An Intertemporal International Asset Pricing Model: Theory and Empirical Evidence

We extend Campbell's (1993) model to develop an intertemporal international asset pricing model (IAPM). We show that the expected international asset return is determined by a weighted average of market risk, market hedging risk, exchange rate risk and exchange rate hedging risk. These weights sum up to one. Our model explicitly separates hedging against changes in the investment opportunity set from hedging against exchange rate changes as well as exchange rate risk from intertemporal hedging risk. A test of the conditional version of our intertemporal IAPM using a multivariate GARCH process supports the asset pricing model. We find that the exchange rate risk is important for pricing international equity returns and it is much more important than intertemporal hedging risk.     

Board Composition And Corporate Use Of Interest Rate Derivatives

We provide new evidence on the motives for corporate hedging by examining the relation between the quality of the firms' monitoring mechanisms and the quantity of interest rate derivatives employed. Because the capital structure decision and hedging decision are considered to be endogenous, the firm's capital structure and level of interest rate derivative use are modeled simultaneously. We show a positive relation between the relative influence of outside directors and the quantity of derivatives used. This evidence indicates that outside directors take an active role in derivatives usage and that firms employ hedging in the shareholders' best interests.     

Noise, equity prices, and hedging: A new approach

The existence of noise trading in equity markets has possible economic implications for arbitrage, and asset pricing. In terms of pricing, noise trading can lead to excess volatility which has been shown to influence the value of options and futures. Furthermore, option research shows that modeling volatility leads to improved hedging performance. To this end, we derive a general hedging model for equity index futures in the presence of noise trading. Our analysis shows how the level and dynamics of noise trading should influence a hedger's behavior. Finally, we empirically test our model using the NASDAQ-100 index futures and FTSE 100 index futures over the period of January 1998 to May 2003.     

Limits to arbitrage and hedging: Evidence from commodity markets

We build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases in producers' hedging demand or speculators' capital constraints increase hedging costs via price-pressure on futures. These in turn affect producers' equilibrium hedging and supply decision inducing a link between a financial friction in the futures market and the commodity spot prices. Consistent with the model, measures of producers' propensity to hedge forecasts futures returns and spot prices in oil and gas market data from 1979 to 2010. The component of the commodity futures risk premium associated with producer hedging demand rises when speculative activity reduces. We conclude that limits to financial arbitrage generate limits to hedging by producers, and affect equilibrium commodity supply and prices.     

Financial distress and corporate risk management: Theory and evidence

This paper extends the current theoretical models of corporate risk-management in the presence of financial distress costs and tests the model's predictions using a comprehensive data set. I show that the shareholders optimally engage in ex-post (i.e., after the debt issuance) risk-management activities even without a pre-commitment to do so. The model predicts a positive (negative) relation between leverage and hedging for moderately (highly) leveraged firms. Consistent with the theory, empirically I find a non-monotonic relation between leverage and hedging. Further, the effect of leverage on hedging is higher for firms in highly concentrated industries.     

Heterogeneity in the Effect of Managerial Equity Incentives on Firm Value

We document significant heterogeneity in the relation between chief executive officer (CEO) equity incentives and firm value using quantile regression. We show that CEO delta is more effective in the presence of ample investment opportunities, while CEO vega is more beneficial for firms lacking investment opportunities. Further, Tobin's Q increases in CEO delta for more risk‐tolerant firms but increases in CEO vega for more risk‐averse firms. We also observe that higher monitoring intensity after the Sarbanes‐Oxley Act reduces CEO delta's role in compensation. Risk aversion alters the optimal incentive‐value relation, and the nature of this relation also depends on the level of Tobin's Q.     

Robustly Hedging Variable Annuities With Guarantees Under Jump and Volatility Risks

Recent variable annuities offer participation in the equity market and attractive protection against downside movements. Accurately quantifying this additional equity market risk and robustly hedging options embedded in the guarantees of variable annuities are new challenges for insurance companies. Due to sensitivities of the benefits to tails of the account value distribution, a simple Black–Scholes model is inadequate in preventing excessive liabilities. A model which realistically describes the real world price dynamics over a long time horizon is essential for the risk management of the variable annuities. In this article, both jump risk and volatility risk are considered for risk management of lookback options embedded in guarantees with a ratchet feature. We evaluate relative performances of delta hedging and dynamic discrete risk minimization hedging strategies. Using the underlying as the hedging instrument, we show that, under a Black–Scholes model, local risk minimization hedging can be significantly better than delta hedging. In addition, we compare risk minimization hedging using the underlying with that of using standard options. We demonstrate that, under a Merton's jump diffusion model, hedging using standard options is superior to hedging using the underlying in terms of the risk reduction. Finally, we consider a market model for volatility risks in which the at‐the‐money implied volatility is a state variable. We compute risk minimization hedging by modeling at‐the‐money Black–Scholes implied volatility explicitly; the hedging effectiveness is evaluated, however, under a joint model for the underlying price and implied volatility. Our computational results suggest that, when implied volatility risk is suitably modeled, risk minimization hedging using standard options, compared to hedging using the underlying, can potentially be more effective in risk reduction under both jump and volatility risks.     

