WHY MOST FIRMS CHOOSE LINEAR HEDGING STRATEGIES

I investigate the efficiency of alternative hedging strategies of nonfinancial firms facing hedgeable price risk, unhedgeable quantity risk, and financial contracting costs in low-profit events. The analysis suggests that variance-minimizing hedging strategies are very close in economic terms to optimal, value-maximizing hedging strategies for most firms. Furthermore, the marginal gains from shifting to nonlinear hedging strategies are often small enough to be neglected. These results illuminate some puzzling findings in survey studies of firms' hedging practices and suggest an alternative view on firms' selective hedging practices termed "cautious selective hedging."     

Corporate hedging versus risk-shifting in financially constrained firms: The time-horizon matters!

The paper presents an intertemporal theory of the optimal risk policy in shareholder-managed firms, which face future financing constraints and act under moral hazard as well as limited liability. Our model provides an integrated framework that overcomes the dilemma of “conflicting motives” of risk-shifting (Jensen and Meckling, 1976) on the one hand and corporate hedging (Smith and Stulz, 1985) on the other hand by considering time-effects. Shareholders face a trade-off between a risk-shifting incentive if the investment horizon is short, and a hedging incentive that becomes dominant if the investment horizon is sufficiently long. Within an infinite-time investment horizon, Jensen and Meckling's risk incentive problem can be fully solved as permanent hedging is optimal except for firms in financial distress, which constantly opt for risk-shifting. We further show that the value of corporate hedging increases if financing constraints become more severe. Our results suggest that life-cycle features play a significant role in the firm's propensity to hedge. They also coincide with existing empirical evidence, which shows that only highly leveraged firms facing financial distress will primarily opt for risk-shifting.     

Corporate Risk Management under Information Asymmetry

This paper examines the financial and operational hedging activities of US pharmaceutical and biotech firms that are subject to a high level of information asymmetry stemming from R&D investments during 2001–2006. We find evidence in support of the information asymmetry hypothesis à la Froot, Scharfstein and Stein (1993) that hedging helps mitigate the under‐investment problem. Specifically, we find that the use of financial derivatives is associated with greater firm value and that the value enhancement is larger for firms subject to greater information asymmetry and better growth opportunities. There is a synergy between financial hedging and operational hedging where the latter is used to counter product development risk. The results are robust with respect to alternative performance measures, industry‐specific growth measures, and the endogeneity problem. Our work is differentiated from existing studies that examined commodity‐based industries without addressing information asymmetry.     

An approximate distribution of delta-hedging errors in a jump-diffusion model with discrete trading and transaction costs

We introduce a jump-diffusion model for asset returns with jumps drawn from a mixture of normal distributions and show that this model adequately fits the historical data of the S&P500 index. We consider a delta-hedging strategy (DHS) for vanilla options under the diffusion model (DM) and the proposed jump-diffusion model (JDM), assuming discrete trading intervals and transaction costs, and derive an approximation for the probability density function (PDF) of the profit-and-loss (P&L) of the DHS under both models. We find that, under the log-normal model of Black–Scholes–Merton, the actual PDF of the P&L can be well approximated by the chi-squared distribution with specific parameters. We derive an approximation for the P&L volatility in the DM and JDM. We show that, under both DM and JDM, the expected loss due to transaction costs is inversely proportional to the square root of the hedging frequency. We apply mean–variance analysis to find the optimal hedging frequency given the hedger's risk tolerance. Since under the JDM it is impossible to reduce the P&L volatility by increasing the hedging frequency, we consider an alternative hedging strategy, following which the P&L volatility can be reduced by increasing the hedging frequency.     

Is operational hedging a substitute for or a complement to financial hedging?

This paper investigates operational hedging by firms and how operational hedging is related to financial hedging by using a sample of 424 firm observations, which consist of 212 operationally hedged firms (firms with foreign sales) and a size- and industry-matched sample of 212 non-operationally hedged firms (firms with export sales). We find that non-operationally hedged firms use more financial hedging, relative to their levels of foreign currency exposure, as measured by the amount of export sales. On the other hand, though operationally hedged firms have more currency exposure, their usage of financial derivatives becomes much smaller than that of exporting firms. These results can explain why some global firms use very limited amount of financial derivatives for hedging purpose despite much higher levels of currency risk exposure. We also show that hedging increases firm value.     

