Abstract
In recent years, Colombia has found several innovative ways to improve the efficiency of its public enterprise sector. One option used by Colombia to reform public enterprises has been to enhance their commercial orientation and limit the fiscal risk. If a public enterprise is considered commercially run, it could be removed from the country’s fiscal indicators and targets. This paper presents the IMF staff’s evaluation of these two enterprises. It also discusses the commercial orientation and fiscal risk of Isagen and Ecopetrol, respectively.
III. Who, Why, How? Currency Risk Hedging by Colombian Corporations14
A. Introduction
1. The financial crises in the late 1990s and early 2000s underscored the importance of risks arising from the balance sheet exposures of different sectors. The effects of macroeconomic policies, such as a rise in interest rates or a currency depreciation, can be influenced by mismatches in the currency composition, the maturity structure and other aspects of the balance sheets of financial institutions, corporations or the public sector. For these reasons, the macroeconomic and sectoral balance sheets of a number of key emerging market countries, including Colombia, have been analyzed in recent years.15
2. A comprehensive assessment of sectoral and economy-wide vulnerabilities, however, needs to take into account off-balance sheet activities. These can alter the net foreign currency and short-term positions of different sectors and the distribution of risk within the economy. Financial transactions such as exchange rate forwards, for example, are not recorded on a balance sheet, but imply predetermined future flows that will eventually affect the overall exposure. By transferring risk to those that are more willing or able to bear it, such transactions can in principle be used to effectively reduce the risk created by balance sheet currency mismatches. For example, importers and exporters can hedge their exchange rate exposure so that their importing costs and exporting revenues become less volatile. Likewise, firms borrowing in foreign markets with no foreign currency earnings can enter into cross-currency forward contracts to reduce their exposure to exchange rate risk.
3. The use of currency derivatives contracts by nonfinancial corporations has grown rapidly in several countries in Latin America, especially in those that have recently switched to more flexible exchange rate regimes (BIS, 2005). Yet to date, firms’ motivations and strategies for using hedging instruments in emerging markets are little understood, let alone their broader implications for corporate and macroeconomic vulnerabilities to exchange rate fluctuations. The only cross-country study that focuses exclusively on emerging markets is Allayanis, Brown, and Klapper (2003), which examines the currency hedging practices of non-financial firms from eight East Asian countries over the period 1996–98. The authors find limited support for existing theories of derivative use: liquidity-constrained firms with higher investment opportunities do not hedge significantly more in their sample. They also document that firms in East Asia use foreign cash income as a substitute for derivative hedging.
4. For developed countries, there is a vast literature that examines firms’ motives to use financial derivatives to manage currency risk. Research on derivatives usage largely focuses on understanding why firms hedge, by appealing to some form of market imperfection. Froot and others (1993) explain currency risk management with market imperfections that make funding from outside the corporation more costly than internal sources of funds. In this case, the variability in the cash flow (internal funds available) can cause variability in both investment spending and/or external funds raised. Thus, without hedging, firms are more likely to pursue sub-optimal investment projects (Myers, 1977). Hedging mitigates this underinvestment problem by reducing not only the costs of obtaining external funds, but also a firm’s dependence on external financing. Evidence on the underinvestment hypothesis is mixed. Mian (1996) and Allayannis and Ofek (2001) find no relation between market-to-book ratios (proxying for growth opportunities) and hedging. Several papers, however, find that R&D expense increases a firm’s incentive to hedge (e.g., Geczy, Minton and Schrand, 1997; Dolde, 1995).
5. Smith and Stulz (1985) show that exogenous bankruptcy costs can create incentives for firms to use currency derivatives.16 By reducing the variance of a firm’s cash flows (or accounting profits), hedging decreases the probability—and thus the expected costs—of financial distress. Many papers use the debt ratio to measure deadweight costs of financial distress and find that hedging increases with the debt ratio (e.g., Graham and Rogers, 2002; Purnanandam, 2004). Others, however, find no evidence or mixed evidence for the relationship between hedging and leverage (e.g., Nance, Smith and Smithson, 1993; Geczy, Minton and Schrand, 1997). Smith and Stulz (1985) also argue that hedging can reduce expected tax liability of a firm in the presence of a progressive tax schedule, which makes volatility is costly. For these firms, a smoother profit stream creates tax advantages.
6. This paper represents a first step towards understanding financial currency risk management by emerging market corporations, with a focus on Colombia. It first documents a dramatic increase in the turnover of forward contracts used by the nonfinancial corporate sector between 1998 and 2005, mostly concentrated in long dollar positions at relatively short maturities. It then analyzes the use of financial derivatives by 1,800 publicly-traded and private companies in Colombia in 2004, drawing on a unique database with information on daily exchange rate forward transactions. It finds strong evidence that the use of derivatives is, in fact, for hedging rather than for speculation. Firms that use FX derivatives have higher proportions of dollar debt, significantly higher leverage, shorter debt profiles, as well as lower liquidity (as measured by current ratios) and are more involved in international trade. The development of cross-currency derivatives has also enabled some large corporations to raise cheaper capital abroad without increasing their exchange rate risk.
7. The rest of the paper proceeds as follows. Section B summarizes recent developments in the domestic forward exchange rate market. Section C looks at the determinants of firms’ decision to use financial hedging. Section D concludes and draws policy implications.
