Jorion, 1990; Pantzalis et al., 2001). A foreign sales ratio is to be the least biased at the
organizational level (Jorion, 1990), and the primary motivation has been the easy
availability of historical data (Allayannis & Ofek, 2001; Bartram et al., 2009; Clark, &
Mefteh, 2011; Dolde & Mishra, 2007; Jong et al., 2006; Jorion, 1990; Pantzalis et al.,
2001). A high foreign sale ratio indicates the level of foreign involvement grows and
increases the company's exposure to the foreign exchange and currency risk (Allayannis
& Ofek, 2001; Bartram et al., 2009; Clark, & Mefteh, 2011; Dolde & Mishra, 2007; Jong
et al., 2006; Jorion, 1990; Pantzalis et al., 2001). The internal and predictive validity
underlying this independent variable have been demonstrated to be high in existing
empirical studies of corporate hedging in foreign exchange and currency risk
management (Allayannis & Ofek, 2001; Bartram et al., 2009; Clark, & Mefteh, 2011;
Dolde & Mishra, 2007; Jong et al., 2006; Jorion, 1990; Pantzalis et al., 2001). The higher
foreign sales ratio a company has, the higher is the probability the company uses

100

corporate hedging to reduce the foreign exchange and currency risk exposure (Allayannis
& Ofek, 2001; Bartram et al., 2009; Clark, & Mefteh, 2011; Dolde & Mishra, 2007; Jong
et al., 2006; Jorion, 1990; Pantzalis et al., 2001). Bartram et al. (2009) reported a positive
relationship between the level of foreign involvement and corporate hedging with foreign
currency derivative holdings using foreign sales ratio as a measure of the extent of
foreign involvement. Therefore, foreign sales ratio was appropriate for use to define the
level of foreign involvement of a U.S. defense company in the study.
Measurement of revenues from U.S. government contracts. To examine the
U.S. defense company's business involvement with U.S. government (see Hypothesis 7),
sales to the U.S. government is measured by a ratio of sales to U.S. government to net
sales or revenues for a U.S. defense company (an independent variable) and represents
revenues from U.S. government defense contracts in the study. A percent of revenues
that are derived from U.S. government contracts indicates how much a U.S. defense
company is engaged in business with the DoD (The Boeing Company, 2009; Lockheed
Martin Corporation, 2009). Increase in sales to the U.S. government may increase the
degree of scrutiny in auditing from U.S. government agencies (The Boeing Company,
2009; Eiteman et al., 2007; Lockheed Martin Corporation, 2009). To shift the risks, a
U.S. defense company might tend to have a lower demand for corporate hedging.
Therefore, the sales to U.S. government for a U.S. defense company offered much
potential as an approach to measure the revenues derived from U.S. government defense
contracts in the study.
Measurement of corporate hedging in foreign exchange and currency risk
management. The dependent variable, corporate hedging by U.S. defense companies in

101

foreign exchange and currency risk management markets, was measured by notional
value of foreign exchange and currency derivatives. According to the FAS 133 standard,
companies are mandated to disclose the notional value of derivative instruments in the
annual financial reports. For the study, only the amount of derivative instruments used
for the purpose of corporate hedging in foreign exchange and currency risk management
were selected. According to Purnanandam (2007), the notional value of derivative
instruments in corporate hedging captures "the firm's total ownership of risk
management instruments and is thus able to distinguish between companies with different
intensities of hedging" (p. 719). The construct validity underlying this dependent
variable has been demonstrated to be high in existing empirical studies of corporate
hedging in foreign exchange and currency risk management (Allayannis & Weston, 2001;
Graham & Rogers, 2002; Lei, 2006; Luiz & Junior, 2011; Menon & Viswanathan, 2005;
Nguyen & Faff, 2003; Purnanandam, 2007; Reynolds & Boyle, 2005; Schiozer & Saito,
2009). Therefore, the notional value of foreign exchange and currency derivative
instruments was appropriate for use with the U.S. defense companies' corporate hedging
in the foreign exchange and currency risk management.
Operational Definition of Variables
The purpose of the quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. In the study, the operational
definition of the dependent and independent variables are defined as follows. Table 1
shows a summary of independent variables, description, and data types for the study.

102
Table 1

Summary of Independent Variable, Description and Data Type

Independent variable

Description

Data type

Financial distress

Debt ratio

Ratio

Tax benefits

Income tax credit range

Ratio

Underinvestment problems

R&D spending

Ratio

Managerial incentives

Presence of CEO stock shares

Ratio

Scale economies

Firm size

Ratio

Level of foreign involvement

Foreign sales ratio

Ratio

Revenues from U.S. government contracts

Sales to U.S. government

Ratio

Independent variable/Financial distress. Financial distress of a U.S. defense


company is measured by a debt ratio, which is a ratio of book value of debt to book value
of equity (an independent variable). Data for book value of debt and book value of
equity can be collected from the annual financial report on Form 10-K. The level of
measurement for the variable is a ratio scale.
Independent variable/Tax benefits. Tax benefits of a U.S. defense company are
measured by an income tax credit range (an independent variable). Data for a company's
income tax credit can be collected from the annual financial report on Form 10-K. The
level of measurement for the variable is a ratio scale.
Independent variable/Underinvestment problems. Underinvestment problems
of a U.S. defense company are measured by R&D spending, which is a ratio of R&D

103

expenses to net sales or revenues (an independent variable). Data for R&D expenses and
net sales or revenues can be collected from the annual financial report on Form 10-K.
The level of measurement for the variable is a ratio scale.
Independent variable/Managerial incentives. Managerial incentives of a U.S.
defense company are measured by presence of CEO's stock shares, which is a ratio of a
company's stock shares held by the corporate executives to total number of stock shares
on issues (an independent variable). Data for a company's stock shares held by the
corporate executives and total number of stock shares on issues can be collected from the
annual proxy statement and the annual financial report on Form 10-K. The level of
measurement for the variable is a ratio scale.
Independent variable/Scale economies. Scales economies of a U.S. defense
company are measured by firm size, which is the natural logarithm of a company's book
value of total assets (an independent variable). Data for a company's book value of total
assets can be collected from the annual financial report on Form 10-K. The level of
measurement for the variable is a ratio scale.
Independent variable/Level of foreign involvement. Level of foreign
involvement of a U.S. defense company is measured by foreign sales ratio, which is a
ratio of international sales to net sales or revenues (an independent variable). Data for
international sales and net sales or revenues can be collected from the annual financial
report on Form 10-K. The level of measurement for the variable is a ratio scale.
Independent variable/Revenues from U.S. government contracts. Revenues
from U.S. government contracts of a U.S. defense company are measured by sales to U.S.
government, which is a ratio of sales to U.S. government to net sales or revenues (an

104

independent variable). Data for sales to U.S. government and net sales or revenues can
be collected from the annual financial report on Form 10-K. The level of measurement
for the variable is a ratio scale.
Dependent variable/Corporate hedging in foreign exchange and currency
risk management. Corporate hedging in foreign exchange and currency risk
management is measured by notional value of derivative instruments (a dependent
variable). Data for the notional value of derivative instruments can be collected from the
annual financial report on Form 10-K. The level of measurement for the variable is a
ratio scale.
Data Collection, Processing, and Analysis
The purpose of the study was to examine the relationship between the risk
attributes of U.S. defense companies and corporate hedging in foreign exchange and
currency risk management markets. A quantitative correlational methodology of data
analysis was utilized for the study. The annual financial reports on Form 10-K and the
annual proxy statement refer to fiscal year 2010. The data collection and data analysis
procedures employed in the study are presented in this section.
Data collection. A sample of a financial dataset used for the study included a
U.S. defense company's book value of debt, book value of equity, income tax credit,
book value of assets, R&D expenses, net sales or revenues, stock shares held by the
corporate executives, total number of stock shares on issues, international sales, sales to
U.S. government, and the notional value of derivative instruments. Since U.S. defense
companies' annual financial report on Form 10-K and the annual proxy statement have
been filed in the EDGAR database system of the SEC, and the financial data from these

105

reports cannot be manipulated and are in "the form of numbers that can be quantified and
summarized" (Golafshani, 2003, p. 598), the richness and accuracy of data necessary to
establish the ability to draw statistical interfaces was provided for the study.
By employing secondary data, "researchers can avail themselves to new sources
of data and can shed new light on or provide important corroborating evidence to
established streams of research that have relied on a limited variety of methodological
approaches" (Houston, 2004, p. 154). With the passage of the Sarbanes-Oxley Act of
2002, corporate executives must certify the financial statements are faithful
representations of the financial positions and results of operations of the company
(Whittington & Pany, 2004). Because of the disclosure improvements for a company's
business and financial information, more empirical studies on the use of financial
derivatives have employed the data on corporate hedging activities contained in the
company's annual financial report (Apostolou & Apostolou, 2008; Bartram et al., 2009;
Carter et al., 2006; Hsu et al., 2009; Judge, 2006; Nguyen et al., 2007; Ramirez, 2007;
Reynolds et al., 2009; Schiozer & Saito, 2009; Spano, 2008; Sprfiic, 2007). Since the
sample data from the annual financial report on Form 10-K is monetary figures with
description, the sample data had face validity (Zikmund, 2003). The study had high
external validity even though the internal validity was not as strong because the study
used actual financial data on real companies.
A problem of using the annual financial report on Form 10-K was a lack of
uniformity in the parts of the annual financial statements where the use of derivative
instruments is reported. Companies disclosed financial derivatives use in a variety of
footnotes to the financial statements, and footnotes were frequently not cross-referenced

106

making it difficult to know if all financial derivatives disclosures had been identified. As
a result, the data collected for analysis may have been skewed to a certain extent. To
improve internal validity and ensure the data gathered in the study was suitable to a
quantitative analysis, several questions were asked as part of an attempt to evaluate the
usefulness of data from the annual financial report on Form 10-K (see Figure 2).
Searching keywords related to corporate hedging by U.S defense companies in foreign
exchange and currency risk management markets on Form 10-K was performed for the
study. The keywords included Item 7A, quantitative disclosure, accounting for hedging,
risk management, financial risk, risk factors, off balance sheet, derivative, hedging,
sensitivity analysis, eamings-at-risk, cash flow at risk, value at risk (VaR), international
sales, foreign sales, foreign exchange rate, foreign currency risk, foreign currency debt,
price risk, market risk, futures contract, forward contract, option, swap, notional value,
and U.S. government sales and contracts. The robustness of data or information can also
be enhanced through multiple-source validation (Zikmund, 2003; Zikmund & Babin,
2010). Therefore, one check included a comparison of financial data collected from the
annual financial report on Form 10-K with information provided from other sources.
Established research as determined that if the sets of data are comparable, the data
collected for the study may have had some degree of reliability.
Data processing and analysis. Methods for analyzing data fall into two
categories of statistical procedures: nonparametric and parametric, which are
distinguished by whether or not assumptions about the distribution of the data are met
(Weiers, 2002). The parametric methods were selected to test hypothesis for the study
because the normality, independence of errors, and equal variance assumptions

107

Do the data help to answer


questions set out in the
problem definition?

No*

Yw
Do the data apply to the
time period of interest?

No*

YM
Applcabiity

ID the current

-<

Do the data apply to the


population of hterest?

No*

project
Do other terms and
variable calssificatais
presented apply to the
current project?

No*

Can the data


be reworked?
If yea,
continue

No*

YM
Vs.

Are the units of


measurement comparable?

No*

Is it possible to go to the
original source of the data?

No*

Y<*
Is the oost of the data
acquisition worth it?

No*

Yw
Is there a possibility
of bias?

VIM*

N
Accuiacyof
the data

Is using the
data worth
the risk?

j
^

Can the accixacy of the


data collection be verified?

No*

(Inaccurate
YM (aocurate) or unsure)

Use data

Figure 2. Evaluating secondary data. From Exploring marketing research (10th ed.) by
W. G. Zikmund and B. J. Babin, 2010, p. 160. Copyright 2010 by South-Westem, a part
of Cengage Learning, Inc. Reproduced by permission, www.cengage.com/permissions
(see Appendix C).

108

underlying the bivariate linear regression for the study are required to be validated
(Allen,2004; Weiers, 2002). If any of the assumptions are violated, insights yielded by
parametric statistical analyses may be inefficient, seriously biased, or misleading. In
other research studies in the proposed research area, Bartram et al. (2009), Berkman et al.
(2002), Carter et al. (2006), Hsu et al. (2009), Jin and Jorion (2006), Jong et al. (2006),
Judge (2006), Khediri (2010), Lei (2006), Marsden and Prevost (2005), Nguyen et al.
(2007), Nguyen and Faff (2010), Reynolds et al. (2009), Spano (2008), and SprCi6 (2007)
demonstrated that parametric methods were appropriate.
Next, the selection of the category of statistical procedures is also determined by
the scale of measurement of variables (Zikmund, 2003). The parametric methods require
an interval or ratio scale of measurement of the variables while the nonparametric
methods require a nominal or ordinal scale of measurement of the variables (Weiers,
2002). For the study, the dependent variable (corporate hedging in foreign exchange and
currency risk management markets) and the independent variables (U.S. defense
company-specific risk attributes) have a ratio scale of measurement. Finally, large
sample sizes are more likely to show significant deviations from normality, and the
nonparametric methods lack statistical power with small samples (Allen, 2004; Weiers,
2002; Zikmund, 2003). For the study, the sample size was less than 100 based upon the
power analysis. To detect any given effect at a specified significance level, a larger
sample size would have been needed for the nonparametric methods. Therefore,
parametric methods to test the hypotheses were selected for the study.
In prior empirical studies, the outcome of corporate hedging decisions was
considered to be a linear function of the independent variables, which are proxies of the

109

determinants of corporate hedging (Allayannis & Weston, 2001; Berrospide et al., 2007;
Carter et al., 2006; Hagelin, 2003; Jin & Jorion, 2006; Judge, 2006; Khediri, 2010; Lei,
2006; Nguyen et al., 2007; Nguyen & Faff, 2010; Reynolds et al., 2009; Spano, 2008;
SprCic, 2007). For the study, the relationship between each U.S. defense companyspecific risk attribute and corporate hedging in foreign exchange and currency risk
management markets was tested using bivariate linear regression analyses. The
dependent variable for each hypothesis in the study was the level of corporate hedging in
foreign exchange and currency risk management. In each hypothesis, an independent
variable was one of the seven U.S. defense company-specific risk attributes. Bivariate
linear regression analysis was applied to address the research questions for the study
because bivariate regression analysis can be used to ensure the relationships identified by
correlation analysis as significant are in fact statistically significant, not a chance
occurrence (Allen, 2004; Weiers, 2002; Zikmund, 2003).
In hypothesis testing, there are always two contradictory hypotheses under
consideration (Allen, 2004; Creswell, 2003; Weiers, 2002; Zikmund, 2003). The
objective of hypothesis testing is to decide, based on information derived from a sample,
which of the two hypotheses is correct (Allen, 2004; Creswell, 2003; Weiers, 2002;
Zikmund, 2003). The two competing statements are called the null hypothesis (Ho) and
the alternative hypothesis (Ha). The following steps were taken for conducting
hypothesis testing to address the research questions in the study: stated the hypothesis to
be tested, analyzed the assumptions of underlying linear regression, selected test statistic
used for measures of association, and defined decision criterion to either reject or fail to
reject the hypothesis (Allen, 2004; Weiers, 2002; Zikmund, 2003).

