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Corporate
Corporate derivatives and foreign derivatives
exchange risk management and FX risk
A case study of non-financial firms of Pakistan
409
Talat Afza
Faculty of Business Administration,
COMSATS Institute of Information Technology, Lahore, Pakistan, and
Atia Alam
Department of Management Sciences,
COMSATS Institute of Information Technology, Lahore, Pakistan

Abstract
Purpose – The purpose of this paper is to identify the factors affecting firms’ decision to use foreign
exchange (FX) derivative instruments by using the data of 86 non-financial firms listed on Karachi
Stock Exchange for the period 2004-2007.
Design/methodology/approach – Required data were collected from annual reports of listed
firms of Karachi Stock Exchange. Non-parametric test was used to examine the mean difference
between users and non-users operating characteristics. Logit model was applied to analyze the impact of
firm’s financial distress costs, underinvestment problem, tax convexity, profitability, managerial
ownership and foreign exchange exposure on firms’ decision to use FX derivative instruments for
hedging.
Findings – Results explain that firms having higher foreign sales are more likely to use
FX derivative instruments to reduce exchange rate exposure. Moreover, financially distressed
large-size firms with financial constraints and fewer managerial holdings are more likely to use
FX derivatives.
Research limitations/implications – Incomplete financial instrument disclosure requirements
restricted researchers to using binary variable as a dependent variable instead of notional value or fair
value of derivative usage.
Practical implications – The study shows that in the presence of amateur derivative market,
Pakistani corporations possessing higher agency costs of debt, agency costs of equity, and financial
constraints will benefit more by defining hedging policies coherent with the firm’s investment and
financing policies in order to enhance firm value.
Originality/value – Until now, no earlier empirical study focused on the determinants of a firm’s
hedging policies in Pakistan, in the presence of volatile exchange rates,. The current study, therefore,
attempts to identify the factors which affect the firm’s decision to use derivative instruments for
hedging FX exposure of non-financial firms in Pakistan.
Keywords Pakistan, Foreign exchange, Risk management, Foreign exchange derivatives, Hedging,
Foreign exchange exposure, Non-financial firms
Paper type Research paper