B. Recent Developments in Domestic Forward Markets
8. In the last five years, the on-shore market for foreign exchange hedging instruments in Colombia has grown remarkably. Consistent with the increased flexibility in the exchange rate and deeper trade and financial integration with the rest of the world, activity in on-shore, currency-based derivative contracts have shown rapid and persistent growth.17 Total turnover reached US$6 billion in December 2005, up from a monthly average of US$884 million in 1998 (Figures 1 and 2). In 2005, total trading volume in the forward market represented 45 percent of GDP and one and a half times total trade (exports and imports) of the whole economy18.
Total Turnover in Forward Exchange Rate Market in Colombia
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Total Turnover in Forward Exchange Rate Market in Colombia
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Total Turnover in Forward Exchange Rate Market in Colombia
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Turnover of Forward Transactions by Sector
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Turnover of Forward Transactions by Sector
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Turnover of Forward Transactions by Sector
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
9. While the turnover in the forward FX market in the last few years has increased significantly, Colombia’s derivatives market is still underdeveloped by international standards. Colombia’s forward market (when measured as a percentage of GDP or total trade), is still considerably smaller than in some other regional countries that have a flexible exchange rate regime (Table 1).
Size of Domestic US Dollars Forward Market, 2003
Size of Domestic US Dollars Forward Market, 2003
| Colombia | Chile | Mexico | |
|---|---|---|---|
| Volume (in US$ billions) | 27.4 | 165.8 | 340.0 |
| As percent of GDP | 34.5 | 225.0 | 53.2 |
| As percent of foreign trade (X+M, goods) | 101.2 | 418.2 | 156.5 |
Size of Domestic US Dollars Forward Market, 2003
| Colombia | Chile | Mexico | |
|---|---|---|---|
| Volume (in US$ billions) | 27.4 | 165.8 | 340.0 |
| As percent of GDP | 34.5 | 225.0 | 53.2 |
| As percent of foreign trade (X+M, goods) | 101.2 | 418.2 | 156.5 |
10. In Colombia, foreign exchange hedging instruments are concentrated in over the counter (OTC) transactions in various types of short-maturity forwards and, more recently, FX swaps. However, the use of other derivatives remains extremely limited or nonexistent. Interest rate derivatives instruments, OTC interest rate swaps and market-traded fixed income futures are fairly limited and illiquid, and used mainly by banks and institutional investors.
11. Banks play a major role as market makers in the local OTC market. In effect, they match corporate end-users and institutional investors’ needs to cover (opposing) exchange rate risk. Demand for foreign exchange hedging (to protect against a devaluation) comes mainly from corporations which are net importers or which borrow in foreign currency abroad. Pension funds are the main providers of foreign exchange hedging to corporate end-users, because their liabilities are in pesos and they want insurance from currency appreciation. Minimum coverage requirements of foreign assets makes pension funds the natural providers of foreign currency hedging to firms since they have an incentive to take the foreign currency paying leg of a derivatives transaction.
12. Table 2 shows the way the forward markets redistributed and reduced the overall exposure to exchange rate risk in 2004 and 2005. By end-December 2004, for example, institutional investors had an outstanding net dollar-paying position of US$1.18 billion, compared to the outstanding net dollar buying (long) position of US$1.23 billion of corporations. Exporters, however, have not been important providers of foreign exchange hedging to other dollar-indebted corporate end-users. Central bank data shown in Table 2 indicate that foreign-currency paying positions of the corporate sector, mainly supplied by exporters, amounted to US$ 237 million, or only 7 percent of the total amount of foreign-currency paying positions (sales) in the domestic derivatives market in 2004. After trading with residents and non-residents, most banks hedge their net exposure by taking an offsetting position in the cash market.
Outstanding Stock of Forward Contracts vis-a-vis the Banking Sector
(In millions of U.S. dollars)
Positive net purchase means long dollar positions.
Trading in currency derivatives in 2005 was mostly done with FX swaps.
Outstanding Stock of Forward Contracts vis-a-vis the Banking Sector
(In millions of U.S. dollars)
| Sales | Purchases | Net Purchase Position 1/ | |
|---|---|---|---|
| December 30, 2004 | |||
| Corporates | 237 | 1,468 | 1,230 |
| Offshore and special purpose vehicules | 943 | 1,370 | 427 |
| Pension funds | 1,919 | 742 | -1,177 |
| Other financial institutions | 393 | 228 | -165 |
| Treasury | 0 | 0 | 0 |
| Banks’ Net FX Forward exposure | 316 | ||
| December 30, 2005 | |||
| Corporates | 465 | 1,150 | 685 |
| Offshore and special purpose vehicules | 609 | 1,093 | 484 |
| Pension funds | 1,363 | 157 | -1,206 |
| Other financial institutions | 366 | 335 | -31 |
| Treasury 2/ | 4 | 0 | -4 |
| Banks’ Net FX Forward exposure | -72 | ||
Positive net purchase means long dollar positions.
Trading in currency derivatives in 2005 was mostly done with FX swaps.
Outstanding Stock of Forward Contracts vis-a-vis the Banking Sector
(In millions of U.S. dollars)
| Sales | Purchases | Net Purchase Position 1/ | |
|---|---|---|---|
| December 30, 2004 | |||
| Corporates | 237 | 1,468 | 1,230 |
| Offshore and special purpose vehicules | 943 | 1,370 | 427 |
| Pension funds | 1,919 | 742 | -1,177 |
| Other financial institutions | 393 | 228 | -165 |
| Treasury | 0 | 0 | 0 |
| Banks’ Net FX Forward exposure | 316 | ||
| December 30, 2005 | |||
| Corporates | 465 | 1,150 | 685 |
| Offshore and special purpose vehicules | 609 | 1,093 | 484 |
| Pension funds | 1,363 | 157 | -1,206 |
| Other financial institutions | 366 | 335 | -31 |
| Treasury 2/ | 4 | 0 | -4 |
| Banks’ Net FX Forward exposure | -72 | ||
Positive net purchase means long dollar positions.