110

State the hypothesis to be tested. For the study, the relationship between each
U.S. defense company-specific risk attribute and corporate hedging in foreign exchange
and currency risk management markets was defined as a bivariate linear regression with
corporate hedging in foreign exchange and currency risk management markets as the
dependent variable and each U.S. defense company-specific risk attribute as the
independent variable. The bivariate linear regression can be expressed as follows:

YJ = AO + BJ XJ + EI

where Xt is the independent variable, which represents for U.S. defense company-specific
risk attribute i. Seven linear regression analyses were performed, with each analysis
including one of the seven risk attributes: Xj is financial distress, X2 is tax benefits, X3 is
underinvestment problems, X4 is managerial incentives, X5 is scale economies, X$ is level
of foreign involvement, and Xj is revenues from U.S. government contracts. Ao is a
constant amount for corporate hedging in foreign exchange and currency risk
management markets with zero U.S. defense company-specific risk attribute, Bt is the
regression coefficient, e, is the random error reflecting other factors that influence
corporate hedging in foreign exchange and currency risk management markets, and F
denoted corporate hedging in foreign exchange and currency risk management markets
for the ith U.S. defense company-specific risk attribute, is the dependent variable.
Given a random sample of pairs of Xt and Y h the method of ordinary least squares
(OLS) was used to estimate the values of Ao and Bt such that the value of e, is minimized
(Allen, 2004; Weiers, 2002; Zikmund, 2003). If there is a linear relationship between
U.S. defense company-specific risk attribute (Xj) and corporate hedging in foreign

Ill

exchange and currency risk management markets (Yt), the value of B, will be different
from zero. If there is no linear relationship between U.S. defense company-specific risk
attribute (X,) and corporate hedging in foreign exchange and currency risk management
markets (7/), the value of 5, will be equal to zero. Since to demonstrate that something is
true is statistically impossible, and statistical techniques are much better at demonstrating
something is not true (Weiers, 2002; Zikmund, 2003), for the study, the null hypothesis
(Ho) was used to predict there is no linear relationship between U.S. defense companyspecific risk attribute (X,) and corporate hedging in foreign exchange and currency risk
management markets (7/). As such, to determine the existence of a significant linear
relationship between U.S. defense company-specific risk attribute (X,) and corporate
hedging in foreign exchange and currency risk management markets (F,), the null and the
alternative hypotheses can be stated as follows:
Ho. Bj = 0

H. B i t 0
Validate the assumptions of underlying linear regression. The proper use of
bivariate linear regression in the study depended on the underlying assumptions of
linearity, independence of errors, normality, and equal variance (Allen, 2004, Weiers,
2002). Among the best ways to validate the linearity, normality, and equal variance
assumptions for the bivariate linear regression is via visual inspections of residual plots
(Weiers, 2002). Although different ways to generate residual plots exist, two types of
residual plots were selected for the study: a normal probability plot of residuals for
assessing the normality of distribution of residuals and a residual scatter plot to provide a
visual indicator of both the linearity of the relationship and the homogeneity of variance

112

for the residuals. When outliers were encountered, the researcher needed to decide
whether or not to include the outliers in the analysis (Weiers, 2002). Regardless of the
decision, the presence of outliers was acknowledged. If the decision was to exclude the
outliers, the researcher provided a clear rationale for deleting the outliers and reported the
regression coefficient both with and without the outliers.
The assumption of independence of errors for the bivariate linear regression was
evaluated with the Durbin-Watson statistic for the study because the Durbin Watson
statistic is a well-known formal method of testing if autocorrelations is a serious problem
undermining the inferential suitability of the linear regression model (Weiers, 2002). The
test statistic of the Durbin-Watson procedure is d and is calculated as follows:

{e-e,_x)2
d =^
TE]
T=i

where e, and et., represent observed residuals, and n is number of observations. The value
of d is between 0 and 4. For a given level of significance, sample size, and number of
independent variables, the critical values of d are tabulated as pairs of values: A, and Dv
(Weiers, 2002). With one independent variable in bivariate linear regression and a
sample size of 55 U.S. defense companies for the study, the critical values, Di = 1.53 and
Du= 1-60, were given for a two-tail test at the 0.05 level of significance (Weiers, 2002).
For the present study, Table 2 shows decision zones and appropriate interpretation for a
calculated value of the Durbin-Watson statistic, d.
Select test statistic used for measures of association. Appropriate parametric
methods to discover whether or not the linear regression is effective in fitting the data are

113
Table 2

General Guidelines for Interpreting the Calculated Value of Durbin-Watson Statistics (d)

Decision zone

Interpretation

0 < d < 1.53

Positive autocorrelation is strong.

1.53 < d < 1.60

The test is inconclusive.

l . 6 0 < d < 2.40

Autocorrelation is absent.

2.40 < d < 2.47

The test is inconclusive.

2.47 < d < 4

Negative autocorrelation is strong.

either F-test or /-test (Allen, 2004; Weiers, 2002). The F-test tests the overall linear
regression model (Allen, 2004; Weiers, 2002). The test for significance of regression in
multiple linear regression analysis is carried out using the F-test. Multiple /-tests analyze
the significance of each regression coefficient (Allen, 2004; Zikmund & Babin, 2010).
Because only one coefficient exists in a bivariate linear regression, the F-test and the /test will be identical and provide the same conclusions of the statistical analysis (Allen,
2004; Weiers, 2002). Given the bivariate linear regression for the study, the /-test was
selected to determine the existence of a significant linear relationship between each U.S.
defense company-specific risk attribute and corporate hedging in foreign exchange and
currency risk management markets.
The two-tailed test always uses = and ^ in the statistical hypotheses and are
directionless in that the alternative hypothesis allows for either the greater than (>) or less
than (<) possibility (Allen, 2004; Weiers, 2002). Based upon the null and the alternative

114

hypotheses stated in the study, the two-tailed test were performed in the hypothesis
testing because results that are obtained for the study may be in opposition to the
direction that the researcher thinks would occur. Knowing the opposite results from what
they expected are true was also important for the study.
Define decision rules to either accept or reject the hypothesis. Alpha level (a),
denoted the probability of Type I error, designated the risk of rejecting the hypothesis if it
is actually true (Allen, 2004; Weiers, 2002; Zikmund, 2003). The alpha level is typically
.05 or .01 (Zikmund, 2003). In previous empirical studies, the accepted alpha level has
been established at 0.05, or a 5% probability that a significant difference will occur by
chance (Bartram et al., 2009; Brown, 2001; Carter et al., 2006; Gay & Nam, 1998;
Graham & Rogers, 2000; Hsu et al., 2009; Judge, 2006; Nguyen et al., 2007; Reynolds et
al., 2009; Spand, 2008). Therefore, all decisions on the statistical significance of the
findings were made using a criterion alpha level of .05 in the hypothesis testing for the
study.
The decision rules to either reject or fail to reject the hypothesis are described by
two equivalent approaches: region of acceptance, and p-value (Allen, 2004; Weiers,
2002). The /?-value is used to quantitatively measure the strength of evidence against the
null hypothesis, and the smaller p-value provides stronger evidence against the null
hypothesis (Allen, 2004; Weiers, 2002). Based upon the hypotheses and research
questions for the study, the p-value approach was selected. If the p- value was less than or
equal to the alpha level (p < .05), the researcher rejected the null hypothesis for the study.
If the p-value was greater than the alpha level (p > .05), the researcher failed to reject the
null hypothesis for the study.

115

Interpretation of correlation. Creswell (2003) defined the final step in


quantitative data analysis as the action "to interpret the findings in light of the hypotheses
or research questions set forth in the beginning" (p. 167). For the study, to support the
interpretation of correlation in bivariate linear regression analysis, the researcher first
looked at the signs of the regression coefficients (B,). These signs are used to give insight
into the effects of the explanatory variables on the linear outcome (Weiers, 2002). The
positive regression coefficient indicates that there is a positive relationship between U.S.
defense company-specific risk attribute and corporate hedging in foreign exchange and
currency risk management markets for the study. For the opposite direction, the negative
regression coefficient indicates that there is a negative relationship between U.S. defense
company-specific risk attribute and corporate hedging in foreign exchange and currency
risk management markets for the study.
Next, the strength of correlation between U.S. defense company-specific risk
attribute and corporate hedging in foreign exchange and currency risk management
markets was measured by the coefficient of determination (Allen, 2004; Weiers, 2002).
For bivariate linear regression, coefficient of determination (R ) represents what
proportion of the variation in the dependent variable is associated with the regression of
an independent variable (Allen, 2004; Weiers, 2002). The value of R2 ranges from 0 to 1.
As a high level of shared variance, a large value of R2 indicates a strong linear
relationship between U.S. defense company-specific risk attribute (the independent
variable) and corporate hedging in foreign exchange and currency risk management
markets (the dependent variable). As a low level of shared variance, a small value of R
is considered as being of little or no practical importance, even though the association

116

between U.S. defense company-specific risk attributes and corporate hedging in foreign
exchange and currency risk management markets is statistically significant. While
performing linear regression analysis for the study using Microsoft Excel 2007 with
PHStat2 add-in, the value of coefficient of determination is provided in the model
summary of linear regression analysis.
Allen (2004) and Zikmund (2003) noted that correlations do not imply causality.
When the researcher finds U.S. defense company-specific risk attribute and corporate
hedging in foreign exchange and currency risk management markets with a strong
correlation, a relationship between U.S. defense company-specific risk attribute and
corporate hedging in foreign exchange and currency risk management markets is
concluded, not changes in U.S. defense company-specific risk attribute causes changes in
corporate hedging in foreign exchange and currency risk management markets.
Linear regression analysis conducted in the study may be one of the most
commonly used statistical analysis techniques in business research (Zikmund & Babin,
2010). Statistical conclusion validity refers to the degree to which one's analysis allows
one to make the correct decision regarding the truth or approximate truth of the null
hypothesis (Creswell, 2003; Zikmund & Babin, 2010). Various threats to making valid
conclusions exist in linear regression analysis (Allen, 2004; Creswell, 2003). The threats
can be reduced by increasing the sample size to increase the statistical power to find a
relationship, accepting lower significance levels (a = .10 instead of a = .05) to reduce the
chance of ignoring relationships that do exist, and by increasing the reliability of
instrumentation and procedures so that relationships can be shown over the noise of
random or irrelevant events (Allen, 2004; Weiers, 2002; Zikmund, 2003). By probing the

117

evidence of direction, magnitude, statistical significance, and variance, together with the
objective and research questions of the study, the researcher can reduce the chance of
reporting trivial findings. Simultaneously, the communication of findings from the study
is improved. Finally, reliability is maintained by revealing every reference and data
source explicitly, and presenting every equation and sampling process adopted in the
study transparently, so that any calculations are able to be audited.
Methodological Assumptions, Delimitations, and Limitations
The purpose of the quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. The methodological
assumptions of the study included financial data collected in annual financial reports was
reliable, consistent, and accurate from the EDGAR database system of the SEC, and the
underlying assumptions of linear regression analysis are linearity, independence of errors,
normality, and equal variance. If the financial data did not satisfy these underlying
assumptions, the statistical results for the study would not be a true reflection of the
relationship between the risk attributes of U.S. defense companies and corporate hedging.
Therefore, if the financial data did not meet the underlying assumptions, a transformation
procedure was required. For the study, a natural logarithmic function was selected for
transformation on a data set (Allen, 2004). Both the dependent and independent variables
were subjected to the same transformation. Using the transformed variables, bivariate
linear regression analyses were performed. The bivariate linear regression can be
expressed as follows:
Log(7/) = A 0 + B i LogPQ + Ej

118

Participants in the study were delimited to U.S. defense companies that conducted
defense related business from 2000 to 2010 in the U.S.. Because the study only focused
on certain aspects of U.S. defense companies' corporate hedging in foreign exchange and
currency risk management, the limitation of the study was the outcome of the study
would not provide a complete understanding of complexity and richness of corporate
hedging in foreign exchange and currency risk management markets for U.S. defense
companies. The results of the study can only be generalized to the population of 194
U.S. defense companies from which the sample was obtained. The generalization of the
study to other industries or foreign defense companies was not warranted.
Ethical Assurances
The purpose of the quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. Ethical issues for the study
were addressed at each phase in the study. In compliance with the regulations of the
Institutional Review Board (IRB), permission for conducting the study was obtained from
Northcentral University's (NCU) IRB before the sample of financial data for the study
was collected. The request for review form was filed, providing information about the
principal investigator, the study title and type, source of funding, type of review
requested, and number and type of subjects. Application for the study permission
contained the description of the study and its significance, methods and procedures,
participants, and research status.
The credibility of a study critically depends on the integrity with which the study
is designed, analyzed, and concluded (Zikmund & Babin, 2010). The researcher's

119

responsibility is to ensure the study is conducted in an ethical and responsible manner.


