Effects of foreign currency debt on leverage adjustments and investment decisions

• Grant number: 23/13155-4
• Support Opportunities: Scholarships abroad - Research Internship - Doctorate
• Effective date (Start): January 15, 2024
• Effective date (End): July 31, 2024
• Field of knowledge: Applied Social Sciences - Administration - Business Administration
• Principal Investigator: Rafael Felipe Schiozer
• Grantee: Guilherme Freitas Cardoso
• Supervisor: Andy Naranjo
• Host Institution: Escola de Administração de Empresas de São Paulo (EAESP). Fundação Getúlio Vargas (FGV). São Paulo , SP, Brazil
• Research place: University of Florida, Gainesville (UF), United States
• Associated to the scholarship: 22/15226-3 - Effects of foreign currency debt on leverage adjustments and investment decisions, BP.DR

Abstract

Firms' foreign exchange rate exposure imposes transaction costs on corporate financing, investment, and risk management decisions. Identifying the main channels through which exchange rate fluctuations exert an impact on the firm's decisions is of great importance for company managers who want to assess the result of their past choices and make further decisions about different aspects of their firm, such as forms of financing, risk management and choice of investment projects. This thesis aims to understand the effects of corporate foreign borrowing on firms' financing and investment decisions. In our model, foreign currency volatility acts as a moderate effect on firms' financial decisions. We begin by analyzing firms' leverage adjustments across countries and investigate whether exchange rate fluctuations help explain the variance in estimated adjustment speeds. Empirical evidence shows that foreign currency borrowing substantially affects the endogenous decision to adjust leverage. We found that debt in foreign currency significantly correlates with firm adjustment speeds through exchange rate volatility, consistent with the hypothesis that more stable economies lower the transaction costs associated with adjusting a firm's leverage due to lower currency volatility. More narrowly, hedge positions are the instruments used by firms in developed economies to deal with exchange fluctuations due to lower costs and more developed financial markets. In emerging markets, debt in foreign currency is used in matching positions with exports, working as operational hedging, but the effect is limited. The adjustments toward target leverage vary with the marginal cost of implementing leverage changes, consistent with the widely used partial adjustment model due to the exchange rate affecting leverage exogenously. Finally, we explore the effect of exchange rate exposure as a result of imperfect currency matching by markets that leads to carry trade positions. The moderating effect of these financing frictions is the finite duration of favorable financing conditions - such as uncovered interest rate parity deviations - combined with the financing costs firms incur when they access debt markets. We aim to examine the effects of interest rate differentials and uncovered interest rate parity deviations on investment decisions to check whether firms are hedging future financing frictions or timing the market when selecting the currency exposure of their debt issuances. (AU)