Trading in currency derivatives in 2005 was mostly done with FX swaps.
13. Pricing of forward contracts subscribed between banks and their corporate clients, varies widely across firms. Figure 3 shows the dispersion of settled forward nominal exchange rates for all contracts signed the same day and with same contractual maturity, across firms. Three key factors explain this dispersion: the lack of a reliable forward curve, the importance of bank-client relationships and regulatory restrictions.19 First, the local money market is under-developed, which makes it hard to find a local short-term interest rate to price FX forwards. Second, firms that enter a forward contract with a bank must have a credit line approved due to counterparty risk. The credit line is costly since it ties up the bank’s economic capital. The cost of the credit line is passed on to the end-user at varying forward rates, according to firms’ net worth and relationship with bank. Third, limits imposed by the Central Bank on the foreign currency net cash position of banks create distortions when banks approach those limits.20
Variation Coefficient for Forward Exchange Rates for Several Tenors1
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
1/ Standard deviation of the forward exchange rates divided by the average level of the forward exchange rate for each tenor.Variation Coefficient for Forward Exchange Rates for Several Tenors1
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
1/ Standard deviation of the forward exchange rates divided by the average level of the forward exchange rate for each tenor.Variation Coefficient for Forward Exchange Rates for Several Tenors1
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
1/ Standard deviation of the forward exchange rates divided by the average level of the forward exchange rate for each tenor.14. The nonfinancial corporate sector has accounted for approximately 25 percent of the turnover in the market throughout this period. Figures 4 and 5 show the evolution of the monthly flow and net outstanding position on derivatives subscribed between the corporate sector and domestic commercial banks, for the time period January 1998 to December 2005. Even though the percent of holdings attributable to nonfinancial firms is less than a quarter of outstanding market values, the magnitudes are large. The notional value of all types of FX derivatives held by nonfinancial firms was almost US$6 billion at the end of 2004. The number of firms participating in the forward market and the number of contracts signed have also increased dramatically (Figures 6 and 7).21
Turnover in Forward Transactions by Corporates
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Turnover in Forward Transactions by Corporates
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Turnover in Forward Transactions by Corporates
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Outstanding Stocks of Forward of the Corporate Sector
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Outstanding Stocks of Forward of the Corporate Sector
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Outstanding Stocks of Forward of the Corporate Sector
(In billions of U.S. dollars)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Corporate Firms
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Corporate Firms
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Corporate Firms
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Number of Forward Contracts signed by Corporate Sector
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Number of Forward Contracts signed by Corporate Sector
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Number of Forward Contracts signed by Corporate Sector
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
15. Over this period, the corporate sector as a whole has consistently been a net purchaser of dollar forward contracts. As shown in Table 2, the notional value of the outstanding FX forward long and short positions in 2004, for example, indicates that purchases of forward dollars by Colombian firms were six times higher than sales.22 Results are consistent with the notion that for firms from emerging economies that have experienced a currency crisis, such as Colombia, a sharp depreciation in the local currency may be a source of greater concern than its sudden appreciation.
16. There is wide variation in derivative use across industries (Figure 8). Firms in the manufacturing, wholesale and retail sectors are the most frequent users of foreign currency derivatives. In 2004, almost 70 percent of corporate forward trading was concentrated in these industries. The differences in derivative use across industries may reflect industry specific characteristics associated with either increased overseas foreign exchange rate exposure, or incentives for optimal risk reduction. Because of these differences, the empirical analysis below includes industry indicator variables.
Distribution of Turnover of Corporate Forward Contracts by Sector of Economic Activity
(In percent)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Distribution of Turnover of Corporate Forward Contracts by Sector of Economic Activity
(In percent)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Distribution of Turnover of Corporate Forward Contracts by Sector of Economic Activity
(In percent)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
17. Liquidity in forward contracts is largely concentrated in the 1-month contract, which represents about 80 percent of outstanding contracts. There is reasonable liquidity up to 3 months, while contracts beyond the 6-month tenor can be found more on a tailor-made basis. Because a majority of contracts have very short maturities, hedging in the forward market may not contribute much to reduce cash flow volatility. This situation, however, is similar to the one in Australia, New Zealand, and Chile.
18. Figure 9 presents the maturity breakdown for onshore forward operations. During 2005, 2.1 percent of total turnover was associated to contracts of over 1 year, quite close to the world average of 3 percent (BIS, 2003). Also, there has been a decreasing share in contracts of less than 36 days. The maturity breakdown of forward contracts in the onshore market is similar to that observed in Australia and New Zealand (see Chan-Lau, 2005).
Maturity Distribution of Tenors
(In percent)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Maturity Distribution of Tenors
(In percent)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Maturity Distribution of Tenors
(In percent)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
19. While forward contract eliminate exchange rate uncertainty, they do not ensure ex-post benefits. The opportunity cost of entering a forward contract can be measured as the foreign exchange gains foregone by locking in the exchange rate in advance. Figure 10 shows new evidence on the average opportunity cost on firms’ trading in forward contracts in Colombia, measured as the difference in percent between the realized spot rate at the time the contract matured and the forward rate settled at the inception of the contract, averaged across firms in each month. For the period starting in 2003 (which coincides with the appreciation of the currency), the average firm incurred systematic ex-post losses in forward market operations.