1. Introduction
Growing globalization has encouraged many corporations to extend their businesses The Journal of Risk Finance
Vol. 12 No. 5, 2011
beyond the geographical boundaries in order to benefit from competitive advantage and pp. 409-420
economies of scale. Penetration into new markets has increased the firm’s profitability, q Emerald Group Publishing Limited
1526-5943
on one hand, and on the other it has also increased the variability in net income DOI 10.1108/15265941111176145
JRF because of various financial risks. Therefore, the managers of the multinational
12,5 firms are focusing on the importance of risk management techniques to reduce
variability of their cash flows from foreign operations due to the fluctuations in foreign
exchange (FX) rates.
It is generally believed that the higher exchange rate movements and the
unpredictability of foreign sales affect the firms’ level of profitability. Therefore,
410 managers dealing in international operations are of the view that different trade
agreements and removal of restrictions on capital flows have increased firms’ exchange
rate exposure. Additionally, majority of the countries are following floating exchange
rate or variations of floating exchange rate system, due to which estimated cash flows
from their international operations are exposed to higher exchange rate risk and thus
highlights the importance of employing different risk management techniques for
hedging firms’ uncovered positions.
Asian crises in 1998 had increased the FX exposure of the countries having large
number of multinational firms, in general, and Asian countries in particular.
Depreciating currency and unstable economic and political environment in Asian
countries have increased the countries’ risk level, although lower cost of the factors of
production and untapped markets have provided many new opportunities for
multinational companies. During the past five years, Pakistani stock markets have
shown higher stock price volatility and can be characterized as among the top unstable
markets. Like many other emerging economies, in order to hedge the firm’s future cash
flows, Pakistan has developed an exchange traded derivative market for future
contracts in 2006 but due to lower trading and liquidity, corporations are reluctant to
invest in derivative instruments. (SECP, 2006).
A significant increase in export and import volume of 36 and 61 percent, respectively,
has been reported by the State Bank of Pakistan, during the last five years (SBP, 2009).
This increase in foreign trade volume has shown an increasing exposure faced by
corporations due to exchange rate fluctuations. Corporations also realize that it is
difficult to manage exchange rate risk at the early stages of economic development.
Thus, a growing need for employment of different risk management techniques exists in
Pakistani firms to reduce the FX exposure. Till now, no exchange traded derivative
market exists in Pakistan, therefore, corporations are using over the counter market
derivative instruments to hedge their risk exposure. In this context, derivatives, defined
as off-balance sheet financial instruments whose values are hypothetically derived from
other financial assets, are widely used by the firms to hedge their FX risk.
Existing empirical evidence has focused on examining the factors, both internal and
external, which affect the firms’ decision to hedge FX exposure (Mian, 1996; Jalivand,
1999; Haushalter, 2000; Guay and Kothari, 2003; Foo and Yu, 2005; Schiozer and Saito,
2009). However, this issue is not well explored yet in developing and third world
countries, especially, in Pakistan. Therefore, the current study focuses on the Pakistani
market to extend the existing literature by identifying the factors affecting FX
derivative usage of firms to reduce exchange rate exposure by using sample data of
86 listed non-financial firms, for the period of 2004-2007.
The remaining paper is organized as follows: next section discusses empirical
literature, whereas the data and methodology are presented in the third section.
Empirical findings are discussed in fourth section while the last section concludes the
discussion.
2. Literature review Corporate
It is generally believed that shareholders are able to reduce risk by constructing a well derivatives
diversified portfolio. However, existing literature on risk management shows that
corporations are using derivative instruments to minimize firms risk exposure. and FX risk
According to Modigliani and Miller (1958) under perfect capital market conditions, it is
useless for a firm to reduce risk by using derivatives. Whereas, theoretical evidence
provided by Stulz (1984) and Smith and Stulz (1985) had shown that, under certain 411
market frictions, corporations having specific operating characteristics like, higher
financial distress costs, tax convexity, growth opportunities, managerial holdings and
liquidity constraints, have an opportunity to enhance firm value by optimally utilizing
hedging techniques.
By considering investment and financing decisions in accordance with firms’
hedging policies, Froot et al. (1993) had proved mathematically that derivatives will be
beneficial for firms in two different situations: first, when external financing cost