The researcher's involvement with data collection for this study included manual
gathering of financial data from the annual financial report on Form 10-K and the annual
proxy statement using the defined procedures, including sampling, data evaluation, and
reliability and validity checks of the research instruments. Selection of samples was a
critical issue in the study. A sample must represent a population; otherwise,
generalizability of the findings using the sample for the study would be limited (Zikmund
& Babin, 2010). To ensure findings from the data analysis can be generalizeable to the
population of 194 U.S. defense companies, a random sample of the population was used
for the study. The necessary sample size was determined using well-developed statistical
techniques.
Another researcher's responsibility is to analyze the data appropriately (Zikmund
& Babin, 2010). Although inappropriate data analysis does not certainly indicate
misbehavior, an intentional exclusive of results from the study will mislead the readers
and cause misinterpretation (Zikmund & Babin, 2010). The researcher therefore needed
to make sure the sample of financial data was gathered, analyzed, and interpreted
honestly and fairly in the study. To ensure appropriate data analysis in the study, all
relevant sources and research methods used to gather related information were
completely disclosed. Failure to have done so may have led misinterpretation of the
results without considering the likelihood of the study being underpowered (Humphrey &
Lee, 2004). The data analysis was performed using rigorous statistical analysis
techniques, and the results were interpreted based on the established values for the
statistical significance of the functions. Any issues of bias were addressed in the study,

120

and the researcher explained how the issues of bias were handled in the design, analysis,
and conclusions of the study.
Summary
The methodology used in conducting the present study was detailed within
chapter 3. Corporate hedging theories were the theoretical foundation of the study. The
findings of the study were formed by an inductive research method. By empirically
testing the relationship between the risk attributes of U.S. defense companies and
corporate hedging in foreign exchange and currency risk management markets through
defined and operationalized variables, sampling strategies, study design, and statistical
analysis, generalization from the sample to population will be possible, which was the
purpose of the study. Based upon the identified research questions and objective, the
quantitative correlational design was most appropriate for the study.
The population for the study was 194 defense companies operating in the U.S., as
indicated in the NAARS database (American Institute of Certified Public Accountants,
2005). Using a quantitative correlational method, the researcher randomly selected 55
U.S. defense companies to examine the relationship between the risk attributes of U.S.
defense companies and corporate hedging in foreign exchange and currency risk
management markets. For the study, bivariate linear regression analysis was selected as
the most appropriate statistical technique to determine if the existence of the risk
attributes of U.S. defense companies, such as costs of financial distress, investment
opportunities, tax benefits, and managerial incentives, would significantly relate to U.S.
defense companies' hedging in foreign exchange and currency risk management markets.
The coefficient of determination and sign of regression coefficients were used to

121

determine the strength and direction of the relationship between the risk attributes of U.S.
defense companies and corporate hedging in foreign exchange and currency risk
management markets.
The findings from the study must yield both internal and external validity because
the ability to generalize research results from the sample to the population of U.S.
defense industry was one of the main purposes of the study. Because the researcher only
focused on certain aspects of corporate hedging in foreign exchange and currency risk
management, the outcome of the study would not provide a complete understanding of
complexity and richness of corporate hedging in foreign exchange and currency risk
management markets for U.S. defense companies. Finally, the researcher's responsibility
was to ensure the study was conducted in an ethical and responsible manner so that the
credibility of the study was achieved. In accord with the IRB regulations, no financial
data for the study were collected prior to the approval for conducting the study.

122

Chapter 4: Findings
The purpose of the quantitative correlational study was to examine the
relationship between the risk attributes of U.S. defense companies and corporate hedging
in foreign exchange and currency risk management markets. Seven research questions
were operationalized based from a single research question: To what extent, if any, is
each of the risk attributes of U.S. defense companies related to corporate hedging in
foreign exchange and currency risk management markets? Seven constructed
independent variables were constructed representing the risk attributes of U.S. defense
companies: (a) financial distress, (b) underinvestment problems, (c) tax benefits, (d)
managerial incentives, (e) scale economies, (f) level of foreign involvement, and (g)
revenues derived from U.S. government contracts. Data collected for the seven
constructed independent variables aligned with (a) debt ratio, (b) income tax credit range,
(c) research and development spending, (d) presence of CEO stock shares, (e) firm size,
(f) foreign sale ratio, and (g) sales to U.S. government. As a constructed dependent
variable for the study, corporate hedging in foreign exchange and currency risk
management markets was defined as "a component of a more general process called risk
management, the alignment of the actual level of risk with the desired level of risk"
(Chance & Brooks, 2007, p. 355). Data collected for the constructed dependent variable
was a notional value of derivatives, as mentioned in Chapter 3.
The results from the analysis of data that were used to address these seven
research questions are described in this chapter. Sections of this chapter include
quantitative results, and the evaluation of the findings. A summary of the findings are
highlighted at the end of the chapter.

123

Results

Descriptive statistics. A random sample for the study was taken from 194
defense companies operating in the U.S. as indicated in the NAARS database (American
Institute of Certified Public Accountants, 2005). According to the power analysis
description noted in Chapter 3, a sample size of 55 U.S. defense companies was required
to establish statistical significance. Information on corporate hedging practices in foreign
exchange and currency risk management was gathered from annual financial reports
(Form 10-K and the annual proxy statement) submitted to the SEC by each of the U.S.
defense companies. A total of 55 U.S. defense companies' financial reports in 2010 were
obtained. All the data for the study was extracted manually from each company's
financial report.
As stated in the financial reports, all 55 U.S. defense companies were found to
have been exposed to foreign exchange and currency risk. In this study, corporate
hedging by U.S. defense companies in foreign exchange and currency risk management
markets (the dependent variable) was measured by a notional value of foreign exchange
and currency derivatives. Reporting the notional value of foreign exchange and currency
derivatives showed many U.S. defense companies had either less than $100 million of
notional value of derivative instruments (n = 18,32.73%) or between $100 and $500
million (n = 19, 34.55%). The remaining U.S. defense companies had either between
$500 and $1,500 million of notional value of derivative instruments (n = 9,16.36%) or
over $1,500 million (n = 9,16.36%). Frequencies and percentage for corporate hedging
in U.S. defense industry are presented in Table 3.

124
Table 3

Frequencies and Percentages of Corporate Hedging in Foreign Exchange and Currency


Risk Management Markets

Variable

Frequency

Percentage

Corporate hedginga
Under 100

18

32.73%

101-500

19

34.55%

501-1,500

16.36%

Over 1,500

16.36%

55

100.00%

Total
Note.

Represented by a notional value of derivative instruments (dollars in million).

The seven risk attributes of U.S. defense companies (the independent variables)
were defined as (a) financial distress, (b) tax benefits, (c) underinvestment problems, (d)
managerial incentives, (e) scale economies, (f) level of foreign involvement, and (g)
revenues derived from U.S. government defense contracts. Financial distress of a U.S.
defense company was measured by a debt ratio, which is a ratio of book value of debt to
book value of equity. Of the 55 U.S. defense companies, many U.S. defense companies
had either less than 1.0 of debt ratio (n = 20, 36.36%) or between 1.0 and 2.0 ( = 19,
34.54%). The remaining U.S. defense companies had either between 2.1 and 3.0 of debt
ratio (n = 8,14.55%) or over 3.0 ( = 8,14.55%). Frequencies and percentages of
financial distress for U.S. defense companies are presented in Table 4.

125
Table 4

Frequencies and Percentages for Financial Distress

Variable

Frequency

Percentage

Financial distress
Under 1.0

20

36.36%

1.1-2.0

19

34.54%

2.1-3.0

14.55%

Over 3.0

14.55%

55

100.00%

Total

Tax benefits of a U.S. defense company were measured by an income tax credit
range. Reporting the tax benefits showed the majority of the U.S. defense companies (n =
31, 56.36%) had less than $100 million of income tax credits. In addition, 25.45% of
U.S. defense companies (n = 14) were $100 to $500 million income tax credits. The U.S.
defense companies with over $500 million categories of income tax credits were roughly
18% (18.19%). Frequencies and percentages of tax benefits for U.S. defense companies
are presented in Table 5.

126
Table 5

Frequencies and Percentages for Tax Benefits

Variable

Frequency

Percentage

Tax benefits3
Under 100

31

56.36%

101-500

14

25.45%

501-1,500

7.27%

Over 1,500

10.92%

55

100.00%

Total
Note.

dollars in million.

Underinvestment problems of a U.S. defense company were measured by R&D


spending, which is a ratio of R&D expenses to net sales or revenues. Reporting the
underinvestment problems showed the majority of the U.S. defense companies (n = 29,
52.73%) had less than 2.0% of R&D spending. The underinvestment problems least
reported were 5.01-8.00% of R&D spending at 7.27% (n = 4). The U.S. defense
companies with 2.01-5.00% (n = 15) and over 8.00% (n = 11) of R&D spending were
27.27% and 12.73%, respectively. Frequencies and percentages of underinvestment
problems for U.S. defense companies are presented in Table 6.

127
Table 6

Frequencies and Percentages for Underinvestment Problems

Variable

Frequency

Percentage

Underinvestment problems8
Under 2.00

29

52.73%

2.01-5.00

15

27.27%

5.01-8.00

7.27%

Over 8.00

12.73%

55

100.00%

Total
Note.

units in percentage.

Managerial incentives of a U.S. defense company were measured by presence of


CEO stock shares, which is a ratio of a company's stock shares held by the corporate
executives to total number of stock shares on issues. Reporting the managerial incentives
showed a large number of U.S. defense companies in = 23,41.82%) had under .05% of
presence of CEO stock shares. The U.S. defense companies with .051-.100% (n = 10),
.101-.200% (n = 11), and over .200% (n = 11) of presence of CEO stock shares were
18.18%, 20% and 20%, respectively. Frequencies and percentages of managerial
incentives for U.S. defense companies are presented in Table 7.

128
Table 7

Frequencies and Percentages for Managerial Incentives

Variable

Frequency

Percentage

Managerial incentives8
Under .05

23

41.82%

.051-.100

10

18.18%

.101-.200

11

20.00%

Over .200

11

20.00%

55

100.00%

Total
Note.

a units

in percentage.

Scale economies of a U.S. defense company were measured by firm size, which is
the natural logarithm of a company's book value of total assets. Reporting the scale
economies showed 47.27% of U.S. defense companies (n = 26) were greater than 9.50,
but no more than 10.5. Furthermore, the U.S. defense companies had either under 9.50 of
firm size (n = 12, 21.82%) or 10.51-11.50 (n = 16, 29.09%). The remaining 1.82% of
U.S. defense companies was over 11.50 of firm size (n = 1). Frequencies and
percentages of scale economies for U.S. defense companies are presented in Table 8.

129
Table 8

Frequencies and Percentages for Scale Economies

Variable

Frequency

Percentage

Scale economies
Under 9.50

12

21.82%

9.51-10.50

26

47.27%

10.51-11.50

16

29.09%

Over 11.50

1.82%

55

100.00%

Total

Level of foreign involvement of a U.S. defense company was measured by


foreign sales ratio, which is a ratio of international sales to net sales or revenues.
Reporting the level of foreign involvement showed a large number of U.S. defense
companies (n = 24,43.64%) with less than 20% of foreign sales ratio. Additionally, the
U.S. defense companies had either 20.1-40.0% of foreign sales ratio (n = 11, 20.00%) or
40.1-60.0% (n = 12, 21.82%). The remaining 14.55% of U.S. defense companies were
over 60.0% of foreign sales ratio (n = 8). Frequencies and percentages of level of foreign
involvement for U.S. defense companies are presented in Table 9.

130
Table 9

Frequencies and Percentages for Level of Foreign Involvement

Variable

Frequency

Percentage

Level of foreign involvement8


Under 20.0

24

43.64%

20.1-40.0

11

20.00%

40.1-60.0

12

21.81%

Over 60.0

14.55%

55

100.00%

Total
Note.

units in percentage.

Revenues derived from U.S. government contracts of a U.S. defense company


were measured by sales to U.S. government, which is a ratio of sales to U.S. government
to net sales or revenues. Reporting the revenues derived from U.S. government contracts
showed a majority of U.S. defense companies (52.73%) with less than 40.0% of sales to
U.S. government (n = 29). In addition, the U.S. defense companies had either 40.160.0% of sales to U.S. government (n = 11, 20.00%) or over 80.0% (n = 11, 20.00%).
The lowest revenues derived from U.S. government contracts (n = 4, 7.27%) were the
U.S. defense companies with 60 to 80% of sales to U.S. government. Frequencies and
percentages of revenues derived from U.S. government contracts for U.S. defense
companies are presented in Table 10.

131
Table 10

Frequencies and Percentages for Revenues Derivedfrom U.S. Government Contracts

Variable

Frequency

Percentage

Revenues from U.S. government contracts8


Under 40.0

29

52.73%

40.1-60.0

11

20.00%

60.1-80.0

7.27%

Over 80.0

11

20.00%

55

100.00%

Total
Note,

units in percentage.

