Linking governance quality and derivatives use: Insights from firms' hedging behavior

We examine the link between country governance quality and firm’s use of derivatives. The analysis is based on a novel and manually collected data. Our panel data covers the 2003 – 2013 period, and includes 881 non-financial firms across 8 East Asian countries consisting of developed countries (Japan), newly industrialized countries (China, Singapore, Hong Kong), and emerging markets (Thailand, Philippines, Indonesia, Malaysia). We find a significant link between governance mechanism, corruption levels and the use of derivatives. Firms located in highly corrupt countries are more likely to use derivatives, but firms in countries with lower corruption use derivatives more intensively. Firms in countries with better governance use derivatives to hedge exposures and mitigate their tax burdens, bankruptcy and financial distress costs - while firms in weakly governed countries use derivatives for selective hedging. We also notice that firms are more likely to use derivatives and use derivatives at a greater extent when they are located in countries with lower economic, financial and political risks. Flexible exchange rate regimes encourage non-financial firms to use derivatives. Further, we find that effects of country-specific factors vary across different types of derivatives. Country-level characteristics are significant determinants of foreign currency and interest rate derivatives use, but they do not touch firms’ decisions on using commodity price derivatives, as the use of these derivatives is mostly industry-specific. Overall, our findings strongly evidence that heterogeneity in the economic, political and social environments of a country plays a key role in the firms’ behaviours of using derivatives. This macro-based effect on derivatives use is independent from firm-specific factors, which are frequently invoked by hedging theories.