exceeds opportunity cost of internal financing and second, when correlation between
investment expenditures and firms’ cash flows were negative. These results were
further tested by Gay and Nam (2002) on 486 non-financial firms of USA over the period
of 1993-1995 and empirical findings were consistent with Froot et al. (1993).
A different justification for corporate risk management had been provided by
Bessembinder (1991) that hedging provides an incentive for the firm to decrease
financial distress costs by reducing the opportunistic behavior of equity holders.
Purnanandam (2008) had empirically tested the relationship between financial
distressed firms and corporate risk management activities on 2000 non-financial US
firms and found that firms’ decision to use derivatives was positively influenced by
leverage whereas highly leveraged firms had lower tendency towards derivative usage.
In order to test the relationship between firms’ endogenous policies, Lin et al. (2008) had
simultaneously examined the relationship between firms endogenous polices-leverage,
growth opportunities and hedging policies, along with other control variables, with a
sample data of 495 S&P firms. They observed that highly leveraged firms were more
likely to use derivatives and highly growth oriented firms, with low debt ratio, were also
more inclined towards the derivative usage.
Graham and Rogers (2002) by taking sample data of 442 US non-financial firms had
calculated two tax-based incentives for hedging by using derivative instruments
and found that debt tax benefit from hedging is four times more than advantage acquired
from tax convexity. In addition, study had analyzed the simultaneous effect of debt and
leverage on each other and reported a significantly positive effect on each other.
Similarly, with another sample data, Borokhovich et al. (2004) also documented a positive
and significant effect of debt and derivative usage on each other. Borokhovich et al.
(2004) had attempted to test the relationship between board composition and derivative
usage on 284 US non-financial firms. By considering other control variables, they
suggested that firms having larger outsiders’ holdings were more likely to use
derivatives. Coefficient of size and financial constraints were consistent with the theory
whereas results depicted no relationship with underinvestment problem.
Researchers had also explored the determinants of firms’ derivative usage. By using
different sample size of US non-financial firms, Mian (1996), Horng and Wei (1999) and
Haushalter (2000) had found positive effect of leverage on firms’ derivative usage for
hedging purpose whereas many studies exhibited negative relationship of debt
JRF (Nance et al., 1993; Fok et al., 1997; Geczy et al., 1997). Nance et al. (1993) and Haushalter
12,5 (2000) depicted positive coefficient for size, growth opportunities and tax convexity.
Whereas, Mian (1996) and Horng and Wei (1999) observed mixed evidence for size and
growth variables and tax convexity. Mixed results for hedging substitutes and
managerial ownership were reported by the empirically studies of Nance et al. (1993),
Fok et al. (1997), Horng and Wei (1999) and Haushalter (2000).
412 Based on the same sample data of Australian non-financial firms, Nguyen and Faff
(2002, 2003) found that derivative usage was an increasing function of leverage and size,
while managerial ownership is negatively related to firms’ decision to use derivatives.
Mixed evidence was reported for growth options and hedging substitutes. By analyzing
77 non-financial Canadian firms, Jalilvand (1999) depicted a positive relationship
between financial distress hypothesis, dividend payout, convertible debt and firm’s
decision to use derivative.
Existing empirical evidence is mainly based on developed countries whereas a few
empirical investigations had been undertaken in Asian countries to identify the factors
effecting the firms hedging polices like Muller and Verschoor (2007) and Faziullah et al.
(2008). Former examined the relationship of firms’ operating characteristics with the FX
exposure on 3,436 Asian firms and estimated a positive influence of size and dividend
payout on FX risk while leverage and liquidity showed a negative impact. Whereas,
the later one empirically tested 101 Malaysian firms using derivatives and found a
positive relationship between debt, tax convexity, size and firms’ decision to use
derivative techniques, whereas market to book value and dividend yield depicted a
negative impact on derivative usage.
In case of Pakistan, although researchers have tried to determine factors affecting
exchange rate of Pakistani rupee, yet no study had explored the factors, both endogenous
and exogenous, affecting the firms’ decision to use FX derivative instruments for
hedging firms’ FX rate risk in Pakistan. Current paper aims to fill this gap by
investigating the factors influencing firm’s decision to use FX derivatives by using the
data of 86 listed non-financial firms of Pakistan for the period 2004-2007. Moreover, it is
also expected that present study may help in providing additional guidelines to decision
makers in managing the firm’s FX risk exposure by simultaneously planning firm’s
investment and financing policies with firm’s hedging policies.