As shown in Table 11, descriptive statistics were calculated to report the mean
values and standard deviations among the sample of 55 U.S. defense companies for each
of organizational risk attributes. The average financial distress, as measured with debt
ratio, was 2.28, SD = 3.6. The average tax benefits, as measured with income tax credit
range, were $522.81 million, SD = $1,295.43 million. The average underinvestment
problems, as measured with R&D spending, were 3.46%, SD = 4.61%. The average
managerial incentives, as measured with presence of CEO stock shares, were .15%, SD =
.20%. The average scale economies, as measured with firm size, was 10.08, SD = .79.
The average level of foreign involvement, as measured with foreign sale ratio, was
30.20%, SD = 24.08%. The average revenues derived from U.S. government contracts,
as measured with sales to U.S. government, were 39.11%, SD = 33.84%. The average

132

corporate hedging in foreign exchange and currency risk management, as measured with
notional value of derivatives, was $1,012.85 million, SD = $1,850.99 million.
Table 11
Descriptive Statistics of the Risk Attributes of U.S. Defense Companies and Corporate
Hedging in Foreign Exchange and Currency Risk Management Markets

Variable

SD

The Risk Attributes of U.S. Defense Companies


Financial distress

2.28

3.6

522.81

1,295.43

3.46

4.61

.15

.20

Scale economies

10.08

.79

Level of foreign involvementb

30.20

24.08

Revenues derived from U.S. government contracts11

39.11

33.84

1,012.85

1,850.99

Tax benefits8
Underinvestment problems'5
Managerial incentives'3

Corporate Hedging
Notional value of derivative instruments8
Note. M mean; SD = standard deviation.
8 dollars

in million.

units in percentage.

Finally, in order to detect an outlier in sample data sets and determine if any cases
should not have been included in the analysis, a standard Z score was computed for the
variables in the study (Weiers, 2002). Since the sample size of the study is less than 80, a
criterion for identification of an outlier for a standard Z score is less than -2.5 or greater

133

than +2.5 (Weiers, 2002). The calculated Z scores of the variables were between -2.1 to
+2.1 thereby confirming that none of the variables had outliers in the analyzed data sets
for the study.
To address the research questions and related hypotheses, seven sets of hypothesis
testing using bivariate linear regression were implemented in the study. Prior to
hypothesis tests associated with each research question, assumptions of underlying
bivariate linear regression were validated. A criterion alpha level of .05 was employed
for all hypothesis tests in the study.
Evaluating the assumptions of underlying bivariate linear regression. Two
sets of the validation of assumptions were performed. To evaluate the linearity,
normality, and equal variance assumptions of underlying bivariate linear regression, the
first set of assumption validations was performed by inspecting visually the residual plots
and normal probability plots of the residuals. To access linearity and equal variance, the
residuals were plotted against each of the seven independent variables for the study (see
Appendix D, Figures D1 through D7). Although scatter occurred in the residual plots, no
relationship between the residuals and each independent variable was evident. The
residuals were randomly and equally distributed relatively above and below -500 for the
differing values of the independent variable. As such, the linearity assumption of
underlying bivariate linear regression was satisfied. Furthermore, no major differences in
the variability of the residuals for different values of each independent variable were
present. The patterns of figures in Appendix D indicated no substantial
heteroscedasticity and potential violation of the equal variance assumption of underlying

134

bivariate linear regression. Therefore, the equal variance assumption of underlying


bivariate linear regression was satisfied.
Normal probability plots of residuals were generated for the dependent variable
on the seven independent variables for hypothesis tests (see Appendix E, Figures El
through E7). The data residuals of the dependent variable in relation to the independent
variables were not distributed normally. The patterns of the figures indicated the data
sampled during the study were skewed. However, the sample of the study was small; to
test the normality would be difficult (Weiers, 2002; Wuensch, 2006). Due to the
robustness of regression analysis with respect to the assumption of normality (Weiers,
2002), the departures from the normality assumption in the sample data of U.S. defense
companies should not be the cause for concern.
To assess the assumption of independence of errors for the bivariate linear
regression, the second set of the validation of assumptions was to calculate the DurbinWatson statistic, d. At the 0.05 level of significance, the calculated Durbin-Watson
statistics of independent variables for the study had a value between 1.60 and 2.20 (see
Table 12). Based upon decision zones defined in Table 2, no evidence of
autocorrelations among residuals for the independent variables was present. Therefore,
the assumption of independence of errors for the study was satisfied.
Overall, the assumptions of linearity, equal variance, and independence of errors
were satisfied. The assumption of normality was not to be seriously violated. The use of
bivariate linear regression was appropriate for the study.

135
Table 12

The Calculated Value of Durbin-Watson Statistic (d) for Independent Variables in the
Analyzed Data Sets

Independent variable

Calculated d

Financial distress

1.6210

Tax benefits

2.1582

Underinvestment problems

1.6882

Managerial incentives

1.6216

Scale economies

1.6687

Level of foreign involvement

1.6653

Revenues derived from U.S. government contracts

1.6648

Correlational analyses. As described in Chapter 3, to assess the relationship


between the risk attributes of U.S. defense companies (X,) and corporate hedging in
foreign exchange and currency risk management markets (Y,), a bivariate linear
regression was defined as:

Y,= A, + B, Xt + ,

For the study, correlational analyses using the bivariate linear regression were performed
on the seven independent and one dependent variables: (a) X] = financial distress, (b) X2
= tax benefits, (c) X3 = under-investment problems, (d) X4 = managerial incentives, (e) X5
= scale economies, (f) Xs = level of foreign involvement, (g) X7 = revenues derived from

136

U.S. government contracts, and (h) Yt = corporate hedging in foreign exchange and
currency risk management markets for the rth U.S. defense company-specific risk
attribute. These constructs were operationalized according to the description of
operational definition of variables in Chapter 3. A Mest was performed to determine the
existence of a significant linear relationship between each U.S. defense company-specific
risk attribute and corporate hedging. The research questions and the corresponding null
and alternative hypotheses are restated. The results of the hypothesis tests are presented
as organized by research questions.
Financial distress. The purpose of the first research question was to investigate
the possible relationship between financial distress and corporate hedging in U.S. defense
industry. The research question and corresponding hypotheses are presented as follows.
Ql. To what extent, if any, is financial distress related to corporate hedging in
foreign exchange and currency risk management markets for U.S. defense companies?
Hlo. Financial distress, as measured with debt ratio, is not correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
HI,. Financial distress, as measured with debt ratio, is correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
The research instrument defined for hypothesis 1 as related to financial distress
(X j ) was debt ratio. As shown in Table 13, the sign of the regression coefficient (Bj) was
positive. As such, the relationship between financial distress and corporate hedging was

137

positive. Furthermore, financial distress accounted for 3% ( R 2 = .03) of the variance in


corporate hedging.
For a two-tail test at the .05 level with n- 2 = 53 degrees of freedom, the critical
values are t -2.006 and t = +2.006. The calculated test statistic t was between the
critical values. The p value of .24 was greater than .05. The results of the bivariate linear
regression analysis for hypothesis 1, 53) =1.18, p > .05, indicated that financial
distress was not statistically significant and positively correlated with corporate hedging
in foreign exchange and currency risk management markets for U.S. defense companies.
Therefore, the null hypothesis (Hlo) was not rejected. The alternative hypothesis (Hla)
was not supported. Results of testing the significance of the linear relationship between
financial distress and corporate hedging are shown in Table 13.
Table 13
Results of Testing the Significance of the Linear Relationship between Financial Distress
and Corporate Hedging (n = 55)

Variable

SEB

R2

X,

82.29

69.69

1.18

.24

.03

.16

Note. X] = financial distress. SE = standard error. * p < .05.

Tax benefits. The purpose of the second research question was to investigate if
tax benefits relate to corporate hedging for U.S. defense companies. The research
question and corresponding hypotheses are presented as follows.
Q2. To what extent, if any, are tax benefits related to corporate hedging in
foreign exchange and currency risk management markets for U.S. defense companies?

138

H2o. Tax benefits, as measured with income tax credit range, are not correlated to
corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.
H2. Tax benefits, as measured with income tax credit range, are correlated to
corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.
The research instrument defined for hypothesis 2 as related to tax benefits ( X j )
was income tax credit range. As shown in Table 14, the sign of the regression coefficient
(JBi) was positive. As such, the relationship between tax benefits and corporate hedging
was positive. Additionally, tax benefits explained 45% (R2 = .45) of the variance in
corporate hedging.
Table 14
Results of Testing the Significance of the Linear Relationship between Tax Benefits and
Corporate Hedging (n = 55)

Variable

SEB

R2

*2

.96

.14

6.64*

.00

.45

.67

Note. X2 = tax benefits. SE = standard error. * p< .05.

For a two-tail test at the .05 level with n- 2 = 53 degrees of freedom, the critical
values are t = -2.006 and t = +2.006. The calculated test statistic t was within the range
of the critical values. The p value of .00 was less than .05. The results of the bivariate
linear regression analysis for hypothesis 2, /(53) = 6.64, p < .05, demonstrated a
statistically significant and positive relationship between tax benefits and corporate

139

hedging in foreign exchange and currency risk management markets for U.S. defense
companies. Therefore, the null hypothesis (H2o) was rejected. The alternative
hypothesis (H2a) was supported. Results of testing the significance of the linear
relationship between tax benefits and corporate hedging are shown in Table 14.
Underinvestment problems. The purpose of the third research question was to
investigate whether the relationship between underinvestment problems and corporate
hedging for U.S. defense companies exists. The research question and corresponding
hypotheses are presented as follows.
Q3. To what extent, if any, are underinvestment problems related to corporate
hedging in foreign exchange and currency risk management markets for U.S. defense
companies?
H3o- Underinvestment problems, as measured with R&D spending, are not
correlated to corporate hedging in foreign exchange and currency risk management
markets, as measured with notional value of derivatives, for U.S. defense companies.
H3a. Underinvestment problems, as measured with R&D spending, are correlated
to corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.
The research instrument defined for hypothesis 3 as related to underinvestment
problems (X3) was R&D spending. As shown in Table 15, the sign of the regression
coefficient (B3) was positive. As such, the relationship between underinvestment
problems and corporate hedging was positive. Furthermore, underinvestment problems
accounted for 10% (R2 = .10) of the variance in corporate hedging.

140

For a two-tail test at the .05 level with n- 2 = 53 degrees of freedom, the critical
values are t = -2.006 and t = +2.006. The calculated test statistic t was outside the critical
values. The p value of .02 was less than .05. The results of the bivariate linear regression
analysis for hypothesis 3, r(53) = 2.44, p < .05, indicated a positive relationship between
underinvestment problems and corporate hedging in foreign exchange and currency risk
management markets for U.S. defense companies. Therefore, the null hypothesis (H3o)
was rejected. The alternative hypothesis (H3a) was supported. Results of testing the
significance of the linear relationship between underinvestment problems and corporate
hedging are shown in Table 15.
Table 15
Results of Testing the Significance of the Linear Relationship between Underinvestment
Problems and Corporate Hedging (n = 55)

Variable

SEB

R2

x3

127.66

52.33

2.24*

.02

.10

.32

Note. Xj = underinvestment problems. SE = standard error. * p< .05.

Managerial incentives. The purpose of the fourth research question was to


investigate if managerial incentives and corporate hedging are related in the U.S. defense
industry. The research question and corresponding hypotheses are presented as follows.
Q4. To what extent, if any, are managerial incentives related to corporate
hedging in foreign exchange and currency risk management markets for U.S. defense
companies?

141

H4o. Managerial incentives, as measured with presence of corporate executives'


stock shares, are not correlated to corporate hedging in foreign exchange and currency
risk management markets, as measured with notional value of derivatives, for U.S.
defense companies.
H4. Managerial incentives, as measured with presence of corporate executives'
stock shares, are correlated to corporate hedging in foreign exchange and currency risk
management markets, as measured with notional value of derivatives, for U.S. defense
companies.
The research instrument defined for hypothesis 4 as related to managerial
incentives (X4) was presence of CEO stock shares. As shown in Table 16, the sign of the
regression coefficient (B4) was negative. As such, the relationship between managerial
incentives and corporate hedging was negative. Additionally, managerial incentives
explained 7% (R2 = .07) of the variance in corporate hedging.
Table 16
Results of Testing the Significance of the Linear Relationship between Managerial
Incentives and Corporate Hedging (n = 55)

Variable

SEB

R2

-2398.87

1247.17

-1.92

.06

.07

-.26

Note. X4 = managerial incentives. SE = standard error. * p < .05.

For a two-tail test at the .05 level with n- 2 = 53 degrees of freedom, the critical
values are t = -2.006 and t = +2.006. The calculated test statistic t was between the
critical values. The p value of .06 was greater than .05. The results of the bivariate linear

142

regression analysis for hypothesis 4, r(53) = -1.92, p > .05, indicated managerial
incentives were not statistically significant and negatively correlated with corporate
hedging in foreign exchange and currency risk management markets for U.S. defense
companies. Therefore, the null hypothesis (H4o) was not rejected. The alternative
hypothesis (H4a) was not supported. Results of testing the significance of the linear
relationship between managerial incentives and corporate hedging are shown in Table 16.
Scale economies. The purpose of the fifth research question was to investigate
the possible relationship between scale economies and corporate hedging for U.S.
defense companies. The research question and corresponding hypotheses are presented
as follows.
Q5. To what extent, if any, are scale economies related to corporate hedging in
foreign exchange and currency risk management markets for U.S. defense companies?
H5o. Scale economies, as measured with firm size, are not correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
H5a. Scale economies, as measured with firm size, are correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
The research instrument defined for hypothesis 5 as related to scale economies
(Xs) was firm size. As shown in Table 17, the sign of the regression coefficient (Bi) was
positive. As such, the relationship between scale economies and corporate hedging was
positive. In addition, the result in the correlation analysis of the study indicated scale
economies accounted for 28% (R2 = .28) of the variance in corporate hedging.