Corporate Hedging: The Relevance of Contract Specifications and Banking Relationships

This article examines the contribution of hedging to firm value and the cost of hedging in a unified framework. Optimal hedging and firm value are explicitly linked to firm risk, the type of debt covenants and the relative priority of the hedging contract. It is shown that in some cases hedging is possible only if the counterparty to the forward contract also holds a significant portion of the debt. Also, the spread in the hedging contract reduces the optimal amount of hedging to less than the minimum-variance hedge ratio. Among other results this article elucidates why some firms hedge using forward contracts while other firms hedge in the futures markets, as well as why higher priority forward contracts are more efficient hedging vehicles.     

Risk management strategies for banks

We analyze optimal risk management strategies of a bank financed with deposits and equity in a one period model. The bank’s motivation for risk management comes from deposits which can lead to bank runs. In the event of such a run, liquidation costs arise. The hedging strategy that maximizes the value of equity is derived. We identify conditions under which well known results such as complete hedging, maximal speculation or irrelevance of the hedging decision are obtained. The initial debt ratio, the size of the liquidation costs, regulatory restrictions, the volatility of the risky asset and the spread between the riskless interest rate and the deposit rate are shown to be the important parameters that drive the bank’s hedging decision. We further extend this basic model to include counterparty risk constraints on the forward contract used for hedging.     

Corporate reputation and hedging activities

This study examines whether corporate reputation affects derivative hedging. We posit that high-reputation firms are more likely to engage in hedging due to greater reputation costs and/or their commitment to lower financial risks. We find that high-reputation firms are more likely to engage in hedging, especially when their hedging efforts or effects are more observable to stakeholders. We also find that high-reputation firms are less likely to disclose the notional values of hedging positions and that interest rate hedging by high-reputation firms is detrimental to firm value. Our results shed light on the impact of reputational concerns on corporate risk management and disclosure policies.     

Commodity futures hedging,risk aversion and the hedging horizon

This paper examines the impact of management preferences on optimal futures hedging strategy and associated performance. Applying an expected utility hedging objective, the optimal futures hedge ratio is determined for a range of preferences on risk aversion, hedging horizon and expected returns. Empirical results reveal substantial hedge ratio variation across distinct management preferences and are supportive of the hedging policies of real firms. Hedging performance is further shown to be strongly dependent on underlying preferences. In particular, hedgers with high risk aversion and short horizon reduce hedge portfolio risk but achieve inferior utility in comparison to those with low aversion.     

Corporate hedging and the cost of debt

For a large sample of U.S. firms from 1994 to 2009, we empirically examine the impact of corporate hedging on the cost of public debt. We find strong evidence that hedging is associated with a lower cost of debt. The negative effect of hedging on the cost of debt is consistent across industries, and remains economically and statistically significant under various controls and econometric specifications. A cross-sectional analysis based on propensity score matching suggests that hedging initiation firms experience a drop in cost of debt, while suspension firms sustain a jump. We confirm our findings after employing an extensive array of models to address potential endogeneity. The influence of hedging on cost of debt is mainly through the lowering of bankruptcy risk and agency cost, and the reduction in information asymmetry. Finally, hedging mitigates the negative effect of rising borrowing costs on capital expenditure and firm value.     

Hedging and competition

We consider firms that, all else equal, wish to minimize variability in their internal capital (due to convex costs of raising external funds). The firms can hedge the cash flow risk of the project, but not that of winning or losing the auction. We characterize optimal hedging and bidding strategies in this competition framework. We show that access to financial markets makes firms bid more aggressively, possibly even above their valuation for the project. In addition, hedging increases the variance of bids and makes firm values more dispersed. Further, with hedging, the covariance of internal capital changes with the risk factor is negative, and is more negative, the higher the correlation of the hedging instrument with the risk factor.     

The impact of hedging on the market value of equity

We examine the annual stock performance of firms that disclose the use of derivatives to hedge over the period 1995 to 1999. We find that only 21.6% of publicly traded U.S. corporations in our sample hedged with derivative instruments over this period and their use is concentrated in the larger companies. Similar to other studies we find that when derivatives are used, interest rate and currency securities are used much more frequently than commodity products. Our sample of 1308 companies that hedge outperforms other securities by 4.3% per year on average over our sample period. This result is robust to several alternative methods of estimating abnormal returns. When we segment performance by the type of hedge used, however, we find that the over-performance is due entirely to larger firms that hedge currency. We find no abnormal returns for firms hedging either interest rates or commodities. The abnormal returns in firms hedging currency is robust to alternative models that seek to control for exchange rate fluctuations and global equity returns; however, we find no significant abnormal returns to currency hedgers when using an augmented model that controls for the role of intangible assets.     

