The management of foreign currency risk: derivatives use and the natural hedge of geographic diversification

Abstract

This study investigates how large US multinational companies use foreign exchange derivatives (FXDs) to manage currency risk. The study tests whether a company's use of FXDs is associated with its exposure to changing exchange rates, and whether such risk management practices are affected by the company's degree of geographic diversification indicative of natural hedging. To date, the empirical evidence on the use of derivatives by large companies is limited, and the impact of geographic diversification on FXD use, in particular, has not been investigated. This study addresses such a gap in the literature and provides results that are consistent with expectations. Specifically, the evidence indicates that large companies' FXD use increases with the level of foreign currency exposure as well as with the degree of geographic concentration indicative of using less natural hedging. Evidence consistent with economies of scale in FXD use is also provided.