3. Data and methodology

Following Nguyen and Faff (2002), the study aims to identify the impact of financial
distress costs, underinvestment costs, tax convexity, managerial incentives and other
control variables on firm’s decision to use FX derivative to reduce FX rate risk. It is
assumed that firms use derivatives to hedge FX exposure, hence, in order to test
whether firms use FX derivatives to hedge risk exposure or not, logit model is used
with a value “one” for users and “zero” for non-users.
In order to test empirically the factors affecting the firm’s decision to use FX
derivatives instruments, a sample data of 86 non-financial firms are taken for the period
of 2004-2007. Data are collected from annual reports of non-financial firms listed on
Karachi Stock Exchange and prices data are gathered from official web site of Karachi
Stock Exchange. According to International Accounting Standards 32 and 39, it is
mandatory for firms to disclose their usage of hedging instruments and their respective
fair value in the notes of annual reports in a uniform manner. Almost 60 percent
of the sample firms declared their usage of foreign currency derivatives. Financial sector Corporate
has been excluded from the sample data since their business activities require
derivatives to be used for trading purpose or speculative motive.
derivatives
For detailed comparison between operating characteristics of firms that consider and FX risk
hedging as a value enhancing activities to those firms whose operating distinctiveness
does not consider derivative usage as a feasible activity, sample data has been divided
into two sub-groups. One group is classified as users and other as non-users. 413
Non-parametric univariate test is used to test the mean difference between the operating
characteristics of users and non-users. In order to identify the determinants of firm’s
hedging policies, logit model is used. Model 1 depicts that derivative usage is a function
of financial distress costs, tax convexity, asset growth cash flow, profitability,
managerial ownership and foreign sales:
DERIVit ¼ a þ b1 FDCit þ b2 INCit þ b3 SIZEit þ b4 AGCFit þ b5 ROAit
þ b6 MNGRLit þ b7 TAXit þ b8 LFSit þ eit ð1Þ
where:
DERIV ¼ dummy one if firm is a FX derivative user and zero otherwise.
FDC ¼ ratio of tangible assets over total assets, representing financial
distress costs.
INCOV ¼ ratio of earning before interest and taxes by interest expense,
representing interest coverage ratio.
SIZE ¼ log of total assets, representing size.
AGCF ¼ ratio of addition of change in tangible assets plus depreciation to net
income plus depreciation, representing firm’s ability to convert
growth options into assets in place.
ROA ¼ ratio of earning after interest and taxes by total assets, representing
profitability.
MNGRL ¼ log of managerial holdings, representing managers ownership in
firm.
TAX ¼ binary value 1 for unused tax losses and 0 otherwise, representing
tax convexity.
LFS ¼ log of foreign sales, representing FX exposure.
Whereas, model 2 observed the interaction between firm’s FX derivative usage and
its investment and financing policies following Mian (1996), Lin et al. (2008) and
Bartam et al. (2009):
DERIVit ¼ a þ b1 LEVit þ b2 MTBit þ b3 DPit þ b4 QRit þ eit ð2Þ
where:
LEV ¼ ratio of total debt to total assets, representing leverage.
MTB ¼ ratio of market value of firm to book value of firm, representing growth
options.
JRF DP ¼ ratio of dividend per share to earning per share, representing dividend
12,5 payout ratio.
QR ¼ ratio of subtraction of current assets minus inventory to current
liabilities, representing liquidity.

414 4. Findings and analysis

(i) Univariate analysis:
Table I shows descriptive statistics of users and non-users of FX derivatives; standard
deviation is in parenthesis. Univarite analysis explains that users have significantly
higher financial distress costs with mean value of 0.4780 as compared to non-users.
Leverage, calculated by taking ratio of total debt over total assets, is lower for the users
though mean difference is not statistically significant. Users, on average have
0.5804 leverage ratio, whereas non-users demonstrate mean value of 0.6244. Inconsistent
with the theory of financial distress costs, derivative users are characterized as low
debited firms, though they are able to pay their finance costs but still the additional
debt will lead a firm to higher financial distress costs and it may be costly for a firm to
adopt risk management techniques in such situations. Another measure of firms’
financial distress cost is its interest coverage ratio, ability of a firm to pay its finance
costs, parallel with the theory, users are less competent to pay its interest costs due to
financial constraints and hence employ derivatives as hedging instruments. Aligned
with the Pakistan’s derivative market situation and economies of scale hypothesis, users
are identified as large size firms with a value of 6.3332 in comparison with non-users that
document an average size of 6.2800. Mann-Whitney U test shows that users and
non-users are statistically different from each other in terms of size.
Firm’s growth opportunities are observed by taking ratio of market value of firm to
book value of firm. Contradictory to theory, users show on average less growth
opportunities, having a mean value of 1.1540, which is lower than average value of
non-users; 1.2864. According to pecking order theory, if firms encounter positive
NPV projects then they are more likely to finance their tasks through internally

