The Value Effects of Foreign Currency and Interest Rate Hedging: The UK Evidence (Report‪)‬

ABSTRACT In this paper we use UK data to present empirical evidence on the valuation and debt capacity effects of foreign currency (FC) and interest rate (IR) hedging. We build on recent studies that have presented mixed results on the link between hedging, leverage and firm value. Our results provide evidence of a significant relationship between firm value, measured as Tobin's Q, and foreign currency and interest rate hedging. These findings are much stronger than those found in previous studies that have examined US firms. Our empirical evidence suggests that this is due to the fact the US studies include in their non-hedging sample other hedging firms, such as firms using non-derivative methods for hedging, which can bias the results against finding positive leverage and firm value effects. The larger value effects in our results could also be due to institutional differences in the bankruptcy codes between the UK and the US that cause higher expected financial distress costs for UK firms and therefore greater benefits generated by hedging. When we look at debt capacity and the tax shield effects of hedging, we find that investors reward interest rate hedgers with a larger hedging premium than that rewarded for FC hedging. In fact, our results show that the debt capacity benefits of interest rate only hedging are around six times those generated by FC only hedging. Finally, the debt capacity results in relation to IR hedging and the Tobin's Q results show that derivative hedging generates more value than nonderivative hedging.