Forgone Profits: Fraction of Dollar Lost by Locking In the Exchange Rate in Advance
(In percent of spot exchange at maturity; 30-day moving avg. across all firms)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Forgone Profits: Fraction of Dollar Lost by Locking In the Exchange Rate in Advance
(In percent of spot exchange at maturity; 30-day moving avg. across all firms)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
Forgone Profits: Fraction of Dollar Lost by Locking In the Exchange Rate in Advance
(In percent of spot exchange at maturity; 30-day moving avg. across all firms)
Citation: IMF Staff Country Reports 2006, 401; 10.5089/9781451808919.002.A003
C. What Determines the Decision to Hedge? A Multivariate Analysis
20. To study the firm-specific determinants of currency-risk hedging, we collected balance sheet information for a large sample of approximately 1,800 publicly-traded and private companies in 2004. We excluded financial firms and utilities, since risk-management activities of these firms are not directly comparable due to regulatory and business related reasons (e.g., some financial firms also act as dealers in derivative markets). In addition to basic accounting data, the database also contains information on the amount of foreign currency debt contracted abroad, exports and imports by each firm.23 Using information in derivative trading provided by the central bank, we identified those firms in the sample that engaged in currency forward trading during the year. Of the 1,827 firms in the sample, 36 percent (661 firms) participated at least once in forward markets in 2004.24
21. Like much of the literature on hedging, this paper analyzes the determinants of the decision to hedge, as opposed to the intensity of hedging. For a country like Colombia—where the use of hedging is relatively limited—it is important to understand why firms decide to hedge. Moreover, an analysis of the intensity of hedging raises complex measurement issues and may reflect short-term considerations, such as expectation of asset prices and their volatility.
22. Table 3 reports estimates on the determinants of the likelihood of derivative use in 2004. It presents the results of probit regressions of a dichotomous variable representing derivatives use on the explanatory variables and industry indicator variables. In all cases, regression estimates represent the implied marginal changes in the probability of using forward contracts that result from a unit change in the explanatory variables. To control for possible endogeneity in any of our independent variables, we measure all of them as of fiscal year end-2003, but measure the choice of derivative use during 2004.25
Probit Regression Estimates on Firms’ Likelihood of Using Currency Derivatives in Colombia, 2004
See Appendix for a detailed explanation of the independent variables.
Probit Regression Estimates on Firms’ Likelihood of Using Currency Derivatives in Colombia, 2004
| Any Forward | Buying Position | Selling Position | |||||
|---|---|---|---|---|---|---|---|
| Independent Variables 1/ | (1) | (2) | (3) | ||||
| Dependent Variable: Indicator of participation in forward markets in the year 2004 | |||||||
| Net Exports over Sales | -0.03 | -0.15 | 0.18 | ||||
| (0.03) | (0.04) *** | (0.02) *** | |||||
| Dollarization of Liabilities | 0.27 | 0.21 | 0.06 | ||||
| (0.07) *** | (0.06) *** | (0.04) | |||||
| Size_Medium | 0.24 | 0.25 | 0.04 | ||||
| (0.03) *** | (0.03) *** | (0.02) | |||||
| Size_Big | 0.36 | 0.38 | 0.08 | ||||
| (0.03) *** | (0.03) *** | (0.02) *** | |||||
| Leverage | 0.11 | 0.11 | -0.01 | ||||
| (0.06) *** | (0.04) ** | (0.02) | |||||
| Residual Short Term Maturity | 0.15 | 0.12 | 0.08 | ||||
| (0.05) *** | (0.05) *** | (0.03) *** | |||||
| Current_Ratio | -0.01 | -0.01 | 0.00 | ||||
| (0.00) | (0.00) | (0.00) | |||||
| Fixed Effects | |||||||
| Economic Sector | Yes | Yes | Yes | ||||
| Observations | 1827 | 1827 | 1827 | ||||
| Adjusted R2 | 0.15 | 0.18 | 0.12 | ||||
| Correctly Classified (in %) | 70.3 | 72.2 | 91.22 | ||||
See Appendix for a detailed explanation of the independent variables.
Probit Regression Estimates on Firms’ Likelihood of Using Currency Derivatives in Colombia, 2004
| Any Forward | Buying Position | Selling Position | |||||
|---|---|---|---|---|---|---|---|
| Independent Variables 1/ | (1) | (2) | (3) | ||||
| Dependent Variable: Indicator of participation in forward markets in the year 2004 | |||||||
| Net Exports over Sales | -0.03 | -0.15 | 0.18 | ||||
| (0.03) | (0.04) *** | (0.02) *** | |||||
| Dollarization of Liabilities | 0.27 | 0.21 | 0.06 | ||||
| (0.07) *** | (0.06) *** | (0.04) | |||||
| Size_Medium | 0.24 | 0.25 | 0.04 | ||||
| (0.03) *** | (0.03) *** | (0.02) | |||||
| Size_Big | 0.36 | 0.38 | 0.08 | ||||
| (0.03) *** | (0.03) *** | (0.02) *** | |||||
| Leverage | 0.11 | 0.11 | -0.01 | ||||
| (0.06) *** | (0.04) ** | (0.02) | |||||
| Residual Short Term Maturity | 0.15 | 0.12 | 0.08 | ||||
| (0.05) *** | (0.05) *** | (0.03) *** | |||||
| Current_Ratio | -0.01 | -0.01 | 0.00 | ||||
| (0.00) | (0.00) | (0.00) | |||||
| Fixed Effects | |||||||
| Economic Sector | Yes | Yes | Yes | ||||
| Observations | 1827 | 1827 | 1827 | ||||
| Adjusted R2 | 0.15 | 0.18 | 0.12 | ||||
| Correctly Classified (in %) | 70.3 | 72.2 | 91.22 | ||||
See Appendix for a detailed explanation of the independent variables.