Does Fair Value Reporting Affect Risk Management? International Survey Evidence

We survey CFOs from 36 countries to examine whether and how firms altered their risk management policies when fair value reporting standards for derivatives were introduced. A substantial fraction of firms (42%) state that their risk management policies have been materially affected by fair value reporting. Firms are more likely to be affected if they seek to use risk management to reduce the volatility of earnings relative to cash flows and if they operate in countries where accounting numbers are more likely to be used in contracting. We document a substantial decrease in foreign exchange hedging and in the use of nonlinear hedging instruments. Finally, firms that take active positions are more likely to be affected by fair value reporting. Taken together, our evidence indicates that requirements to report derivatives at fair values have had a material impact on derivative use; while speculative activities have been reduced, sound hedging strategies have been compromised as well.     

Corporate Hedging: The Relevance of Contract Specifications and Banking Relationships

This article examines the contribution of hedging to firm valueand the cost of hedging in a unified framework. Optimal hedgingand firm value are explicitly linked to firm risk, the typeof debt covenants and the relative priority of the hedging contract.It is shown that in some cases hedging is possible only if thecounterparty to the forward contract also holds a significantportion of the debt. Also, the spread in the hedging contractreduces the optimal amount of hedging to less than the minimum-variancehedge ratio. Among other results this article elucidates whysome firms hedge using forward contracts while other firms hedgein the futures markets, as well as why higher priority forwardcontracts are more efficient hedging vehicles. JEL Classificationnumbers: G13, G22 and G33.     

Optimal hedging for fund and insurance managers with partially observable investment flows

All financial practitioners are working in incomplete markets full of unhedgeable risk factors. Making the situation worse, they are only equipped with imperfect information on the relevant processes. In addition to the market risk, fund and insurance managers have to be prepared for sudden and possibly contagious changes in the investment flows from their clients so that they can avoid the over- as well as under-hedging. In this work, the prices of securities, the occurrences of insured events and (possibly a network of) investment flows are used to infer their drifts and intensities by a stochastic filtering technique. We utilize the inferred information to provide the optimal hedging strategy based on the mean-variance (or quadratic) risk criterion. A BSDE approach allows a systematic derivation of the optimal strategy, which is shown to be implementable by a set of simple ODEs and standard Monte Carlo simulation. The presented framework may also be useful for manufacturers and energy firms to install an efficient overlay of dynamic hedging by financial derivatives to minimize the costs.     

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.     

Optimal static quadratic hedging

We propose a flexible framework for hedging a contingent claim by holding static positions in vanilla European calls, puts, bonds and forwards. A model-free expression is derived for the optimal static hedging strategy that minimizes the expected squared hedging error subject to a cost constraint. The optimal hedge involves computing a number of expectations that reflect the dependence among the contingent claim and the hedging assets. We provide a general method for approximating these expectations analytically in a general Markov diffusion market. To illustrate the versatility of our approach, we present several numerical examples, including hedging path-dependent options and options written on a correlated asset.     

Hedging the value of waiting

We analyze the optimal hedging policy of a firm that has flexibility in the timing of investment. Conventional wisdom suggests that hedging adds value by alleviating the under-investment problem associated with capital market frictions. However, our model shows that hedging also adds value by allowing investment to be delayed in circumstances where the same frictions would cause it to commence prematurely. Thus, hedging can have the paradoxical effect of reducing investment. We also show that greater timing flexibility increases the optimal quantity of hedging, but has a non-monotonic effect on the additional value created by hedging. These results may help explain the empirical findings that investment rates do not differ between hedgers and non-hedgers, and that hedging propensities do not depend on standard measures of growth opportunities.     

Performance of utility-based strategies for hedging basis risk

The performance of optimal strategies for hedging a claim on a non-traded asset is analysed. The claim is valued and hedged in a utility maximization framework, using exponential utility. A traded asset, correlated with that underlying the claim, is used for hedging, with the correlation ρ typically close to 1. Using a distortion method (Zariphopoulou 2001 Finance Stochastics 5 61–82) we derive a nonlinear expectation representation for the claim’s ask price and a formula for the optimal hedging strategy. We generate a perturbation expansion for the price and hedging strategy in powers of ε²?=1?ρ². The terms in the price expansion are proportional to the central moments of the claim payoff under the minimal martingale measure. The resulting fast computation capability is used to carry out a simulation-based test of the optimal hedging program, computing the terminal hedging error over many asset price paths. These errors are compared with those from a naive strategy which uses the traded asset as a proxy for the non-traded one. The distribution of the hedging error acts as a suitable metric to analyse hedging performance. We find that the optimal policy improves hedging performance, in that the hedging error distribution is more sharply peaked around a non-negative profit. The frequency of profits over losses is increased, and this is measured by the median of the distribution, which is always increased by the optimal strategies. An empirical example illustrates the application of the method to the hedging of a stock basket using index futures.