Purpose The purpose of this paper is to identify the factors affecting firms' decision to use foreign exchange (FX) derivative instruments by using the data of 86 non‐financial firms listed on Karachi Stock Exchange for the period 2004‐2007. Design/methodology/approach Required data were collected from annual reports of listed firms of Karachi Stock Exchange. Non‐parametric test was used to examine the mean difference between users and non‐users operating characteristics. Logit model was applied to analyze the impact of firm's financial distress costs, underinvestment problem, tax convexity, profitability, managerial ownership and foreign exchange exposure on firms' decision to use FX derivative instruments for hedging. Findings Results explain that firms having higher foreign sales are more likely to use FX derivative instruments to reduce exchange rate exposure. Moreover, financially distressed large‐size firms with financial constraints and fewer managerial holdings are more likely to use FX derivatives. Research limitations/implications Incomplete financial instrument disclosure requirements restricted researchers to using binary variable as a dependent variable instead of notional value or fair value of derivative usage. Practical implications The study shows that in the presence of amateur derivative market, Pakistani corporations possessing higher agency costs of debt, agency costs of equity, and financial constraints will benefit more by defining hedging policies coherent with the firm's investment and financing policies in order to enhance firm value. Originality/value Until now, no earlier empirical study focused on the determinants of a firm's hedging policies in Pakistan, in the presence of volatile exchange rates,. The current study, therefore, attempts to identify the factors which affect the firm's decision to use derivative instruments for hedging FX exposure of non‐financial firms in Pakistan.
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