23. We present results for three probit regressions, each specifying a different indicator of participation in forward markets. Column 1 displays results when the dependent variable is a binary dummy variable that takes a value equal to one if the firm uses any kind of currency derivatives during the year. In column 2 (3), the dependent variable takes the value of one when the firm was a buyer (seller) of forward contracts during 2004, and zero otherwise. Results on columns 2 and 3 thus capture both the decision and the direction of hedging.
24. The model provides a very good fit. Based on the numeric breakdown of model-predicted participation versus actual participation, the model is capable of predicting between 70 and 91 percent of the actual participation choices (with better success rates observed for non-participants), depending on the specification.
25. Size is an important determinant of participation in forward markets, especially for firms holding long dollar positions (specification 2). To capture firm size, we sort the sample of firms into thirds based on firm-level total assets. Separate dummies are used for large-sized (top-third) and medium-sized (middle-third) firms (small-sized firms being the excluded category). Moving from the lower to the upper third part of the firm size distribution, increases the probability of participating in forward markets by almost 40 percent. This suggests that over-the-counter forward markets exhibit significant scale economies in the structure of transaction costs, implying that large firms are more likely to hedge with these instruments.26
26. Forward contracts in Colombia have additional costs that can work against their use by smaller corporate end-users. Corporate end-users that enter a forward contract with a bank may be required to post collateral because of counterparty risk, especially from clients who do not meet internal credit rating requirements. Costs associated to collateral and credit lines are passed on to the end-user as less favorable forward rates.
27. In specifications (1) and (2), the estimated coefficient on the share of dollar debt is positive and significant at conventional confidence levels, while insignificant in column (3). In other words, higher shares of dollar debt in firms’ balance sheets make it more likely that the firm purchases a forward contract, but has no effect on the probability of taking the dollar-paying side of the forward transaction. Based on the distinct effect on the direction of hedging, results suggest that firms use forward positions—at least in part—to offset balance sheet exchange rate exposures.
28. We can use the estimates of column (2) in Table 3 to calculate the economic significance of debt currency composition as an incentive to hedge. Our estimate of the marginal effect of foreign currency borrowing on the likelihood of holding a long forward contract is 0.21. At the same time, the fraction of firms taking a long forward position (the unconditional mean) in 2004 is almost 36 percent. Thus, an increase in average firm liability dollarization of one-standard deviation above the sample mean increases the likelihood of observing a forward contracting firm by almost 20 percent.27
29. Taken together, the positive and significant effect of size and dollar debt issued abroad on the probability of taking a long dollar forward position, may also reflect a wider financial strategy of using derivative markets to lower borrowing costs. Bigger corporations are able to borrow internationally in U.S. dollars, at nominal rates that are usually lower than domestic dollar interest rates. Firms then layoff the associated foreign exchange rate risk by purchasing dollar forward in domestic markets. The combination of low external interest rates and low implied forward rate (due to pricing distortions described in Section B) allowed firms to effectively borrow in pesos at a lower rate that would be possible in Colombia’s domestic market.
30. Controlling for dollar debt, firms exporting a larger share of their sales (net of imports) hold significantly lower long dollar derivative positions (column 2). The negative sign of net exports in column 2 suggests that firms use derivatives as a substitute to natural hedges—that is, firms are less likely to use derivatives to offset the balance-sheet risk of dollar debt when they earn foreign currency revenues. On the other hand, the positive sign on trade exposure in column 3 indicates that net exporters effectively insure themselves against earning volatility by participating in the derivatives market and forward selling their dollars.28 Finally, it is not surprising that the estimated coefficients on net exports is not significant in column (1), as long positions are treated the same as short positions in the dummy variable.
31. Our results also suggest that avoiding financial distress is an important consideration in firms’ hedging decisions. The likelihood of participating in forward markets increases with high debt-to-asset ratios and shorter maturities of debt. For example, if firms are frequently rolling over their debt, they will suffer more from a negative shock to the supply of credit. At the same time, a firm with a higher debt load is expected to hedge more, as it needs to reassure external financiers that its probability of financial distress or default is low.
32. Finally, results not tabulated indicate that foreign ownership has a negative impact on the likelihood of participating in domestic forward markets. This could be reflecting alternative strategies by multinational companies to hedge exchange rate risk across markets. On the one hand, domestic subsidiaries sometimes hedge through their parent companies only in off-shore markets. On the other hand, by using strategies called “leading and lagging,” a parent company can bring forward or delay payments or receipts of foreign currency with its subsidiaries to offset the currency risks associated with other foreign currency transactions. This financial strategy may be substituting for financial hedging by its Colombian subsidiaries in domestic markets.
D. Concluding Remarks and Policy Implications
33. Larger firms are significantly more likely to hedge foreign currency risk. This result reflects the importance of economies of scale in setting up risk management programs, and probably a higher degree of financial sophistication in bigger firms. Given the key role that bank-client relationships play in OTC forward markets, these results also highlights supply-side, credit access constraints faced by small firms.
34. The firm’s liability structure shapes hedging choices. Contracting forward positions is significantly motivated by the need to offset the balance-sheet risk of dollar debt and net trade flows. Even in countries like Colombia, typically regarded as a low-dollarized country, we find that the level of foreign currency-denominated debts play a major role in explaining a firm’s decision to hedge foreign exchange risk.