Coberturas financieras con derivados y su incidencia en el valor de mercado en empresas colombianas que cotizan en Bolsa

The financial theory (Modigliani & Miller, 1958) rises that risk management was not an issue for companies because shareholders could make their own hedging management through portfolio diversification; however, further studies conflict with that statement and show that corporate financial hedging improves performance and increases the value thereof (Ahmed, Azevedo, & Guney, 2014; Allayannis & Weston, 2001; Allayannis & Ofek, 1998). Efficient management of market risks, which is based on the use of financial derivatives, demands strategic and efficient managers in hedging that adds value to the firm, especially in against shocks and imbalances from a macroeconomic and financial nature. Empirical evidence analyzes the performance of the Q-Tobin as an indicator of the effect of hedging strategies of exchange rate associated to the market value. This paper aims to find evidence in Colombia on the effect of using derivatives in the market value of the firm. Its added value lies in the analysis made by economic sectors, identified by CIIU codes and grouped into 5 sectors (Agricultural, Commercial, Industrial or Manufacturing, Services and Construction). The methodology includes several models estimating regression panel data, using a Pooled regression with estimators of fixed and random effects by maximum likelihood estimator. In general, it was found a premium due to hedging, statistically and financially significant, for companies exposed to exchange rate risks that use derivatives by an average of 6.3% on the market value. Moreover, mixed results were found regarding the analyzed variables in the model.     

Cross hedging under multiplicative basis risk

Cross hedging price risk in an incomplete financial market creates basis risk. We propose a new way of modeling basis risk where price risk and basis risk are combined in a multiplicative way. Under this specification, positive prudence is a necessary and sufficient condition for underhedging in an unbiased market. Using the example of cross hedging jet fuel price risk with crude oil futures, we show that the new specification is superior in describing the price series and that optimal cross hedges differ significantly from those derived under the traditional additive cross hedging model.     

Managerial Stock Options and the Hedging Premium

Previous studies have found mixed evidence on whether hedging increases firm value. Some studies have shown that managerial incentives may influence firm hedging. In this paper we provide evidence that when hedging is based upon incentives from managers' options, firm value decreases.     

Hedging,Financing and Investment Decisions: A Simultaneous Equations Framework

We empirically investigate the interactions among hedging, financing, and investment decisions. We argue that the way in which hedging affects a firm's financing and investing decisions differs for firms with different growth opportunities. We find that high growth firms increase their investment, but not leverage, by hedging. However, we also find that firms with few investment opportunities use derivatives to increase their leverage.     

Does multinationality matter? Implications of operational hedging for the exchange risk exposure

An important issue in global corporate risk management is whether the multinationality of a firm matters in terms of its effect on exchange risk exposure. In this paper, we examine the exchange risk exposure of US firms during 1983–2006, comparing multinational and non-multinational firms and focusing on the role of operational hedging. Since MNCs and non-multinationals differ in size and other characteristics, we construct matched samples of MNCs and non-multinationals based on the propensity score method. We find that the multinationality in fact matters for a firm’s exchange exposure but not in the way usually presumed – the exchange risk exposures are actually smaller and less significant for MNCs than non-multinationals. The results are robust with respect to different samples and model specifications. There is evidence that operational hedging decreases a firm’s exchange risk exposure and increases its stock returns. The effective deployment of operational risk management strategies provides one reason why MNCs may have insignificant exchange risk exposure estimates.     

CBDC uncertainty: Financial market implications

The current state of the art in the central bank digital currency (CBDC) literature views indexes constructed from digital currency news to be fully informed about CBDC uncertainty and its impact on the financial system. We argue that the hedging behavior of participants in the currency futures market could be more informative than CBDC uncertainty news in the presence of limited risk absorption capacity in futures markets. We show that the hedging factor has a statistically significant effect on financial market risk aversion and measures of uncertainty. The hedging behavior of currency futures market participants is informative of agents' reactions to the news and central bank policies around CBDC. Our results also show that CBDC uncertainty is a significant risk transmitter in the financial system. Hence, this characteristic makes the hedging factor even more important because it can directly impact risk aversion via its moderating effects, which later influence CBDC uncertainty.     