143

For a two-tail test at the .05 level with n - 2 = 53 degrees of freedom, the critical
values are t = -2.006 and t = +2.006. The calculated test statistic t was outside the critical
values. The p value of .00 was less than .05. The results of the bivariate linear regression
analysis for hypothesis 5, 53) = 4.54, p < .05, concluded a statistically significant and
positive relationship between scale economies and corporate hedging in foreign exchange
and currency risk management markets for U.S. defense companies. Therefore, the null
hypothesis (H5o) was rejected. The alternative hypothesis (H5a) was supported. Results
of testing the significance of the linear relationship between scale economies and
corporate hedging are shown in Table 17.
Table 17
Results of Testing the Significance of the Linear Relationship between Scale Economics
and Corporate Hedging (n = 55)

Variable

SEB

R2

1241.44

273.31

4.45*

.00

.28

.53

Note. Xs = scale economies. SE = standard error. * p< .05.

Level of foreign involvement. The purpose of the sixth research question was to
investigate whether level of foreign involvement relates to corporate hedging in U.S.
defense industry. The research question and corresponding hypotheses are presented as
follows.
Q6. To what extent, if any, is level of foreign involvement related to corporate
hedging in foreign exchange and currency risk management markets for U.S. defense
companies?

144

H60. Level of foreign involvement, as measured with foreign sale ratio, is not
correlated to corporate hedging in foreign exchange and currency risk management
markets, as measured with notional value of derivatives, for U.S. defense companies.
H6. Level of foreign involvement, as measured with foreign sale ratio, is
correlated to corporate hedging in foreign exchange and currency risk management
markets, as measured with notional value of derivatives, for U.S. defense companies.
The research instrument defined for hypothesis 6 as related to level of foreign
involvement (Xg) was foreign sales ratio. As shown in Table 18, the sign of the
regression coefficient (Bg) was positive. As such, the relationship between level of
foreign involvement and corporate hedging was positive. In addition, level of foreign
involvement accounted for 4% (R2 = .04) of the variance in corporate hedging.
Table 18
Results of Testing the Significance of the Linear Relationship between Level of Foreign
Involvement and Corporate Hedging (n = 55)

Variable

SEB

R2

x6

15.02

10.35

1.45

.15

.04

.20

Note. X(, = level of foreign involvement. SE - standard error. * p< .05.

For a two-tail test at the .05 level with n- 2 = 53 degrees of freedom, the critical
values are t = -2.006 and t = +2.006. The calculated test statistic t was between the
critical values. The p value of.15 was greater than .05. The results of the bivariate linear
regression analysis for hypothesis 6, /(53) = 1.45, p > .05, showed that level of foreign
involvement was not statistically significant and positively correlated with corporate

145

hedging in foreign exchange and currency risk management markets for U.S. defense
companies. Therefore, the null hypothesis (H6o) was not rejected. The alternative
hypothesis (H6a) was not supported. Results of testing the significance of the linear
relationship between level of foreign involvement and corporate hedging are shown in
Table 18.
Revenues derived from U.S. government contracts. The purpose of the seventh
research question was to investigate if revenues from U.S. government contracts and
corporate hedging are related in U.S. defense industry. The research question and
corresponding hypotheses are presented as follows.
Q7. To what extent, if any, are revenues from U.S. government contracts related
to corporate hedging in foreign exchange and currency risk management markets for U.S.
defense companies?
H7o. Revenues derived from U.S. government contracts, as measured with sales
to U.S. government, are not correlated to corporate hedging in foreign exchange and
currency risk management markets, as measured with notional value of derivatives, for
U.S. defense companies.
H7a. Revenues derived from U.S. government contracts, as measured with sales
to U.S. government, are correlated to corporate hedging in foreign exchange and currency
risk management markets, as measured with notional value of derivatives, for U.S.
defense companies.
The research instrument defined for hypothesis 7 as related to revenues derived
from U.S. government contracts (A was sales to U.S. government. As shown in Table
19, the sign of the regression coefficient {Bj) was negative. As such, the relationship

146

between revenues derived from U.S. government contracts and corporate hedging was
negative. Furthermore, the result of the study showed revenues derived from U.S.
government contracts explained 9% (R2 = .09) of the variance in corporate hedging.
For a two-tail test at the .05 level with n- 2 = 53 degrees of freedom, the critical
values are t = -2.006 and t = +2.006. The calculated test statistic t was not within the
range of the critical values. The p value of .02 was less than .05. The results of the
bivariate linear regression analysis for hypothesis 7, t(53) = -2.39, p < .05, displayed a
negative relationship between revenues derived from U.S. government contracts and
corporate hedging in foreign exchange and currency risk management markets for U.S.
defense companies. Therefore, the null hypothesis (H7o) was rejected. The alternative
hypothesis (H7a) was supported. Results of testing the significance of the linear
relationship between revenues derived from U.S. government contracts and corporate
hedging are shown in Table 19.
Table 19
Results of Testing the Significance of the Linear Relationship between Revenues Derived
from U.S. Government Contracts and Corporate Hedging (n = 55)

Variable

SEB

R2

*7

-17.05

7.14

-2.39*

.02

.09

-.31

Note. Xy - revenues derived from U.S. government contracts. SE - standard error.


*p< .05.

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Evaluation of Findings
With the level and amount of corporate hedging increasing, U.S. defense
companies are exposed to financial risks resulting in a potential loss of millions of dollars
of profits (The Boeing Company, 2009; Chance & Brooks, 2007; Eiteman et al., 2007;
Gregory, 2010; Lockheed Martin Corporation, 2009; Stulz, 2003). However, whether
organizational risk factors relate to corporate hedging in the U.S. defense industry is not
determined (Artez & Bartram, 2010). To ensure the success of company managers
performing corporate hedging in risk management, a need exists for empirical assessment
regarding the relationship between organizational risk attributes and corporate hedging in
the U.S. defense industry (Artez & Bartram, 2010; Petersen & Thiagarajan, 2000; Stulz,
2003). The results of this study illustrated the need for the assessment of the relationship
between the risk attributes of U.S. defense companies and corporate hedging in foreign
exchange and currency risk management markets. According to the research questions
and related hypotheses in the study, the findings of the correlation analyses are discussed
below.
HI. Financial distress, as measured with debt ratio, is not correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
The evidence of the correlational analysis in the study indicated financial distress,
as measured by the debt ratio, is not related to corporate hedging in foreign exchange and
currency risk management markets for U.S. defense companies, /(53) = 1.1 S,p > .05. In
theory, the higher leveraged company with debts might have a strong incentive to hedge
(Geczy et al., 1997; Smith & Stulz, 1985). A large number of empirical studies

148

supported financial distress is significantly and positively related to corporate hedging


(Bartram et al., 2009; Berkman, 2002; Berrospide et al., 2007; Dolde & Mishra, 2007;
Graham & Rogers, 2002; Haushalter, 2000; Lei, 2006; Nguyen & Faff, 2003; Reynolds et
al., 2009; Schiozer & Saito, 2009; Spano, 2008). In direct contrast to theoretical and
empirical predictions, the evidence of the study showed financial distress is not
considered to be a significant organizational risk factor related to corporate hedging in
the U.S. defense industry. The lack of association between financial distress and
corporate hedging in this study could be applied in support of the findings by Davies et
al. (2006) and Sprfiic (2007) that financial leverage with debts is not an explanatory
factor for corporate hedging. Therefore, the results of this study, in conjunction with the
conclusions made by Davies et al. (2006) and Sprcic (2007), signify that financial distress
is not significantly related to corporate hedging.
H2. Tax benefits, as measured with income tax credit range, are correlated to
corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.
The evidence of the correlational analysis in the study showed tax benefits, as
measured by the income tax credit range, are significantly and positively related to
corporate hedging in foreign exchange and currency risk management markets in the U.S.
defense industry, t(53) = 6.64, p < .05. The positive regression coefficient indicated a
higher level of tax benefits is correlated to a higher level of corporate hedging. The
evidence of the study indicated the U.S. defense companies with $500 million of tax
benefits are more likely to hedge, compared to those with $100 million of tax benefits.
This finding is aligned with other empirical studies indicating a more significant

149

convexity of progressive tax function (tax incentives) will lead to a likelihood of


corporate hedging (Berrospide et al., 2007; Graham & Smith, 1999; Lin & Smith, 2007).
Therefore, the results of this study, in conjunction with the conclusions made by
Berrospide et al. (2007), Graham and Smith (1999), and Lin and Smith (2007), signify
that tax benefits and corporate hedging are significantly and positively related.
H3. Underinvestment problems, as measured with R&D spending, are correlated
to corporate hedging in foreign exchange and currency risk management markets, as
measured with notional value of derivatives, for U.S. defense companies.
The evidence of the correlational analysis in the study indicated underinvestment
problems, as measured by the R&D spending, are positively related to corporate hedging
in foreign exchange and currency risk management markets for U.S. defense companies,
t(53) = 2.44, p < .05. The positive regression coefficient indicated a higher level of
underinvestment problems is correlated with a higher level of corporate hedging. The
evidence of the study showed the U.S. defense companies with 5.0% of underinvestment
problems are more likely to hedge, compared to those with 2.0% of underinvestment
problems. This finding is aligned with the empirical research in the body of literature,
which indicated the companies with high investment opportunities hedge more with
derivative instruments (Carter et al., 2006; Crabb, 2006; Graham & Rogers, 2000; Hsu et
al., 2009; Lei, 2006; Mseddi & Abid, 2010; Sprdic, 2007; Schiozer & Saito, 2009).
Therefore, the results of this study, in conjunction with the conclusions made by Carter et
al. (2006), Crabb (2006), Graham and Rogers (2000), Hsu et al. (2009), Lei (2006),
Mseddi and Abid (2010), Sprdic (2007), and Schiozer and Saito (2009), signify that
underinvestment problems and corporate hedging are significantly and positively related.

150

However, given the relatively small amount of variance noted in the study results (see
Table 15), the significance of the positive relationship between underinvestment
problems and corporate hedging in foreign exchange and currency risk management
markets is considered weak in U.S. defense industry.
H4. Managerial incentives, as measured with presence of corporate executives'
stock shares, are not correlated to corporate hedging in foreign exchange and currency
risk management markets, as measured with notional value of derivatives, for U.S.
defense companies.
The evidence of the correlational analysis in the study indicated managerial
incentives, as measured by the presence of corporate executives' stock shares, are not
correlated to corporate hedging in foreign exchange and currency risk management
markets for U.S. defense companies, t(53) = -1.92, p > .05. The evidence of the study
showed managerial incentives are not considered to be a significant organizational risk
factor related to corporate hedging in the U.S. defense industry. In contrast to other
empirical research findings, this study did not indicate the empirical support to the
managerial incentives hypothesis developed by Gonzalez et al. (2010), Marsden and
Prevost (2005), Purnanandam (2007), Sprdic (2007), and Supanvanij and Strauss (2010)
who specifically concluded increases in executive's stock shares are significantly related
to corporate hedging. Therefore, the results of this study, in contrast to the conclusions
made by Gonzalez et al. (2010), Marsden and Prevost (2005), Purnanandam (2007),
SprCic (2007), and Supanvanij and Strauss (2010), signify that managerial incentives are
not significantly related to corporate hedging.

151

H5. Scale economies, as measured with firm size, are correlated to corporate
hedging in foreign exchange and currency risk management markets, as measured with
notional value of derivatives, for U.S. defense companies.
The evidence of the correlational analysis in the study showed scale economies,
as measured by the firm size, and corporate hedging in foreign exchange and currency
risk management markets for the U.S. defense companies are significantly and positively
related, /(53) = 4.54, p < .05. The positive regression coefficient indicated a higher level
of scale economies is correlated with a higher level of corporate hedging. The evidence
of the study indicated the U.S. defense companies with 11.50 of scale economies are
more likely to hedge, compared to those with 9.50 of scale economies. The finding of
this study is consistent with the findings of previous empirical studies supporting the
hypothesis that corporate hedging exhibits scale economies (Berrospide et al., 2007;
Carter et al., 2006; Davies et al., 2006; Guay & Kothari, 2003; Hagelin et al., 2007;
Haushalter, 2000; Hsu et al., 2009; Jong et al., 2006; Judge, 2006; Klimczak, 2008; Lei,
2006; Mseddi & Abid, 2010; Nguyen et al., 2007; Spano, 2008). Therefore, the results
of this study, in conjunction with the conclusions made by researchers in previous
empirical studies (Berrospide et al., 2007; Carter et al., 2006; Davies et al., 2006; Guay &
Kothari, 2003; Hagelin et al., 2007; Haushalter, 2000; Hsu et al., 2009; Jong et al., 2006;
Judge, 2006; Klimczak, 2008; Lei, 2006; Mseddi & Abid, 2010; Nguyen et al., 2007;
Spano, 2008), signify that scale economies and corporate hedging are significantly and
positively related.

