The instruments CFOs use to smooth their earnings may also be quietly funding their next decade of innovation, argues Dr Sapnoti Eswar, Senior Lecturer at the University of St Andrews Business School.
Ask most boards why they hedge foreign exchange risk, and the answer tends to be a version of the same: to prevent currency swings from distorting quarterly numbers. Hedging is filed under defense, alongside insurance, as a cost the business accepts to make bad outcomes a little less bad. That view is not wrong, but it is incomplete, and the part it leaves out is precisely the part that ought to interest any finance leader thinking about growth.
In research I conducted with Dr. Lora Dimitrova of the University of Exeter Business School, published in Research Policy, we find that when firms use hedging instruments to smooth their earnings, they also expand the scope of what they can build. Companies that hedged their currency exposure went on to produce around 12 percent more patents than comparable firms that did not. Hedging, in other words, is not only a way to protect this year’s results; it is also a way to fund the products that will define the business a decade from now.
Some may say that more patents can lead to more hedging. That may be true – firms that produce more patents have more financial resources, giving them the slack needed to pay the costs of hedging. But we isolate the precise effect of hedging on patenting by using a natural experiment. In 1987, the International Swaps and Derivatives Association (ISDA) released its Master Agreement, which standardized derivative contracts and sharply reduced the legal and transaction costs of hedging, effectively lowering the price of risk management. Firms already carrying significant currency exposure had every reason to take advantage of that change, while firms without such exposure had little reason to act.
Comparing the two groups before and after the agreement reveals a clear pattern. Firms with high pre-1987 exposure increased their use of FX derivatives and then increased their patent output, both in volume and in quality, as measured by citations. The effect did not appear straight away, but emerged from the third year onward, which is consistent with the lag you would expect between committing money to research and seeing a granted patent come out at the other end. That delay matters because it is the mark of genuine investment working its way through the business rather than a statistical quirk.
The mechanism behind the result is cash flow. Research and development are the most exposed line in the budget precisely because it is discretionary and can take years to deliver returns. When a currency move opens a gap in a given quarter, the multi-year research program becomes an obvious candidate for cuts, even though cutting it is usually the wrong decision for the long term. By capping that downside, hedging removes the macroeconomic shock as a reason to raid the innovation budget in the first place.
That stability shows up in the financing decisions that follow. In the years after they began hedging, the firms in our sample did not simply protect their existing budgets. They raised additional debt, reduced debt repayments, issued more equity, and increased spending on research and development. Hedging, in effect, widened their access to capital and gave them the confidence to commit it to projects that take years to pay off.
The benefit is not evenly distributed. Our results are strongest among firms that find it expensive or difficult to raise equity, typically because outside investors struggle to value what is happening inside the business. A company whose value largely rests in intangible research, rather than in physical assets that a lender can easily assess, often faces what economists call equity rationing: capital is available, but only at a price that discourages investment. For a firm like this, a poor quarter in the currency markets can be the difference between continuing a critical project and shelving it. Stabilizing cash flow gives it the room to keep going, which is why the innovation effect we measured is concentrated among exactly these constrained, research-intensive businesses.
This is worth emphasizing because it inverts a common assumption. Hedging is often treated as a tool for large, sophisticated treasuries with the scale to run an active program. Our findings suggest that the firms with the most to gain in terms of innovation are frequently the smaller, harder-to-finance ones, for which a stable cash flow is not a convenience but a precondition for investing at all.
One result is worth stating plainly rather than dressing up. Hedging did not turn cautious firms into prolific risk-takers. The additional innovation was overwhelmingly incremental, taking the form of steady improvement to existing products and processes rather than radical departures into the unknown. The firms in question did not become bolder, but they did become better at sustaining the work they were already good at.
Incremental innovation is the quiet engine of long-term growth, and for most established businesses it is where the returns actually come from: the successive refinements that keep a flagship product competitive, and the process improvements that protect margins year after year. A stable financial base lets a company keep compounding those gains instead of interrupting them every time the currency market moves against it.
None of this is a historical curiosity. If anything, the mechanism is more relevant now than in the 1980s, given that corporate revenues and supply chains are far more international, and that modern hedge accounting under IFRS 9 has made it easier to align risk management with transparent reporting. Recent disclosures by several companies point to a direct link between risk management and innovation. Apple has raised its FX hedge ratio from 48 to 80 percent to protect its strategic investments; Adobe has expanded its hedge book specifically to shield research and development from a strong dollar; and Merck has long used currency options so that exchange-rate volatility does not force it to underfund clinical trials. Active FX hedging is now the norm rather than the exception among large corporates, and a growing share of firms in emerging markets are following suit as their currencies become more volatile.
The honest caveat we would attach to our own work is that the precise magnitudes belong to the period we studied, which combined a coordinated effort to weaken the dollar with a particular pattern of corporate hedging. The underlying logic, however, travels well beyond that window.
The reframing for finance leaders is therefore straightforward. Derivatives are not simply a tool for keeping the earnings line well-behaved. Used deliberately, they are a means of protecting the innovation pipeline and a way of assuring research teams that a swing in the currency markets will not cost them their funding. The question a board should ask is not only how much volatility its hedging program removes from reported earnings, but also how much long-term investment that same stability enables. Seen in that light, a hedging policy is not a defensive posture at all. It is part of how a company decides where its future lies.