35. The level and source of firms’ exchange rate exposure affects both the decision to hedge and the choice between buying or selling forward. We find that corporations tend to cover their downside risk arising from a currency depreciation and may underestimate the probability of an appreciation of the peso. They may also perceive that the authorities’ foreign exchange intervention will be more concerned about limiting an appreciation of the peso, which may slow export growth. We also find the operational currency hedge, that is, the mitigation of risk due to matching of debt and earnings in foreign currency, is an important substitute for derivatives. In other words, firms that hedge dollar debt naturally with their international operations use proportionally less currency derivatives. We take these results to indicate that in our sample firms are hedging, and not speculating, on average.
36. Firm have structured their cross-border financing to lower their cost of borrowing. The development of cross-currency derivatives has enabled some large corporations to raise cheaper capital abroad without increasing their exchange rate risk. Firms can borrow abroad in hard currency, and then use derivatives to reverse their foreign currency exposure back into peso liabilities, at an effective peso interest rate that is lower than borrowing directly in the Colombian capital market (see Dodd and Griffith-Jones, 2006 for a similar description for the case of Chile).
37. The development of a futures market (with standardized contracts and diversification of counterparty risk) could broaden access to smaller firms. The authorities may want to consider fostering the development of derivatives exchanges as a complement to the over the counter market. A centralized clearing-house reduces this risk by acting as the sole counterparty to all the exchange members. Risk is also reduced as the clearing-house nets aggregate positions across members. Thus, exchanges do a better job than over-the-counter markets in reducing counterparty risk and its associated costs, facilitating price discovery, and allowing access to risk sharing instruments to small corporations with limited net worth.
38. A credible reference interest rate would provide an accepted forward differential curve, allowing for standard and fair pricing of risk at longer maturities. In this vein, current regulation restricting the net cash positions of banks should be subject to a cost/benefit analysis that takes into account the price distortions that they may create, especially at longer tenors. Fostering exchange rate risk hedging at longer maturities would in turn help economic agents deal more effectively with exchange rate uncertainty in the context of flexible regimes. At the same time, more active use of hedging instruments, especially at longer maturities, would help ease pressures for foreign exchange intervention by the central bank during periods of significant exchange rate volatility.
39. Taken together, it follows from our results that the growing importance of forward markets in Colombia should be taken into account seriously when evaluating the financial condition of firms and when assessing their capital structure decisions, and should be an important input in surveillance of country vulnerabilities.
References
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Data Appendix
1. The firm-level data set used in this paper is compiled from four major sources. We first collected balance sheet and income statement data from all publicly traded firms and a large sample of private companies in Colombia. Data for publicly traded firms comes from Superintendencia Financiera. Additionally, the Superintendencia de Sociedades, another government agency, collects income statements and balance sheets for a large sample of private firms. In addition to basic accounting data, both databases contain information on the amount of foreign currency debt contracted abroad by each firm and the fraction of its shares hold by foreigners. To identify firms’ involvement in international trade, we used Banco de la República’s Balance of Payments database with information on exports and imports at the firm level. We merged all three datasets using the NIT (Número de Identificación Tributaria), a unique identifier for each firm across databases.
2. The final sample contains approximately 1,800 publicly-traded and private non-financial firms, together accounting for 48 percent of total sales and 54 percent of total trade (exports plus imports) of the Colombian economy in 2004. The final sample excludes financial firms, since risk-management activities of these firms are not directly comparable due to regulatory and business related reasons (for example, financial firms also act as dealers in derivative markets). We also excluded public utilities because they are heavily regulated and their accounting statements are not comparable to the rest of the firms in the sample.
3. To identify those firms in the sample that participated in forward markets, we use a unique dataset on exchange rate hedging activity of Colombian firms in 2004. This dataset is compiled at the Colombian Central Bank and covers all forward contracts signed between non-financial firms and a domestic bank or financial intermediary over this period. Using the NIT codes of both the party and counter-party involved in forward transactions, we identified those firms in the sample that did foreign exchange forward transactions and the number of contracts they subscribed during the year 2004.29 Of the 1,827 firms in the sample, 36 percent (661 firms) participated at least once in forward markets in 2004, and together accounted for 83 percent of total turnover in forward market activity of the corporate sector in 2004.
4. For each derivative transaction, the database reports the notional principal, its contractual and residual maturity, and whether the corporate took the buying leg (i.e., went long on dollars) or selling leg (short on dollars) of the transaction. We also calculate notional outstanding values as of December 2004 and classify positions as “long” or “short.” A long dollar position is one that benefits for the rise of the value of the exchange rate during the remaining of the contract. Conversely, a short dollar position is one. The net position is the difference between each firm’s long and short position. Based on this information, we calculate for each corporate user, the net buying position in foreign currency derivatives outstanding at the end of 2004.
5. Although the data set created for this analysis permits a novel approach for examining the determinants of financial hedging decisions at the firm-level, it also has some shortcomings. For a start, it does not include information on currency derivatives trading conducted by domestic firms in off-shore markets, in particular, the Non-Deliverable Forward (NDF) market in New York.30 Thus, our strategy may be incorrectly classifying a firm as a non-derivative user, when in fact it is hedging currency risk, but in off-shore markets. Additionally, the database does not identify firms that are hedging interest rate risk.
6. While these caveats should be taken into consideration when assessing the empirical results, several factors suggest that they do not represent an important limitation for our empirical analysis. First, and according to interviews with market participants, those firms that actively manage exchange rate risk in off-shore markets, tend to do so domestically too. Possible exceptions are multinational corporations, which sometimes hedge through their parent companies only in off-shore markets. Second, most median to small-sized firms are unlikely to have access to foreign currency derivative markets, so financial currency risk management (if any), is done on-shore. Third, according to local intermediaries, the peso interest rate derivative market is almost non-existent and concentrated mostly in financial institutional investors.