152

H6. Level of foreign involvement, as measured with foreign sale ratio, is not
correlated to corporate hedging in foreign exchange and currency risk management
markets, as measured with notional value of derivatives, for U.S. defense companies.
The evidence of the correlational analysis in the study indicated the level of
foreign involvement, as measured by the foreign sales ratio, is not correlated to corporate
hedging in foreign exchange and currency risk management markets for the U.S. defense
companies, t(53) = 1.45, p > .05. The evidence of the study showed the level of foreign
involvement is not considered to be a significant organizational risk factor related to
corporate hedging in the U.S. defense industry. The finding of the present study does not
concur with Jorion's (1990) expectations, who suggested companies with the greater
level of foreign involvement have greater benefits from corporate hedging at the
corporate level. The finding of the study does coincide with the conclusion of Howton
and Perfect (1998) who posited that level of foreign involvement is not a theoretical
determinant in corporate hedging by analyzing 461 U.S. nonfinancial companies.
Therefore, the results of this study in conjunction with the conclusion made by Howton
and Perfect (1998) signify the relationship between the level of foreign involvement and
corporate hedging is not supported.
H7. Revenues derived from U.S. government contracts, as measured with sales to
U.S. government, are correlated to corporate hedging in foreign exchange and currency
risk management markets, as measured with notional value of derivatives, for U.S.
defense companies.
The evidence of the correlational analysis in the study revealed revenues derived
from U.S. government contracts, as measured by the sales to U.S. government, are

153

negatively related to corporate hedging in foreign exchange and currency risk


management markets for the U.S. defense companies, /(53) = -2.39, p < .05. The
negative regression coefficient indicated a higher level of revenues derived from U.S.
government contracts is correlated with a lower level of corporate hedging. The evidence
of the study showed the U.S. defense companies with 40.0% of sales to U.S. government
are more likely to hedge, compared to those with 60.0% of sales to U.S. government.
This finding indicated the U.S. defense companies may be pressured to restrict corporate
hedging in order to contend for U.S. government contracts. The finding of the study is
aligned with the conclusions of Rogers (2002) and Schiozer and Saito (2009) indicating
companies in regulated industries are less likely to use financial derivatives for corporate
hedging. However, given the relatively small amount of variance indicated in the study
results (see Table 19), the significance of the inverse relationship between revenues
derived from U.S. government contracts and corporate hedging is considered weak in the
U.S. defense industry.
Summary
This researcher sought to answer research questions regarding the relationship
between the risk attributes of U.S. defense companies and corporate hedging in foreign
exchange and currency risk management markets. The preceding chapter presented an
analysis of the data obtained through following the methodology outlined in Chapter 3.
In the study, a random sample of 55 U.S. defense companies from the population was
analyzed by using a correlation analysis method. Descriptive statistics for the sample as
well as information on the risk attributes of U.S. defense companies and corporate
hedging were included. The bivariate linear regression analyses with Mest were

154

performed to assess whether each of the risk attributes of U.S. defense companies
associates with corporate hedging in foreign exchange and currency risk management
markets. A total of seven hypotheses for the study were tested. The findings of the study
supported tax benefits and scale economies were significantly and positively related to
corporate hedging in foreign exchange and currency risk management markets in the U.S.
defense industry, and underinvestment problems were positively related to corporate
hedging in foreign exchange and currency risk management markets in the U.S. defense
industry, and revenues derived from U.S. government contracts were negatively related
to corporate hedging in the U.S. defense industry. However, the findings of the study did
not support the hypotheses that financial distress, managerial incentives, and level of
foreign involvement were correlated with corporate hedging in foreign exchange and
currency risk management markets for U.S. defense companies. The current study
expanded on prior empirical investigations that researchers have conducted in applying
corporate hedging theories towards understanding corporate hedging behaviors in risk
management. Consequently, the findings from the study provided the understanding of
the risk attributes of U.S. defense companies in relation to corporate hedging practices in
foreign exchange and currency risk management markets. A number of implications
produced from this study will be discussed in the next chapter.

155

Chapter 5: Implications, Recommendations, and Conclusions


The problem investigated in the study was U.S. defense companies are exposed to
financial risks resulting in a potential loss of millions of dollars of profits as a result of
corporate hedging practices in foreign exchange and currency risk management markets
(The Boeing Company, 2009; Chance & Brooks, 2007; Eiteman et al., 2007; Gregory,
2010; Lockheed Martin Corporation, 2009; Stulz, 2003). The purpose of the study was to
examine the relationship between the risk attributes of U.S. defense companies and
corporate hedging in foreign exchange and currency risk management markets. The
overarching research question for the study was: To what extent, if any, is each of the risk
attributes of U.S. defense companies related to corporate hedging in foreign exchange
and currency risk management markets? A quantitative research methodology was
employed to address the research questions. The research design involved correlation
analyses in hypothesis testing. The results from the present study must be interpreted in
the context of limitations.
The primary limitation of the study was the outcome of the study did not provide
a complete understanding of the complexity and richness of corporate hedging in foreign
exchange and currency risk management markets for U.S. defense companies. The
existing corporate hedging literature suggested a range of factors that might influence
corporate hedging decisions in risk management (Artez & Bartram, 2010; Stulz 2003).
Due to the scope of the study and data availability, only seven organizational risk
attributes related to corporate hedging were selected for the study. Furthermore, the
generalization of the findings was limited by the size and nature of the sample. The
findings of the study only generalized to the population of 194 U.S. defense companies

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from which the sample was obtained. The generalization of the study to other industries
or foreign defense companies was not warranted.
Another important limitation of the study was related to the study design. A
quantitative correlational method was employed in this study. The correlational design of
the study permitted an analysis of the direction of relationships, but could not be utilized
to address issues of cause and effect (Allen, 2004; Zikmund, 2003). Therefore, any
significant relationship found between the risk attributes of U.S. defense companies and
corporate hedging in foreign exchange and currency risk management markets in the
study cannot be characterized as a causal relationship.
Despite the limitations, the researcher strictly adhered to NCU's IRB guidelines.
Approval to conduct data collection for the present study was obtained from the IRB
prior to the data collection. See Appendix F for the approval letter.
In this chapter, the implications of the study are provided, including conclusions
for each finding in relation to previous empirical studies. Practical recommendations for
future research regarding the organizational determinants of corporate hedging in the
U.S. defense industry are presented. The current chapter ends with conclusions of the
findings.
Implications
One of the most important issues of corporate hedging decisions in risk
management has been to develop robust, internally consistent, and quantifiable
determinants of corporate hedging (Artez & Baxtram, 2010; Petersen & Thiagarajan,
2000; Stulz, 2003). At the simplest level, corporate hedging is designed to reduce or
even eliminate risk exposures such as the fluctuation of foreign exchange rates (Chance

157

& Brooks, 2007; Stulz, 2003). To understand what rationale companies typically use to
engage in corporate hedging and what the effects of corporate hedging can be, the
imperative consideration of research has been to develop sound corporate hedging
theories (Artez & Bartram, 2010; Stulz, 2003).
The two leading theoretical explanations of corporate hedging, shareholder value
maximization and managerial utility maximization, have been subjected to rigorous
empirical challenges for more than 10 years (Artez & Bartram, 2010). Although the
empirical evidence is inconclusive, the theoretical explanations of corporate hedging
remain significant because, in the theories, corporate hedging is expressed as a function
of one or more organizational risk attributes that systematically influence all corporate
hedging decisions in risk management (Artez & Bartram, 2010; Stulz, 2003). In
particular, the risk attributes are financial distress (Smith & Stulz, 1985),
underinvestment problems (Froot et al., 1993), tax benefits (Graham & Smith, 1999;
Smith & Stulz, 1985), and managerial incentives (Jensen & Meckling, 1976; Morellec &
Smith, 2007; Shapiro, 2005).
Since corporate hedging theories do not completely explain the determination of
which companies use derivative instruments for hedging (Artez & Bartram, 2010),
researchers have investigated additional factors associated with corporate hedging in risk
management. These additional factors include scale economies (Allayannis & Ofek,
2001; Nance et al., 1993), firm value (Carter et al., 2006; Jin & Jorion, 2006), level of
foreign involvement (Howton & Perfect, 1998; Menon & Viswanathan, 2005), foreign
debt (Judge, 2009; Nguyen & Faff, 2006), asymmetric information (Breeden &
Viswanathan, 1996; DeMarzo & Duffie, 1991), board characteristics (Borokhovich et al.,

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2004; Prevost, 2005), industry-specific characteristics (Rogers, 2002; Schiozer & Saito,
2009), country-specific characteristics (Lei, 2006; Marsden & Prevost, 2005), and
accounting reporting methods (Sapra, 2002; Supanvanij & Strauss, 2010). Despite the
intense debates about various risk factors associated with corporate hedging at the
organizational level, the findings of the literature are controversial. The actual
organizational determinants for corporate hedging decisions remain unsettled (Artez &
Bartram, 2010; Nguyen & Faff, 2010; Stulz, 2003).
This researcher's intent was to renew the challenge of explaining the determinants
of corporate hedging from the U.S. defense companies' perspective. Specifically, the
purpose of the study was to assess the relationships between the risk attributes of U.S.
defense companies and corporate hedging in foreign exchange and currency risk
management markets. The organizational risk attributes of U.S. defense companies
considered in the study were drawn from literature pertaining to corporate hedging
theories and prior empirical studies. The findings of the study have the potential to be
used to inform and guide company managers in U.S. defense industry in identifying
organizational risk factors that may be related to corporate hedging in risk management.
As a result, efficiency in corporate hedging practices at the organizational level might be
improved (Artez & Bartram, 2010; Stulz, 2003).
The need to assess the relationships between the risk attributes of U.S. defense
companies and corporate hedging in foreign exchange and currency risk management
markets led to seven research questions and related hypotheses. For the study, evidence
showed four organizational risk attributes are associated with corporate hedging in the
U.S. defense industry: (a) tax benefits, (b) underinvestment problems, (c) scale

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economies, and (d) revenues derived from U.S. government contracts. No statistically
significant relationship was found in answering research question 1 (financial distress),
research question 4 (managerial incentives), and research question 6 (level of foreign
involvement). The findings and implications related to each research question and
associated hypotheses are described below. Limitations affecting the implications are
discussed when appropriate.
Financial distress. The purpose of research question 1 was to examine the
relationship between financial distress and corporate hedging for U.S. defense
companies. Bivariate linear regression was used to test the hypotheses associated with
this question. The analysis using a /-test demonstrated financial distress did not relate to
corporate hedging in foreign exchange and currency risk management markets in the U.S.
defense industry, /(53) = 1.18, p> .05. The evidence of the study indicated that financial
distress is not an important organizational risk factor in relation to corporate hedging in
the U.S. defense industry.
Financial distress can impose significant costs on a company (Andrede & Kaplan,
1998; Korteweg, 2006; Warner, 1977; Weiss, 1990). Companies that face greater risk of
financial distress may benefit from corporate hedging (Artez & Bartram, 2010). The
study results contrasted with the conclusions made by researchers in previous empirical
studies. The previous empirical studies suggested financial distress is significantly and
positively related to corporate hedging (Bartram et al., 2009; Berkman, 2002; Berrospide
et al., 2007; Dolde & Mishra, 2007; Graham & Rogers, 2002; Haushalter, 2000; Lei,
2006; Nguyen & Faff, 2003; Reynolds et al., 2009; Schiozer & Saito, 2009; Spano,
2008). The study results could be applied in support of claims by Davies et al. (2006)

160

and Sprcic (2007) that financial leverage with debts is not an explanatory factor for
corporate hedging. The contradiction might be explained by the differences in
instruments that measured financial distress. The implication of the finding demonstrated
the difficulty of selecting the proper instruments to measure the financial distress.
Further research is needed to understand these instruments in relation to corporate
hedging for the U.S. defense industry.
Tax benefits. The purpose of research question 2 was to examine the relationship
between tax benefits and corporate hedging for U.S. defense companies. Bivariate linear
regression was used to test the hypotheses associated with this question. The analysis
using a /-test demonstrated tax benefits were significantly and positively related to
corporate hedging in foreign exchange and currency risk management markets in the U.S.
defense industry, t(53) = 6.64, p < .05. The evidence of the study indicated tax benefits
are an important organizational risk factor in relation to corporate hedging in the U.S.
defense industry.
Tax benefits are one of the key elements in shareholder value maximization
theory used to explain corporate hedging (Graham & Smith, 1999; Smith & Stulz, 1985).
Theorists predicted tax benefits could impact corporate hedging decisions (Graham &
Smith, 1999; Smith & Stulz, 1985). The study results showed support of other empirical
studies that showed higher tax benefits were related to increases in corporate hedging
(Berrospide et al., 2007; Graham & Smith, 1999; Lin & Smith, 2007; Smith & Stulz,
1985). The implication of the significantly positive relationship between tax benefits and
corporate hedging in foreign exchange and currency risk management markets is U.S.
defense companies with higher tax incentives will hedge more in foreign exchange and

161

currency risk management. Given the relatively large amount of variance observed in the
study results (see Table 14), the significance of the positive relationship between tax
benefits and corporate hedging in foreign exchange and currency risk management
markets is reinforced.
Underinvestment problems. The purpose of research question 3 was to examine
the relationship between underinvestment problems and corporate hedging for U.S.
defense companies. Bivariate linear regression was used to test the hypotheses
associated with this question. The analysis using a /-test demonstrated underinvestment
problems were positively related to corporate hedging in foreign exchange and currency
risk management markets for U.S. defense companies, /(53) = 2.44, p < .05. The
evidence of the study indicated underinvestment problems are an important
organizational risk factor related to corporate hedging in the U.S. defense industry.
Companies with R&D investment opportunities will hedge to reduce the
variability of the internal funds so the companies have adequate internal funds to finance
the R&D investment opportunities (Froot et al., 1993). The theoretical and empirical
analysis indicated a significantly positive relationship between R&D investment
opportunities and corporate hedging (Carter et al., 2006; Crabb, 2006; Graham & Rogers,
2000; Hsu et al., 2009; Lei, 2006; Mseddi & Abid, 2010; Sprcic, 2007; Schiozer & Saito,
2009). This finding is consistent with the conclusions made in previous empirical studies
showing companies with high investment opportunities hedge more (Carter et al., 2006;
Crabb, 2006; Graham & Rogers, 2000; Hsu et al., 2009; Lei, 2006; Mseddi & Abid,
2010; SprCic, 2007; Schiozer & Saito, 2009). The implication of the positive relationship
between underinvestment problems and corporate hedging in foreign exchange and