Hedging,financing, and investment decisions: Theory and empirical tests

In this paper we theoretically and empirically examine the interaction between hedging, financing, and investment decisions. A simple equilibrium model with costly financial distress suggests that as firms become more efficient at risky investments vis a vis low risk investments, they will borrow less, invest more in risky assets, and hedge more. The model also predicts a positive relationship between hedging and leverage – a result consistent with debt capacity arguments. We test the model empirically using a simultaneous equations framework to investigate the determinants of firm-level hedging, financing and investing decisions. The results strongly support the hypothesis that the hedging, financing and investment decisions are jointly determined. In addition, we find strong support for the central hypothesis that firms more efficient investing in risky technologies more aggressively hedge and use less debt financing in order to maximize their comparative advantage.     

KNOW YOUR CLIENT! INVESTOR PROFILE AND TAILOR‐MADE ASSET ALLOCATION RECOMMENDATIONS

We study how the investor profile influences the asset allocation recommendations of professional advisors. We find the investor's perceived risk attitude influences more the mix of risky assets, whereas the socioeconomic variables influence more the cash percentage. The recommendations are consistent with a diversification behavior driven by actual asset correlations. These findings support the utility of investor advisory that may help enhance the risk and return trade‐off. The main drawback of the recommendations may consist in the degree of customization that is limited by the small number of investor characteristics actually influencing the asset allocation.     

Discerning the Impact of Derivatives on Asset Risk: The Case of Canadian Banks

The Canadian banks have shown remarkable resilience to the financial crisis that intensified in the late 2008. The interesting question is whether this stability is due to their prudent lending practices to limit the original risk exposures or due to effective risk management through hedging by using financial derivatives. In this paper, we implement the option‐theoretic model of Merton to calculate the implied asset risk and discern the impact of these derivatives on the aggregate risk for Canadian banks over the period 1997–2008. An algorithm of iterative procedure is developed to impute asset value and risk from bank stock prices. Our estimates show that the risk for Canadian banks is low and even decreasing till the unfolding of the recent crises in 2008. Further analyses reveal that such low risks are not due to reliance on hedging, nor is it related to trading in derivatives, after disentangling the intertwined effects of hedging and trading. These results suggest that involvements in derivatives, in and of themselves, should not be blamed for causing the bank crises; rather, it is conservatism in controlling original risk exposures that remains fundamental for safeguarding a healthy financial system.     

Production and hedging implications of executive compensation schemes

This paper connects executive compensation with hedging and analyzes a crucial shareholders and managers agency source that evolves from the pricing of the hedging device. The shareholders are risk-neutral, while the risk-averse manager hedges the price risk of the manufactured quantity, and his compensation package includes equity-linked compensation-stock grants. Only when the hedging instrument's pricing includes a risk premium, hedging is costly to the shareholders, while it is costless to the manager. Then from the owners' point of view, we observe managerial over-hedging, increasing in the equity-linked compensation level. This result leads to a violation of the classical production and hedging separation theorem. We conclude that, in the case where the hedging device's pricing bears a risk premium, shareholders can regulate the corporate value diversion to managers through diminishing the managerial equity-linked compensation scheme or by putting restrictions on the extent of hedging activities of executives.     

Individual investor perceptions and behavior during the financial crisis

Combining monthly survey data with matching trading records, we examine how individual investor perceptions change and drive trading and risk-taking behavior during the 2008–2009 financial crisis. We find that investor perceptions fluctuate significantly during the crisis, with risk tolerance and risk perceptions being less volatile than return expectations. During the worst months of the crisis, investors’ return expectations and risk tolerance decrease, while their risk perceptions increase. Towards the end of the crisis, investor perceptions recover. We document substantial swings in trading and risk-taking behavior that are driven by changes in investor perceptions. Overall, individual investors continue to trade actively and do not de-risk their investment portfolios during the crisis.     

How fair-value accounting can influence firm hedging

The potential influence of accounting regulations on hedging strategies and the use of financial derivatives is a research topic that has attracted little attention in both the finance and the accounting literature. However, recent surveys suggest that company hedging can be substantially influenced by the accounting for financial instruments. In this study, we illustrate not only why but also how the accounting regulations may affect hedging behavior. We find that under mark-to-market accounting, most firms concerned with earnings smoothness adopt myopic hedging strategies relative to the benchmark, cash flow hedging. The specific influence of the accounting regulations depends on market and firm-specific characteristics, but, in general, the firms dramatically reduce the extent of hedging addressing price risk in future accounting periods. We illustrate that the change in hedging behavior significantly dampens the increase in earnings volatility stemming from fair value accounting of derivatives. However, the adjusted hedging strategies may substantially increase the firms’ cash flow volatility.     

Risk and return in convertible arbitrage: Evidence from the convertible bond market

In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds (“CBs”) while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-of-sample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.