7. Table 1A provides summary statistics on several indicators of hedging activity by corporations. The average (median) firm traded 8 (1.1) million dollars in forward contracts, with maturity of little more than three months (seventy-six days). Because a majority of contracts have very short maturities, hedging in the forward market may not contribute much to reduce cash flow volatility. However, evidence in Table 3 also indicates that the average firms signed 12 contracts at different times during 2004, suggesting the possibility of rollover strategies and higher effective duration of hedge. As shown in Panel B, during 2004, most of the firms (81 percent) signed forward contracts by going long on dollars. Panel C shows the average gross (sales plus purchases) outstanding positions at the end of the year expressed in dollars, and as a fraction of total assets and total FX exposure.
Descriptive Statistics on Firms’ Hedging Activity in 2004
Notional value of total outstanding forward contracts in December 2004.
Total FX Exposure is defined as total external Dollar Debt plus total international trade (exports plus imports).
Descriptive Statistics on Firms’ Hedging Activity in 2004
| Panel A: Flow Activity | |||
| Firm-Level Variables | Mean | Median | Standard Deviation |
| Total Forward Trading | 8.01 | 1.01 | 27.35 |
| (in millions USD) | |||
| Value of Contract | 0.53 | 0.12 | 1.25 |
| (in millions USD) | |||
| Number of Contracts | 12 | 3 | 31 |
| Subscribed | |||
| Maturity of Contract | 99.4 | 76.0 | 87.6 |
| (in days) | |||
| Panel B: Direction of Hedging | |||
| Buying FX Forward | Selling FX Forward | Both Buying and | |
| (long dollar position) | (short dollar position) | Selling FX Forwards | |
| Number of Firms | 632 | 161 | 91 |
| Number of Contracts | 7,258 | 2,879 | |
| Panel C: Outstanding FX Forward Positions at Year-End | |||
| Mean | Median | Standard Deviation | |
| Total FW Position 1/ | 3.3 | 0.6 | 10.2 |
| (in millions USD) | |||
| Total FW Position | 11.5 | 6.3 | 16.1 |
| (as % of Total Assets) | |||
| Total FW Position | 42.3 | 5.1 | 212.6 |
| (as % of Total FX Exposure) 2/ | |||
Notional value of total outstanding forward contracts in December 2004.
Total FX Exposure is defined as total external Dollar Debt plus total international trade (exports plus imports).
Descriptive Statistics on Firms’ Hedging Activity in 2004
| Panel A: Flow Activity | |||
| Firm-Level Variables | Mean | Median | Standard Deviation |
| Total Forward Trading | 8.01 | 1.01 | 27.35 |
| (in millions USD) | |||
| Value of Contract | 0.53 | 0.12 | 1.25 |
| (in millions USD) | |||
| Number of Contracts | 12 | 3 | 31 |
| Subscribed | |||
| Maturity of Contract | 99.4 | 76.0 | 87.6 |
| (in days) | |||
| Panel B: Direction of Hedging | |||
| Buying FX Forward | Selling FX Forward | Both Buying and | |
| (long dollar position) | (short dollar position) | Selling FX Forwards | |
| Number of Firms | 632 | 161 | 91 |
| Number of Contracts | 7,258 | 2,879 | |
| Panel C: Outstanding FX Forward Positions at Year-End | |||
| Mean | Median | Standard Deviation | |
| Total FW Position 1/ | 3.3 | 0.6 | 10.2 |
| (in millions USD) | |||
| Total FW Position | 11.5 | 6.3 | 16.1 |
| (as % of Total Assets) | |||
| Total FW Position | 42.3 | 5.1 | 212.6 |
| (as % of Total FX Exposure) 2/ | |||
Notional value of total outstanding forward contracts in December 2004.
Total FX Exposure is defined as total external Dollar Debt plus total international trade (exports plus imports).
Variable Definitions and Sources
This appendix provides a summary of all variables used in the empirical analysis and a detailed description of the method of calculation. The firm-level, explanatory variables are constructed as follows: Flow variables are measured during the year of derivatives use (2004), and stock variables are measured at the beginning of the year (fiscal year end 2003). The source for balance sheet and income statement variables is Superintendencia Financiera and SuperSociedades. Data on firm-level exports and imports comes from Banco de la República.
Variable Definitions and Sources
This appendix provides a summary of all variables used in the empirical analysis and a detailed description of the method of calculation. The firm-level, explanatory variables are constructed as follows: Flow variables are measured during the year of derivatives use (2004), and stock variables are measured at the beginning of the year (fiscal year end 2003). The source for balance sheet and income statement variables is Superintendencia Financiera and SuperSociedades. Data on firm-level exports and imports comes from Banco de la República.
