Empirical evidence on the incentives to hedge transaction and translation exposure

We investigate Swedish firms’ use of financial hedges to reduce their foreign exchange exposure for 1997–2001. The study uses survey data, which enables us to differentiate between hedging aimed at translation exposure and transaction exposure, respectively. The survey responses show that more than 50% of the firms employ financial hedges and that transaction exposure is more frequently hedged than translation exposure. We find that the likelihood of using financial hedges is increasing with firm size and exposure and that liquidity constraints are important in explaining transaction exposure hedging. Importantly, we find that the existence of loan covenants explains translation exposure hedging. This suggests that firms hedge translation exposure in order to prevent costly violations of loan covenants.