162

currency risk management markets is U.S. defense companies with higher R&D
investment opportunities will hedge more in foreign exchange and currency risk
management.
However, the practical significance of the positive relationship between
underinvestment problems and corporate hedging is weak, as underinvestment problems
account for a small amount of corporate hedging for U.S. defense companies (see Table
15). The reasons for the low level of shared variances between underinvestment
problems and corporate hedging cannot be identified from the study results. In addition,
the small coefficient of determination denotes that other independent variables
unaccounted for in the study could have a significant influence on the relationship
between underinvestment problems and corporate hedging for U.S. defense companies
(Allen, 2004; Weiers, 2002). Therefore, the implication of the positive relationship
between underinvestment problems and corporate hedging in foreign exchange and
currency risk management markets must be considered carefully with this limitation.
Further research is needed to explore other independent variables that might account for
the level of shared variance between underinvestment problems and corporate hedging in
the U.S. defense industry.
Managerial incentives. The purpose of research question 4 was to examine the
relationship between managerial incentives and corporate hedging for U.S. defense
companies. Bivariate linear regression was used to test the hypotheses associated with
this question. The analysis using a t-test demonstrated managerial incentives were not
related to corporate hedging in foreign exchange and currency risk management markets
for U.S. defense companies, t(53) = -1.92, p > .05. The evidence of the study indicated

163

that managerial incentives are not an important organizational risk factor in relation to
corporate hedging in the U.S. defense industry.
Company managers may seek to maximize their own self-interest and have
incentives to hedge their private wealth at the expense of the shareholders (Jensen &
Meckling, 1976; Shapiro, 2005; Stulz, 2003). To prevent company managers from
advancing their own private wealth at the expense of the shareholders, managerial
compensation policy must ensure company managers to act in the best interest of
shareholders by maximizing the value of the company (Jensen & Meckling, 1976; Smith
& Stulz, 1985; Tufano, 1996). Company managers and shareholder interests must be
aligned regarding value maximization with an appropriately structured managerial
compensation package including stock and option holdings (Coles et al., 2004; Jensen &
Meckling, 1976; Perry & Zenner, 2000; Smith & Stulz, 1985; Tufano, 1996). The study
results contrasted with the conclusions made by researchers in previous empirical studies.
The study results could not be utilized to support the managerial incentives hypothesis
developed by Gonzalez et al. (2010), Marsden and Prevost (2005), Purnanandam (2007),
Sprcic (2007), and Supanvanij and Strauss (2010), thereby indicating increases in
executive's stock shares are significantly related to corporate hedging. The contradiction
might be explained by the differences in instruments that measure managerial incentives
such as executive option shares in the U.S. defense industry. The implication of the
finding showed the difficulty of selecting the proper instruments to measure the
managerial incentives. Further research is needed to understand the differences of these
instruments in relation to corporate hedging.

164

Scale economies. The purpose of research question 5 was to examine the


relationship between scale economies and corporate hedging for U.S. defense companies.
Bivariate linear regression was used to test the hypotheses associated with this question.
The analysis using a t-test demonstrated scale economies were significantly and
positively related to corporate hedging in foreign exchange and currency risk
management markets in the U.S. defense industry, t(53) = 4.54, p < .05. The evidence of
the study indicated scale economies are an important organizational risk factor in relation
to corporate hedging in the U.S. defense industry.
Theorists suggested scale economies and corporate hedging in risk management
are related (Allayannis & Ofek, 2001; Nance et al., 1993; Smith & Stulz, 1985). Large
companies are more likely to hedge than small companies because the large companies
may have better access to external financing in capital markets (Allayannis & Ofek,
2001). The study results aligned with prior empirical evidence indicating larger
companies are more likely to hedge (Berrospide et al., 2007; Carter et al., 2006; Davies et
al., 2006; Guay & Kothari, 2003; Hagelin et al., 2007; Haushalter, 2000; Hsu et al., 2009;
Jong et al., 2006; Judge, 2006; Klimczak, 2008; Lei, 2006; Mseddi & Abid, 2010;
Nguyen et al., 2007; Spano, 2008). The implication of the significantly positive
relationship between scale economies and corporate hedging in foreign exchange and
currency risk management markets is larger U.S. defense companies will hedge more in
foreign exchange and currency risk management. Given the relatively large amount of
variance identified in the study results (see Table 17), the significance of the positive
relationship between scale economies and corporate hedging in foreign exchange and
currency risk management markets is reinforced.

165

Level of foreign involvement. The purpose of research question 6 was to


examine the relationship between level of foreign involvement and corporate hedging for
U.S. defense companies. Bivariate linear regression was used to test the hypotheses
associated with this question. The analysis using a /-test demonstrated level of foreign
involvement was not related to corporate hedging in foreign exchange and currency risk
management markets for U.S. defense companies in the U.S. defense industry, /(53) =
1.45, p > .05. The evidence of the study indicated level of foreign involvement is not an
important organizational risk factor in relation to corporate hedging in the U.S. defense
industry.
Corporate hedging reduces exposure to foreign exchange and currency risk
(Allayannis & Ofek, 2001; Jorion, 1990). Foreign sales are significantly and positively
correlated with corporate hedging decisions (Allayannis & Ofek, 2001). However, the
study results contradicted with Jorion's (1990) expectations, which indicated companies
with a greater level of foreign involvement have greater benefits from corporate hedging
at the corporate level. The study results can be used in support of the conclusion of
Howton and Perfect (1998), who indicated the relationship between the level of foreign
involvement and corporate hedging was not demonstrated in a random sample of 461
U.S. nonfinancial companies. The contradiction might be explained by the differences in
instruments that measure foreign involvement. The implication of the finding showed the
difficulty of selecting the proper instruments to measure the level of foreign involvement.
Further research is needed to understand these instruments in relation to corporate
hedging activities for the U.S. defense industry.

166

Revenues derived from U.S. government contracts. The purpose of research


question 7 was to examine the relationship between revenues from U.S. government
contracts and corporate hedging for U.S. defense companies. Bivariate linear regression
was used to test the hypotheses associated with this question. The analysis using a /-test
demonstrated revenues derived from U.S. government contracts were negatively related
to corporate hedging in foreign exchange and currency risk management markets in the
U.S. defense industry, /(53) = -2.39, p < .05. The evidence of the study indicated
revenues derived from U.S. government contracts are an important organizational risk
factor in relation to corporate hedging in the U.S. defense industry.
Industry-specific characteristics may influence corporate hedging decisions at the
organizational level (Jorion, 1991). One of the U.S. defense industry-specific
characteristics is to conduct business with the U.S. Government using contract bidding
(Watts, 2008). The study results showed support for the conclusions of other empirical
studies indicating if regulated companies are subjected to increased scrutiny and lower
contracting costs, company managers are less likely to use derivative instruments to
hedge (Rogers, 2002; Schiozer & Saito, 2009). The implication of the negative
relationship between revenues derived from U.S. government contracts and corporate
hedging in foreign exchange and currency risk management markets is as U.S. defense
companies increase their business activities with the U.S. government, U.S. defense
companies will hedge less in foreign exchange and currency risk management markets.
However, the practical significance of the negative relationship between revenues
derived from U.S. government contracts and corporate hedging is weak, as revenues
derived from U.S. government contracts account for a small amount of corporate hedging

167

for U.S. defense companies (see Table 19). The reasons for the low level of shared
variances between revenues derived from U.S. government contracts and corporate
hedging cannot be identified from the study results. In addition, the small coefficient of
determination denotes that other independent variables unaccounted for in the study
could have a significant influence on the relationship between revenues derived from
U.S. government contracts and corporate hedging for U.S. defense companies (Allen,
2004; Weiers, 2002). Therefore, the implication of the negative relationship between
revenues derived from U.S. government contracts and corporate hedging in foreign
exchange and currency risk management markets must be considered carefully within
this limitation. Further research is needed to explore other independent variables that
might account for the level of shared variance between revenues derived from U.S.
government contracts and corporate hedging in the U.S. defense industry.
Recommendations
To establish an analytical framework for guiding the empirical research on
corporate hedging is a difficult task (Artez & Bartram, 2010; Nguyen & Faff, 2010). The
analytical framework developed by this study can be used to provide researchers and
company managers in the U.S defense industry with the ability to investigate the
relationships between U.S. defense company's risk attributes and corporate hedging in
foreign exchange and currency risk management markets. The findings of the study led
to several recommendations for future studies in corporate hedging at the organizational
level. The recommendations resulting from the study findings could be applied to
potentially contribute to the body of knowledge on corporate hedging in foreign exchange

168

and currency risk management markets. These recommendations are based upon the
study results.
Since significant correlations between tax benefits, underinvestment problems,
scale economies, revenues derived from U.S. government contracts, and corporate
hedging in foreign exchange and currency risk management markets were identified,
future research should continue to examine the relationship between these organizational
risk attributes and corporate hedging in foreign exchange and currency risk management
markets. The validation of measurements of constructs plays a critical role in a broader
effort to understand corporate hedging determinants at the organizational level (Nguyen
& Faff, 2010; Stulz, 2003). A potential area for future research is to identify and use
other relevant instruments to replicate the study and assist in obtaining additional
information about the relationship between the risk attributes of U.S. defense companies
and corporate hedging. The more company managers know about the relationship
between the organizational risk factors and corporate hedging, the better they can
improve the effectiveness of decision-making in corporate hedging practices.
From the study, the establishment of a significant correlation between the risk
attributes of U.S. defense companies and corporate hedging was important, but should be
considered preliminary. In the study, only seven organizational determinants of
corporate hedging were selected. However, various risk factors might relate to corporate
hedging decisions in the U.S. defense industry (Artez & Bartram, 2010; Berrospide et al.,
2007; Dolde & Mishra, 2007). To evaluate efficacy more fully, additional research is
needed to expand the study and include a more comprehensive set of organizational risk
factors other than those tested in the study. However, time and resource constraints do

169

not permit such studies to be conducted at this time. Nevertheless, the additional research
would broaden the perspective of what attributes the U.S. defense companies have used
to engage in corporate hedging and which attributes have practical benefits for company
managers in the U.S. defense industry.
Since the researcher did not address the causal relationship between the risk
attributes of U.S. defense companies and corporate hedging in foreign exchange and
currency risk management markets, the final recommendation for future studies is to
investigate the influence of key risk attributes of U.S. defense companies on corporate
hedging decisions. The researcher also did not make any assumptions about the
correlations being causal. By ascertaining the impact of the organizational determinants
on corporate hedging, additional conclusions could be made to strengthen the
understanding of corporate hedging practices in risk management for the U.S. defense
industry (Allayannis & Ofek, 2001; Carter et al., 2006; Judge, 2006). The type of
relationship identified in the study could be the foundation for other studies of U.S.
defense companies' corporate hedging in risk management.
Conclusions
Corporate hedging has led to significant advances in corporate risk management
and become an integral part of furthering risk management objectives in the U.S. defense
industry. With the level and amount of corporate hedging increasing, however, U.S.
defense companies are exposed to financial risks resulting in a potential loss of millions
of dollars of profits. To improve the effectiveness of decision-making for corporate
hedging in foreign exchange and currency risk management markets in the U.S. defense
industry, the forefront of advancements in identifying and measuring the organizational

170

determinants of corporate hedging is demanded (Artez & Bartram, 2010; Petersen &
Thiagarajan, 2000; Stulz, 2003). The researcher specifically addressed the assessment of
relationships between the risk attributes of U.S. defense companies and corporate
hedging in foreign exchange and currency risk management markets.
In the study, seven organizational risk factors were used to measure financial and
managerial characteristics for U.S. defense companies. First, evidence in the study
indicated a significantly positive relationship exists between tax benefits and corporate
hedging in foreign exchange and currency risk management markets in the U.S. defense
industry, a positive relationship exists between underinvestment problems and corporate
hedging in foreign exchange and currency risk management markets in the U.S. defense
industry, a significantly positive relationship exists between scale economies and
corporate hedging in foreign exchange and currency risk management markets in the U.S.
defense industry, and a negative relationship exists between revenues derived from U.S.
government contracts and corporate hedging in foreign exchange and currency risk
management markets in the U.S. defense industry.
Findings of this study demonstrate the importance of organizational risk attributes
in corporate hedging practices in the U.S. defense industry. Tax benefits,
underinvestment problems, scale economies, and revenues derived from U.S. government
contracts are considered important organizational risk attributes in relation to corporate
hedging practices in the U.S. defense industry. The implication of the significantly
positive relationship between tax benefits and corporate hedging in foreign exchange and
currency risk management markets is high tax benefits are associated with more
corporate hedging. Similarly, the implication of the positive relationship between

171

underinvestment problems and corporate hedging in foreign exchange and currency risk
management markets is corporate hedging may be increased as far as underinvestment
problems are increased. The implication of the significantly positive relationship
between scale economies and corporate hedging in foreign exchange and currency risk
management markets is large scale economies are associated with more corporate
hedging. Finally, the implication of the negative relationship between revenues derived
from U.S. government contracts and corporate hedging in foreign exchange and currency
risk management markets is as revenues derived from U.S. government contracts are
high, less corporate hedging is discovered.
The study results indicated tax benefits and scale economies contributed
significantly to corporate hedging in the U.S. defense industry. However, due to the
relatively small amount of shared variances noted in the study results, the relationships
between underinvestment problems, revenues derived from U.S. government contracts,
and corporate hedging in the U.S. defense industry were weak. Therefore, the
implications of the relationships between underinvestment problems, revenues derived
from U.S. government contracts, and corporate hedging should be interpreted with some
reservation. Additional research is needed to identify other independent variables that
might be applied to explain the level of shared variances between underinvestment
problems, revenues derived from U.S. government contracts, and corporate hedging in
the U.S. defense industry.
Next, evidence in the study showed financial distress is not related to corporate
hedging in foreign exchange and currency risk management markets in the U.S. defense
industry, managerial incentives are not related to corporate hedging in foreign exchange

172

and currency risk management markets in the U.S. defense industry, and level of foreign
involvement is not related to corporate hedging in foreign exchange and currency risk
management markets in the U.S. defense industry. Therefore, financial distress,
managerial incentives, and level of foreign involvement are not considered important
organizational risk attributes in relation to corporate hedging in the U.S. defense industry.
The implications showed a complete understanding of the differences in instruments to
measure financial distress, managerial incentives, and the level of foreign involvement is
required. Further research is needed to explore these instruments in relation to corporate
hedging activities in the U.S. defense industry.
The empirical evidence obtained in the study will potentially make a substantial
contribution to the body of knowledge regarding the organizational determinants of
corporate hedging in foreign exchange and currency risk management markets. As
important organizational risk attributes, the relationships between financial distress,
underinvestment problems, tax benefits, managerial incentives, scale economies, level of
foreign involvement, and revenues from U.S. government contracts, and corporate
hedging provide ways to understand the organizational determinants of corporate hedging
activities in risk management for U. S defense companies (Artez & Bartram, 2010; Stulz,
2003). These organizational determinants could therefore be used to evaluate the U. S
defense companies' corporate hedging activities. As such, using these organizational
determinants would establish a roadmap for improving the effectiveness of corporate
hedging decisions in the U.S. defense industry (Artez & Bartram, 2010; Stulz, 2003).
Finally, in light of the study results indicating a significant correlation between
tax benefits, underinvestment problems, scale economies, revenues derived from U.S.