Mean
Variables Non-user (140) User (204) Mann-Whitney U test

FDC 0.5921 (0.4317) 0.4780 (0.2137) 2 3.335 (0.001) * *

LEV 0.6244 (0.5139) 0.5804 (0.2125) 2 0.870 (0.384)
INC 4.7916 (3.7856) 4.0418 (3.2221) 2 0.853 (0.394)
SIZE 6.2800 (0.6690) 6.3332 (0.9391) 2 2.340 (0.019) * *
MTB 1.2846 (0.7931) 1.154 (0.5812) 2 1.979 (0.048) * *
AGCF 0.4490 (0.7169) 0.9654 (1.3995) 2 3.660 (0.000) * * *
ROA 6.9357 £ 102 02 (0.1213) 5.1372 £ 102 02 (7.11 £ 10-02) 2 0.222 (0.824)
DP 0.5487 (2.4462) 0.1925 (1.2714) 2 0.709 (0.478)
QR 4.1415 (3.3618) 2.6851 (2.3274) 2 5.577 (0.000) * * *
MNGRL 0.5256 (0.2991) 0.7101 (0.2174) 2 1.381 (0.167)
TAX 0.4500 (0.4992) 0.3970 (0.4904) 2 0.976 (0.329)
LFS 1.4888 (2.3763) 3.5456 (2.7339) 2 0.6727 (0.000) * * *
Table I.
Univariate analysis Note: Significant at: *10, * *5 and * * *1 percent, respectively
generated funds. Therefore, corporations having growth opportunities are more Corporate
probable to issue debt and thus tend less towards using FX derivative instruments due derivatives
to of high transactions costs. Moreover, less growth oriented firms have little FX
exposure thus less likely to use foreign currency hedging instruments. and FX risk
Theory predicts that firms’ ability to finance its growth opportunities provides them
an incentive to use hedging instruments. Consistent with theory, by taking ratio of
change in net tangible assets plus depreciation to net income plus depreciation, reveals 415
that users are less able to finance its growth opportunities with a mean value of 0.9654 in
comparison with non-users which are on average only 0.4490 incapable in financing
their growth opportunities. Mean difference test of asset growth over cash flow shows
that users and non-users are significantly different from each other.
Similarly, coherent with the expected coefficients for liquidity and profitability, it is
found that users have lower level of profitability and liquidity. Users are identified on
average 5.13 percent profitable, whereas non-users are more profitable firms with the
mean value of 6.93 percent. Nevertheless, mean difference of users and non-users are not
statistically significant. Moreover, users are identified as liquidity constrained firms
with the mean value of 2.6851 in comparison with non-users, having an average value
of 4.1451. In this case, Mann-Whitney U test shows that users and non-users are
significantly different in terms of liquidity.
Contradictory to the theory of substitutes of hedging, firms with lower dividend
payout ratio are characterized as user of hedging instruments. Supporting financial
distress hypothesis, users report that non-users have higher dividend payout ratio of
54.87 percent, whereas users have 19.25 percent dividend payout ratio, as lower dividend
payout firms perceive themselves riskier because of highly invariable cash flows, hence,
they use hedging instruments to reduce financial distress costs by minimizing cash flow
unpredictability. However, mean difference test demonstrate statistically insignificant
difference between dividend payout ratio of both the groups.
According to agency cost of equity, managers having higher equity stake are more
probable to use derivative in best interest of firm as it will ultimately affect firm value.
Hence, consistent with the theory, users have higher managerial ownership with the
mean value of 0.7101 while non-users document an average value of 0.5256,
nevertheless, the mean difference for both groups is not statistically significant.
A dummy variable is used to measure tax convexity. Contradictory to expectations,
non-users show higher tax losses with the mean value of 0.45 in contrast with users
which have 39.7 percent tax losses. This might be due to the infant status of Pakistani
derivative market. Mian (1996) considering sample data of 3,022 firms observed
hedgers as having lower tax losses.
It is expected that firms’ need to hedge risk exposure is directly proportional to its FX
exposure which is supported by our findings. Users of hedging instruments are found to
be having more foreign currency exposure with the mean value of 3.5456, whereas,
non-users report an average value of 1.4888 of foreign sales. Mean difference results
show that users are significantly different from non-users in terms of FX exposure.
Generally, users are identified as a financially distressed large size firms with the lower
debt ratio and growth opportunities. In addition, financially constrained firms having
high FX exposure and larger managerial ownership are characterized as the user of
derivative instruments for hedging purpose.
JRF Correlations coefficients are presented in Table II. Firms’ operating characteristics
12,5 are divided into two groups. Correlation results of Group A, excluding all investment
and financing variables, explain that profitable firms are large in size, have higher
interest coverage ratio, more ability to convert its growth options into assets in place
and lower managerial ownership; which is consistent with the theory. In addition,
firms having higher financial distress costs have lower interest coverage ratio as it is
416 difficult for them to fulfill their obligations. Group B reports correlation coefficients for
firms’ endogenous polices which supports the theory that financially constrained firms
are more likely to take debt for their investments.

