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| Exchange Rate Risk Hedging and M&As: A Free Cash Flow Perspective |
| ZHU Mengnan, XU Yunjiao
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| School of Economics, Xiamen University |
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Abstract Financial derivatives provide an important means for enterprises to manage their exchange rate risk and are becoming increasingly popular among large enterprises. In recent years, the scale of China's foreign exchange derivatives market has shown a rapid upward trend and consistently maintained a growth rate of more than 20%. In the first half of 2021, the number of companies using foreign exchange derivatives such as forwards and options to manage their exchange rate risk increased by 94% year-on-year. In this context, it is worth exploring the impact of foreign exchange derivatives on the economic behavior of enterprises, as current developments are likely to be of great importance to the future development of China's foreign exchange derivatives market.
Based on information on the use of foreign exchange derivatives provided in the annual reports of A-share listed firms in China from 2001 to 2019, this paper examines the impact of exchange rate risk management behavior on firms' merger and acquisition (M&A) activities. In the process, we explore whether foreign exchange derivatives promote or inhibit the initiation of M&As. We also seek to explain the mechanisms through which exchange derivatives might inhibit M&As.
We find that although listed companies that use foreign exchange derivatives are less likely to initiate M&As than companies that do not use derivatives, the M&A market and the operating performance of companies using derivatives improve. As Chinese listed companies usually pay for M&As in cash using their own funds, the use of foreign exchange derivatives greatly reduces their corporate precautionary cash holdings, and thus reduces their likelihood of initiating M&As. Furthermore, hedging exchange rate risk can reduce company's excessive investment behavior, and thereby improves their investment efficiency. In general, the use of foreign exchange derivatives for exchange rate risk hedging can lead listed companies to pay more attention to the quality of M&As rather than the number of M&As, and thus implement a “less but better” investment strategy.
This paper makes the following contributions to the literature. First, we use text analysis methods to build a unique database on the use of foreign exchange derivatives by companies, and examine how foreign exchange derivatives affect corporate M&As. Second, research on the impact of hedging on companies' investment behavior is mostly based on the cost of corporate debt, and we complement these works by analyzing the impact from a cash holding perspective. Thus, our paper provides a new perspective from which to explain how foreign exchange derivatives affect corporate M&As. Third, as Chinese firms use different payment and financing methods from foreign companies when conducting M&As, the research presented in this paper is adapted to local conditions. Finally, the findings of this paper contrast with the negative impressions that some enterprises have of derivatives and should improve their awareness of exchange rate risk management.
The findings of this paper have a number of policy implications. First, we should accelerate the development of the foreign exchange derivatives market because our findings show that listed companies use foreign exchange derivatives for exchange rate risk hedging rather than speculative purposes. Second, listed companies should optimize their governance mechanisms to avoid conducting inefficient M&As. In particular, our findings show that companies need to prevent large shareholders or management from using excessive cash reserves out of self-interest, which can damage a company's value.
Future studies should collect more accurate data on the use of foreign exchange derivatives by listed companies, such as the intensity of their foreign exchange derivative use. In this paper, we only use the binary dummy variable as the core explanatory variable due to limited data availability. In particular, the data do not reflect the different effects of the use intensity of foreign exchange derivatives on corporate M&As. Second, scholars should use the appropriate instrumental variables for Chinese listed companies to further resolve the endogeneity problems in the empirical model. Finally, M&As are just one way for enterprises to expand, as they can also directly invest in building facilities. Therefore, it is worth exploring how the use of foreign exchange derivatives affects firms' other investment behaviors.
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Received: 21 March 2022
Published: 20 January 2023
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