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Cash Flow, Investment, and Hedging

George Allayannis 

University of Virginia - Darden School of Business

Abon Mozumdar 

Virginia Polytechnic Institute & State University - Department of Finance
June 2000

AFA 2001 New Orleans Meetings 
Abstract:      
Using a sample of S&P 500 non-financial firms between 1993 and 1995, we examine whether the use of foreign currency derivatives by firms with significant exposure to exchange-rate risk enables them to reduce their dependence on internal cash flow for making investments, as predicted by Froot, Scharfstein, and Stein's (1993) model of optimal hedging. Consistent with our hypothesis, we find that while hedgers and non-hedgers have similar sensitivities of investment to net cash flow, sensitivity to unhedged cash flow is significantly lower for hedgers than non-hedgers. This result is robust to the use of alternative specifications of cash flow, investment, and Q; to further controls for leverage, size, and diversification; and to controls for the endogeneity of the hedging decision. Finally, we find additional evidence supporting the effectiveness of hedging as indicated in the above model: hedgers reduce the volatility of net cash flow significantly more than non-hedgers.