(ii) Empirical results

Logit model is used to identify the determinants of the firms’ decision to use FX
derivatives. Estimated results of models 1 and 2 are presented in Table III. The results
of model 1 report that financial distress costs, interest coverage ratio, size, asset growth
over cash flow, profitability and foreign sales have signs consistent with the theory,
whereas managerial ownership and tax convexity have estimated signs contrary to
risk management theory. According to financial distress theory, corporations having
higher financial distress costs and less ability to pay its interest costs are more likely
to employ foreign currency derivative instruments for hedging firm risk exposure and
to avoid opportunistic behavior of debt holders. Outside directors emphasize value
creation activities thus firms with smaller managerial holdings have fewer chances
to make hedging decisions via derivative instruments in their own interest.
Haushalter (2000) and Bartram et al. (2009) had also found a negative relationship
between managerial holdings and derivative usage. In line with Howten and Perfect
(1998), results show inverse relationship between tax losses and decision to use FX
derivatives. Since tax losses reduce firms’ income gains, thus tax-benefits acquired
from unused tax losses are smaller than reduction in income gain, so it is not feasible
for firm having unused tax losses to use FX derivatives.
Empirical results of model 2 support our earlier results of univariate analysis.
Similar to Nance et al. (1993), Fok et al. (1997) and Geczy et al. (1997), leverage depicts
a significant negative effect on firms’ likelihood of derivative usage. Hence,

Group A
FDC INC SIZE AGCF ROA MNGRL TAX LFS
FDC 1.00
INC 20.24 1.00
SIZE 0.07 0.05 1.00
AGCF 0.07 2 0.07 0.03 1.00
ROA 0.08 0.35 0.23 20.06 1.00
MNGRL 0.11 2 0.15 20.19 0.10 2 0.18 1.00
TAX 0.28 2 0.27 0.10 0.11 2 0.18 0.01 1.00
LFS 0.01 2 0.13 0.11 0.09 2 0.07 2 0.04 0.13 1.00
Group B
LEV MKBK DP QR
LEV 1.00
MTB 0.02 1.00
Table II. DP 0.00 0.26 1.00
Correlation matrix QR 20.25 2 0.01 0.00 1.00
 Corporate
Model 1 Model 2
Variables Predicted signs Coeff. p-value Coeff. p-value derivatives
FDC 2 2 2.743 0.000 * * *
and FX risk
LEV þ 20.933 0.036 * *
INC 2 2 0.011 0.026 * *
SIZE 2 /þ 0.123 0.427 417
MTB þ 20.0235 0.519
AGCF þ 0.087 0.023 * *
ROA 2 2 3.122 0.066 *
DP 2 /þ 20.1337 0.122
QR 2 20.2180 0.000 * * *
MNGRL þ 2 0.008 0.079 *
TAX þ 2 0.527 0.062 *
LFS þ 0.304 0.000 * * *
Constant 1.128 0.266 1.769 0.000 * * *
Table III.
Note: Significant at: *10, * *5 and * * *1 percent, respectively Logit regression

proving that high debt leads firm to more financial distress and increases its cost of
hedging, therefore making it difficult for a leveraged firm to bear higher risk
management costs. Dividend payout ratio shows a negative effect on firms’ derivative
usage, supporting signaling theory. Firms having volatility in cash flows are more
likely to cut dividend amounts in advance so that at the end of fiscal year lower
dividend payout ratio signals a weak financial position of firm; consistent with
Haushalter (2000). Generally, large size financially distressed firms, having lower
leverage, dividend payout ratio, liquidity, managerial ownership, profitability and tax
convexity are more likely to use derivative instruments for hedging purpose.