| Variable Name | Variable Description |
| Size Dummies | To capture firm size, we sort the sample of firms into thirds based on the book value of firm’s total assets at year end 2003. Separate dummies are used for large-sized (top-third) and medium-sized (middle-third) firms. Small-sized firms is the excluded category. |
| Investment in Fixed Capital | Change in the real stock of net Property, Plant and Equipment during the year (using CPI as deflator) =[K(t)−K(t-1)]. |
| Investment to Total Asset ratio | [K(t) − K(t-1)] / Total Assets (t-1). |
| Leverage ratio | Total Liabilities over Total Assets. |
| Quick ratio | Current Assets over Current Liabilities. |
| Foreign Currency denominated Liabilities | Book value of financial debt denominated in foreign currency and contracted abroad. It is converted into local currency using the exchange rate for December. |
| Total Sales | Revenues from main operating activities. |
| Sector Affiliation | Sector is the industry in which the firm has its main operations, according to the one-digit ISIC rev2 classification to the one-digit ISIC 2 classification. |
| Net Exports | Total sales in foreign markets minus total imports. |
| Foreign Ownership | Dummy variable that takes the value of 1 if 100% of firm’s shares are owned by foreign residents, 0 otherwise. |
Variable Definitions and Sources
This appendix provides a summary of all variables used in the empirical analysis and a detailed description of the method of calculation. The firm-level, explanatory variables are constructed as follows: Flow variables are measured during the year of derivatives use (2004), and stock variables are measured at the beginning of the year (fiscal year end 2003). The source for balance sheet and income statement variables is Superintendencia Financiera and SuperSociedades. Data on firm-level exports and imports comes from Banco de la República.
| Variable Name | Variable Description |
| Size Dummies | To capture firm size, we sort the sample of firms into thirds based on the book value of firm’s total assets at year end 2003. Separate dummies are used for large-sized (top-third) and medium-sized (middle-third) firms. Small-sized firms is the excluded category. |
| Investment in Fixed Capital | Change in the real stock of net Property, Plant and Equipment during the year (using CPI as deflator) =[K(t)−K(t-1)]. |
| Investment to Total Asset ratio | [K(t) − K(t-1)] / Total Assets (t-1). |
| Leverage ratio | Total Liabilities over Total Assets. |
| Quick ratio | Current Assets over Current Liabilities. |
| Foreign Currency denominated Liabilities | Book value of financial debt denominated in foreign currency and contracted abroad. It is converted into local currency using the exchange rate for December. |
| Total Sales | Revenues from main operating activities. |
| Sector Affiliation | Sector is the industry in which the firm has its main operations, according to the one-digit ISIC rev2 classification to the one-digit ISIC 2 classification. |
| Net Exports | Total sales in foreign markets minus total imports. |
| Foreign Ownership | Dummy variable that takes the value of 1 if 100% of firm’s shares are owned by foreign residents, 0 otherwise. |
Paper prepared by Herman Kamil of the IMF and Ana Fernanda Maiguashca and David Perez Reina of the Banco de la República.
For the case of Colombia, see Lima, Montes, Varela and Wiegand (2005) and Etcheverry, Fergusson, Steiner and Aguilar (2003).
These exogenous costs can include, for example, the costs related to loss of long term relationships with suppliers and customers.
Two regulatory changes in 2000 encouraged the development of the derivatives markets. On the one hand, the Central Bank allowed credit institutions to use external borrowing to hedge their net exposure in forward markets. On the other hand, the Banking Superintendency imposed a 20 percent limit on the currency exposure of pension fund portfolios, forcing them to actively hedge their foreign investments.
Trading in the offshore market is in the form of NDFs and is not regulated. Tenors for this instrument are for up to one year. The NDF market for the peso is among the smaller ones within the Latin America, with an average daily turnover of US$50 million. Deals are executed in New York, with the tasa de cierre representiva del mercado (TRM) or closing market price rate on Reuters being used for settlement.
Papaioannou and Vicente (2006) examine the current structure and operations of hedging instruments and derivatives markets, and identify the main impediments to the development of these instruments and markets.
There are some other regulatory issues that create price distortions, such as the limits on net foreign currency exposure of pension funds.
A noticeable fact of Figure 7 is the huge and temporary increase in corporate trading activity in February 2005. That month, the government implemented a subsidy-scheme aimed at promoting the agricultural sector’s hedging of their net dollar assets. The government, through the agricultural ministry, provided COP$200 per dollar hedged to certain exported farming sectors. Rent-seeking behavior by many firms led to a spike in market’s turnover and in the number of transactions that month, which did not last beyond the period covered by the subsidy.
A long dollar position (net buyer of foreign exchange forwards) is one that benefits from the rise of the dollar during the horizon of the contract.
This data comes from SuperSociedades and SuperValores, two government agencies. The Appendix provides a detailed descritpion of sources and procedures to construct the database.
All firm-level analysis was handled within the Central Bank to ensure strict confidentiality of financial information.
Implicit in this construction are two assumptions: First, decisions to use derivatives (measured during 2004) are based on information available to the firm during 2004; second, actual flows in 2004 are the best proxy for management’s expectations in 2004.
Risk management involves fixed costs, such as foreign exchange personnel or computer system requirements, the unit cost of which can be reduced with firm size.
A 20 percent point increase in the independent variable “liability dollarization” is, for example, an increase from the mean value of this variable in the sample, which is 0.10, to 0.28. Given the estimated coefficient on liability dollarization, this 0.18 increase in the independent variable increases the left hand side by: 0.18*(0.21) = 0.038. The left hand-side variable is either “0’s” or “1’s”. Because approximately 36 percent of the observations in the sample are 1’s, a 0.038 change in the left hand side variable means that there is a increase in the probability of observing a 1 instead of a 0 (i.e. observing a firm taking a forward) of approximately (0.038/0.21)*100 = 18.1 percent.
Note that the hypothesis is that an exporter will be more likely to benefit from a depreciation and an importer will be more likely to be harmed by a depreciation.
All firm-level analysis was handled within the Central Bank to ensure strict confidentiality of financial information.
The NDF market interacts closely with the deliverable forward market in Colombia. There are no reporting requirements for this off-shore portion of the peso-dollar derivative market.