173

government contracts, and corporate hedging in foreign exchange and currency risk
management markets, additional empirical research is recommended to enhance the
understanding of corporate hedging practices in the U.S. defense industry. The
recommendations for further studies stem from the findings of the present research,
including to identify and use other relevant instruments to the study to assist in obtaining
additional information about the relationship between corporate hedging and the risk
attributes of U.S. defense companies, assess the relationship between corporate hedging
and the risk attributes of U.S. defense companies other than those tested in the study, and
investigate the influence of key risk attributes of U.S. defense companies on corporate
hedging decisions.

174

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Appendixes

195

Appendix A:

A Random Sampling Procedure


To select a sample of U.S. defense companies from the population, the following
steps were involved. First, the researcher constructed a list of names for 194 U.S.
defense companies into a column in an Excel spreadsheet using Microsoft Excel 2007.
Second, the researcher assigned a random number to each U.S. defense company by
using the RAND() function. That is, enter the RAND() function in the column right next
to the list of names for the 194 U.S. defense companies column, and a series of random
numbers between 0 and 1 would fill in the cells in the random number column. Third,
the researcher sorted both the list of names for 194 U.S. defense companies and the
random number columns by the random numbers generated. Now the list of names for
the 194 U.S. defense companies was arranged in a random order from the lowest to the
highest random number. The first 55 U.S. defense companies in the sorted list would be
taken as the sample of U.S. defense companies for the study.

196

Appendix B:

Determination of Sample Size with a Priori Power Analysis


To determine the necessary sample size of the quantitative correlational study, a
priori power analysis provides an efficient method of controlling statistical power
before the study is actually conducted (Cohen, 1989). Power of a statistical test
refers to the probability of wrongly accepting the null hypothesis when it is actually false
or failure to reject the null hypothesis that is false, which is called Type II error (Allen,
2004; Cohen, 1989; Weiers, 2002; Zikmund, 2003). By convention, power of .80 or
above is usually judged to be adequate (Cohen, 1989). For the study, the desired level of
statistical power was set at .80.
Alpha level (a) determines the probability of obtaining an erroneously significant
result (Allen, 2004; Weiers, 2002; Zikmund, 2003). The alpha level is typically .05 or
.01 (Zikmund, 2003). The accepted Alpha level in previous empirical studies has been
established at the 0.05 level of significance (Bartram et al., 2009; Brown, 2001; Carter et
al., 2006; Gay & Nam, 1998; Graham & Rogers, 2000; Hsu et al., 2009; Judge, 2006;
Nguyen et al., 2007; Reynolds et al., 2009; Spano, 2008). As such, the alpha level was
set as .05 for the study.
Effect size means the degree to which the phenomenon is present in the
population or the degree to which the null hypothesis is false (Cohen, 1989). Cohen
(1989) proposed that a medium effect size off2 = .15 for regression analysis as it would
be able to approximate the average size of observed effects in various fields. Therefore,
the effect size was set at/2 = .15 for the study.
A power analysis using G* Power 3.1 is used to determine the sample size of U.S.

197

defense companies required for the study. To perform a priori estimation, test conditions
must be specified. Within G*Power 3.1 software application, the "Linear multiple
regression: Fixed model, single regression coefficient: procedure was selected because
bivariate linear regression analyses will be performed to test the hypotheses (seven
independent variables and a dependent variable) of this study. After the above input
parameters were specified in G*Power 3.1, the a priori power analysis was performed with
results shown in Figure A1. The relationship between the achieved power and the sample
size for the study is shown in Figure A2. For the study, an effect size of/2 = .15 requires
a minimum of 55 U.S. defense companies to reach a power of .80. Therefore, the
required sample size of 55 U.S. defense companies was determined in the study.

Central and noncentral distributions |Protocol ot ntmtr imlytw|


critical t - 2.00575

0.3

0.2

0.1

0
Statistical test

Test famiiy
*ul

Type of power analysis

Output Parameters

Input Parameters

NoncentraHty parameter 6

2.8722813

Effect size P

0.1 S

Critical t

2.0057460

si err prob

0.05

Df

53

Power (1 -p err prob)


Number of predictors

|SO I

Total sample size

55

Actual power

0.8050826

Figure Bl. Determination of the required sample size with G* Power software

198

t tests - Linear multiple regression: Fixed model, single regression coefficient

Tail(s) = Two, Number of predictors = 1, a err prob = 0.05, Effect size P = 0.15

90

80

a 60

40

0.6

0.65

0.7

0.75
0.8
Power (1 -0 err prob)

0.85

0.9

0.95

Figure B2. The relationship between the achieved power and the sample size. For the
study, an effect size off2 = .15 will require a minimum of 55 U.S. defense companies to
reach a power of .80.

199

Appendix C:

Permission to Use the Diagram of Evaluating Secondary Data

4 CENGAGE
Learning*

NEL80N

DUCATION

Rights Administration and Content Reuse


20 Davis Drive, Belmont, California 94002 USA

Phone: 800-73(5-2214 or 65CM13-7456 Fax: 800-730-2215 or 650-595-4603

Email: permissionrequest@cengage.com

Submit all requests online at vyww.cengage.com/Derniissions.

Request # 267187
12/19/2011
Charlie Shao
Northcentral University
Business
10000 University Drive
Prescott Valley, AZ 86314

Permission is granted by Cengage Learning/Nelson Education, or one of their respective subsidiaries, divisions or
affiliates (collectively, "Cengage/Nelson") for one-time use to photocopy the material indicated here for educational
purposes only during the term specified below.
Title:
Exploring Marketing Research (with Qualtrics Card) 10E
Authors):
ZIKMUND/BABIN
ISBN:
9780324788440 (0324788444)
Publisher:
South-Western
Year:
2010
Specific material: Diagram for Evaluating secondary data on p. 160.
Total pages:
1
For use by Instructor:
Steven Munkeby
Term of use:
Life of Adoption 2011
School/University/Company: Northcentral University

Course title/number: Business Research


Number of users:
1

The permission granted in this letter extends only to material that is original to the aforementioned text.
As the requestor, you will need to check all on-page credit references (as well as any other credit / acknowledgement
section(s) in the front and/or back of the book) to identify all materials reprinted therein by permission of another source.
Please give special consideration to all photos, figures, quotations, and any other material with a credit line attached. You
are responsible for obtaining separate permission from the copyright holder for use of all such material.
This credit line must appear on the first page of text selection and with each individual figure or photo:
From ZIKMUND/BABIN. Exploring Marketing Research (with Qualtrics Card), 10E. 2010 South
western, a part of Cengage Learning, Inc. Reproduced by permission, www.cengage.com/permissions
Permission to use Cengage Learning material has been granted per gratis.
Sincerely,
Donna Phillips
Permissions Associate

200

Appendix D:

Residual Plots for the Independent Variables

Debt Ratio Residual Plot


8000
7000

6000
5000
4000

TZ
f
Qd
^

3000
2000

1000

0
-1000
-2000

0.00

5.00

10.00

15.00

Debt ratio

Figure Dl. Residual plot for financial distress.

20.00

25.00

Income Tax Credit Range Residual Plot


6000

5000
4000
3000
2000

"3

*5 iooo
>r.

Oi
w

-1000
-2000

-3000
-4000
0.00

1,000.00 2,000.00 3,000.00 4,000.00 5,000.00 6,000.00 7,000.00 8,000.00 9,000.00

Income tax credit range

Figure D2. Residual plot for tax benefits.


R&D Spending Residual Plot
8000

6000

4000

tA
"S
K
3
ai

2000

0
2000

-4000
0.00

5.00

1000

15.00

20.00

R&D spending

Figure D3. Residual plot for underinvestment problems.

25.00

30.00

202

Presence of CEO Stock Shares Residual Plot

8000
7000

6000
5000

n 4000

6 3000
'3

ai

2000

1000

-looo j

Si'

-2000
0.00

0.10

>

0.20

0.30

0.40

0.50

0.60

0.70

0.80

Presence of CEO stock shares

Figure D4. Residual plot for managerigal incentives.


Firm Size Residual Plot
7000
6000
5000
4000
3000

g 2000

$ 1000

Oi

0
-1000
-2000

-3000
-4000
0.00

2.00

4.00

6.00

8.00

Finn size

Figure D5. Residual plot for scale economies.

10.00

12.00

14,00

203

Foreign Sales Ratio Residual Plot


8000
7000
6000
5000
a 4000

"3
6
ra

Ui
1>
0C

3000
2000

1000 ;

o*

-1000
-2000

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

100.00

Foreign sales ratio(o)

Figure D6. Residual plot for level of foreign involvement.


Sales to U.S. Government Residual Plot
7000

6000 !
5000 )
4000 j

"I

3000 |

J} 2000 |

1000 j

y * ' *

-1000 i . A.
-2000

0.00

20.00

40.00

60.00

80.00

100.00

Sales to U.S. government

Figure D7. Residual plot for revenues from U.S. government contracts.

120.00

204

Appendix E:

Normal Probability Plots of Residuals for the Dependent Variable

Normal Probability Plot: Debt Ratio


8000

7000
6000

5000
"000

o>
06

3000

tJi

2000
1000

0
-1000

-2000

-2.5

-2

-0.5

-1.5

0.5

1.5

2.5

Z Value

Figure El. Normal probability plot of residuals for corporate hedging in foreign
exchange and currency risk management on finacial distress.
Normal Probability Plot: Income Tax Credit Range
6000

5000
4000
3000

V,

2000

"3
1000

<u
o

0
-1000

-2000

-3000
-4000
-2.5

-1.5

-1

-0.5

Z Value

0.5

1.5

2.5

Figure E2. Normal probability plot of residuals for corporate hedging in foreign
exchange and currency risk management on tax benefits.
Normal Probability Plot: R&D Spending
8000

6000

,
4000

"3
">r. 2000
CrZ

-2000

-4000
-2.5

-2

-1.5

-1

-0.5

0.5

1.5

2.5

Z Value

Figure E3. Normal probability plot of residuals for corporate hedging in foreign
exchange and currency risk management on underinvestment problems.
Normal Probability Plot: Presence of CEO's Stock Shares
8000

7000

eooo
5000
4000
e 3000

s
cac

2000
1000

0
-1000


-2000

-2.5

-2

-1.5

-1

-0.5

0.5

1.5

2.5

Z Value

Figure E4. Normal probability plot of residuals for corporate hedging in foreign

206

exchange and currency risk management on managerigal incentives.


Normal Probability Plot: Firm Size
7000
5000
5000
4000
3000

V5
*3 2000
<u 1000

Oi

0
-1000

-2000

-3000
-4000
-2.5

-1.5

-1

-0.5

0.S

1.5

2.5

Z Value

Figure E5. Normal probability plot of residuals for corporate hedging in foreign
exchange and currency risk management on scale economies.
Normal Probability Plot. Foreign Sales Ratio
8000

7000

6000

5000
* 4000

~3
%
'A
"2
C

3000
2000
1000

0
-1000


-2000

2.5

-2

-1.5

-1

-0.5

0.5

1.5

2.5

Z Value

Figure E6. Normal probability plot of residuals for corporate hedging in foreign
exchange and currency risk management on level of foreign involvement.

207

Normal Probability Plot: Sales to U.S. (jovernment

5000
4000
73 3000

T3

2000
|

1000

2000

-2

-1.5

-1

-0.5

0.5

1.5

2.5

Z Value

Figure E7. Normal probability plot of residuals for corporate hedging in foreign
exchange and currency risk management on revenues from U.S. government contracts.

208

Appendix F:

Approval Letter for the Research Study from the University's IRB

March 19, 2012


Reference: Charlie Shao
IRB: 2012-03-19-061
Dear Dr. Steven Munkeby, Dissertation Chair:
On March 17, 2012, Northcentral University approved Charlie's research
project entitled, Examining the Relationship between U.S. Defense Firms'
Risk Attributes and Corporate Hedging.
IRB approval extends for a period of one year and will expire on March
19, 2013.
Please inform the Northcentral University IRB when the project is
completed.
Should the project require an extension, an application for an extension
must be submitted within three months of the IRB expiration date.
In the interim, if there are any changes in the research protocol
described in the proposal, a written change request describing the
proposed changes must be submitted for approval.
Sincerely,

Dr. Chris Cozby


IRB Committee Chair
Northcentral University