5. Conclusion
Current study extends the existing literature by identifying factors influencing firms’
decision to use FX derivative as an instrument for hedging exchange rate exposure of
86 non-financial firms listed on Karachi Stock Exchange for the period 2004-2007.
The estimated results support the hedging theory by Smith and Stulz (1985) that FX
derivatives are used to enhance shareholder’s wealth by reducing firm’s FX exposure.
In case of Pakistani non-financial firms, coefficient of financial distress, size, interest
coverage ratio, profitability and foreign sales are consistent, in terms of direction and
magnitude, with the risk management theory. Contrary to financial distress theory,
negative relationship between leverage and firm’s derivative usage depicts that high
leverage increases corporation’s financial distress costs and decreases firms’ ability to
bear high risk management costs. Firms having larger outsiders’ holdings are more
likely to make hedging decision in the best interest of shareholders as company’s
financial health signals their performance in the market. Tax convexity, measured by
tax losses carry forward has negative impact on firm’s decision to use FX derivatives –
inconsistent with the risk management theory. This might be due to the inappropriate
measure for tax convexity and the fact that cost of risk management exceeds the tax
deductible benefit of unused tax losses. Unexpected coefficient of dividend payout
though inconsistent with the hedging theory but still supports the signaling theory.
Growth options though shows positive effect on firm’s hedging policies, have
JRF insignificant effect on firm’s derivative usage to hedge exchange rate risk. Study also
12,5 attempts to examine the relationship between corporate FX derivative usage and firm’s
FX exposure, and a significant positive relationship between firm’s foreign sales and
their decision to use FX derivatives to hedge FX exposure is reported, despite of
illiquid and amateur Pakistani derivative market.
The estimated results provide the policy guidelines to the Pakistani firms having FX
418 transactions, that the optimal usage of FX derivative instruments may enable them to
smooth their future cash flows by reducing opportunistic behavior of shareholders and
managers, hence, minimizing the agency costs of debt and equity. The findings of
current empirical investigation also suggest that the policy makers should develop a
well-organized exchange traded derivative market in Pakistan for the benefit of
financially constrained firms with highly variable cash flows and foreign sales.
The study also highlights that effective usage of derivative instruments may enable
corporations to define their hedging policies that are compatible with firm’s internal
investment and financing policies. Therefore, properly planned and implemented
investment, financing and hedging policies, will not only facilitate firms in achieving
their primary goal of shareholders’ wealth maximization, but may also enhance
economic stability. The current study has identified the factors affecting the firm’s
decision to use FX derivative instruments; however, future research could be focused on
determining the factors influencing the usage of interest rate derivative instruments and
extent of such derivative usage.

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JRF About the authors
Dr Talat Afza (Professor of Finance) holds a PhD in International Trade and Finance and an MA
12,5 Economics degree from Wayne State University, Detroit, USA. She also earned an MBA Finance
degree from B.Z. University, Multan, Pakistan. She has taught at various prestigious universities
including University of Michigan Dearborn (USA), Wayne State University, Detroit (USA), B.Z.
University, Multan (Pakistan), University of Lahore (Pakistan) and Virtual University of Pakistan.
Currently, she is working as Dean, Faculty of Business Administration at COMSATS Institute of
420 Information Technology, Islamabad, Pakistan. Her areas of research interests include international
trade and finance, money and banking, women entrepreneurship and financial management. She
has published more than 30 research papers in reputed national and international journals and
a similar number of research papers were presented in national and international conferences.
She has successfully completed a 16 months research project on “Women Entrepreneurship”
funded by the Higher Education Commission of Pakistan and also supervised a number of research
theses of MS and PhD students. Dr Afza is also a member of editorial boards and an active reviewer
for a number of national and international research journals. Talat Afza is the corresponding
author and can be contacted at: talatafza@ciitlahore.edu.pk
Atia Alam is an MS Research Scholar at COMSATS Institute of Information Technology,
Lahore. Her areas of research include hedging policies, derivatives, financial restructuring and
the bond market of Pakistan.

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