We study the impact of corporate governance on foreign exchange risk management by using a large-scale natural experiment, the adoption of the Sarbanes-Oxley (SOX) Act of 2002 and its sweeping governance changes on US listed companies. The paper is novel in using comprehensive measures of the governance changes induced by the SOX mandates and their staggered implementation; thus, it allows for a sharper identification of the causal effect, via a difference-in-difference approach, than has been attempted earlier. This investigation is of interest in light of ambiguous theory views on the question how improvements in corporate governance standards should impact managers’ hedging decisions. One view suggests that managers tend to hedge too little due to agency problems, and reduce corporate risk when exposed to more stringent governance rules. In the opposite view, managers tend to be imperfectly diversified or overly risk-averse, and hence ‘overhedge’ in the absence of oversight looking out for shareholders’ interests; stronger governance will then lead to less hedging. There is substantial empirical evidence to support either point of view.
Our sample starts out with all listed US firms in the Russell 1000 index, and after various filters arrives at a balanced panel of 507 US non-financial firms over the period 2000 to 2007. We deploy a dual measure of corporate hedging, the exposure to foreign exchange rate movements as a comprehensive measure on one hand, and the use of foreign exchange derivatives to ensure that the observed changes are intentional on the other hand. We use a comprehensive index of 41 measures describing the quality of corporate governance. To strengthen the identification, we also extract two subindexes of the exogenous governance reforms, those that were mandated by the SOX reform or are most directly related to it.
We find that foreign exchange exposure is smaller and the use of foreign exchange derivatives is greater for firms that adopted a better quality governance, as measured by our set of governance indexes. The economic magnitude of the effect is substantial: according to our coefficient estimates, the median increase in the 41 governance attributes that we observe in our sample between 2002 and 2007 leads to a 17.1% decrease in foreign exchange exposure and a 14.8% increase in the probability of derivatives use. The reaction is much stronger in response to the subindexes of the exogenous governance reforms, and most of the economic effects can be attributed to them. Our findings are consistent with the notion that a weak governance environment is associated with insufficient attention to risk management – rather than ‘overhedging’ by managers acting in their own interests.
Exploring the dynamic evolution of hedging, we find that the governance reforms have a lasting impact on foreign exchange risk exposure. We also find a subtle but clear difference in the way how the increased use of derivatives is deployed: the increase in derivatives use is immediate but then recedes, consistent with derivatives being partially replaced by other techniques such as operational hedges. We confirm the robustness of our results with the use of various other subindexes and a dynamic panel generalized method of moments estimator that further addresses endogeneity concerns.