Convex costs and the hedging paradox

Financial theory suggests that hedging can increase shareholder value in the presence of capital market imperfections, including direct and indirect costs of financial distress, costly external financing, and convex tax exposure. The influence of these costs, which are high when profits are low and low or negligible when profits are large, on the extent of firm hedging has not been consistently addressed in the finance literature. In Brown and Toft's (2002) model, more convex costs imply that a firm will decrease the extent of hedging. At the same time, one version of Smith and Stulz's (1985) tax hypothesis implies that a given firm is expected to increase the extent of hedging under a more convex tax exposure. I address this ambiguity in the literature by showing that, in incomplete markets, value-maximizing firms that stand to gain the most from hedging may in fact hedge less than otherwise identical firms with less to gain from hedging. This hedging paradox can partly account for the lack of conclusive evidence to suggest that convex costs can influence both a firm's decision to hedge and the extent of the firm's hedging. Finally, I introduce a new interpretation of empirical relations between potential hedging gains and the extent of 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.     

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.     

Do Firms Hedge in Response to Tax Incentives?

There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.     

Why and How UK Firms Hedge

This paper attempts to differentiate among the theories of hedging by using disclosures in the annual reports of 400 UK companies and data collected via a survey. I find, unlike many previous US studies, strong evidence linking the decision to hedge and the expected costs of financial distress. The tests show that this is mainly because my definition of hedging includes all hedgers and not just derivative users. However, when the tests employ the same hedging definition as previous US studies, financial distress cost factors still appear to be more important for this sample than samples of US firms. Therefore, a secondary explanation for the strong financial distress results might be due to differences in the bankruptcy codes in the two countries, which result in higher expected costs of financial distress for UK firms. The paper also examines the determinants of the choice of hedging method distinguishing between non‐derivative and derivatives hedging. My evidence shows that larger firms, firms with more cash, firms with a greater probability of financial distress, firms with exports or imports and firms with more short‐term debt are more likely to hedge with derivatives. Thus, differences in opportunities, in incentives for reducing risk and in the types of financial price exposure play an important role in how firms hedge their risks.     

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 determinants of Norwegian exporters’ foreign exchange risk management

Abstract

This paper examines foreign exchange (FX) hedging by Norwegian exporting firms to provide empirical evidence on the determinants of the hedging decision. The paper contributes to prior studies by, first, focusing on exporters to ensure that the companies in the sample have FX exposure, thereby allowing a more rigorous test of the theoretical determinants of hedging, and, secondly, in contrast to most previous studies that have focused on FX external hedging instruments, the use of both internal and external instruments is examined. Univariate, multivariate and multinominal analyses all provide evidence consistent with the firm value maximization hypotheses of underinvestment and risk aversion. Also, the following characteristics of firms—size, extent of internationalization and liquidity—are found to be related to the decision to hedge FX risk. However, the evidence on the links between the firm characteristics and the decision to hedge is not consistent across internal and external FX hedgers, and also varies for individual hedging instruments. Therefore it is argued that the empirical evidence on the theoretical determinants cannot be generalized to cover the full range of FX hedging strategies (which includes internal hedging instruments). Unlike empirical studies for other countries the evidence for Norwegian firms does not support the hypothesis that the avoidance of financial distress and the need to resort to external capital markets is a significant determinant of the hedging decision. Whilst the evidence suggests that country-specific factors may play a role in determining the use of FX hedging, it does not imply that the different policies adopted are necessarily inconsistent with the firm value maximization hypothesis.     

Financial hedging and corporate investment

Building on the well-documented relationship between corporate financial hedging and firms' borrowing costs, this study examines the impact of utilizing financial derivative instruments on corporate investment. We document that engaging in financial hedging enables firms to pursue more inorganic growth opportunities in the form of M&As. Acquiring firms with financial hedging programs have a lower borrowing cost and are more likely to pay for their deals with cash and use external borrowing. While financial hedging serves as a vehicle for firms to bring their inorganic investment plans to fruition by facilitating their financing, it also leads to inferior investment choices when conflicts of interest among managers and shareholders are more likely to arise. Our study shows for the first time that the financial flexibility emanating from corporate financial hedging can give rise to agency costs by instigating entrenched managers to overinvest.     

Hedging and Value in the U.S. Airline Industry

This article discusses the findings and practical import of the authors' study of the fuel hedging activity of 28 U.S. airlines during the period 1992‐2003. The aim of the study was to answer the following question: Does fuel hedging add value to the airlines and, if so, how? The airline industry provides a natural experiment for investigating the relation between hedging and value for a number of reasons: (1) the industry is by and large competitive and remarkably homogeneous; (2) airlines are exposed to a single, volatile input commodity—jet fuel—that represents a major economic expense for all competitors; and (3) fuel price increases cannot be easily passed through to customers because of competitive pressures in the industry. The results of the study show that jet fuel hedging is positively related to airline firm value. Those airlines that hedged their fuel costs had Tobin's Q ratios that were 5‐10% higher, on average, than those of airlines that did not hedge. What's more, the higher the proportion of future fuel requirements hedged, the larger the valuation premium. The authors' results also suggest that the main source of value added by hedging in the airline industry is its role in preserving the firm's ability to take advantage of investment opportunities that arise when fuel prices are high and airline operating cash fl ows and values are down. Consistent with this argument, the study finds that the value premium associated with hedging increases with the level of the firm's capital spending. The authors also report that the most active hedgers of fuel costs among the airlines are the larger firms with the least debt and highest credit ratings. This result is somewhat surprising, at least to the extent that smaller airlines are expected to have larger financial distress costs (as a percentage of firm value) and hence greater motive to hedge. One explanation is that the smaller airlines have lacked either sufficient resources or the strategic foresight to acquire a derivatives hedging capability. A second possibility—one that is consistent with the study's main findings—is that the largest airlines also have the highest costs of financial distress (even as a percentage of firm value) in the form of larger growth opportunities that could be lost as a result of high leverage and financial risk. In other words, only the largest airlines are typically able to buy distressed assets during periods of industry weakness; to the extent this is so, such firms may also have the most to gain from hedging.     

Which workers get insurance within the firm?

Industry-level time series data suggest that low-skilled workers get less insurance within the firm than high-skilled workers. In particular, wages respond relatively more to productivity shocks in low-skilled industries than high-skilled industries. Our theory is that low-skilled workers get relatively less insurance from their firms because they have relatively lower displacement costs. Under limited commitment, lower displacement costs make the workers' outside options more attractive, and hence decrease the amount of risk sharing sustainable within the firm. Evidence on average displacement costs by industry support the theory's predictions.     

Empirical evidence concerning incentives to hedge transaction and translation exposures

We investigate Swedish firms’ use of financial hedges against foreign exchange exposure. Our survey data lets us distinguish between translation exposure and transaction exposure hedging. Survey responses indicate that over 50% of the sampled firms employ financial hedges, and that transaction exposure is more frequently hedged than is translation exposure. The likelihood of using financial hedges increases with firm size and exposure, and liquidity constraints are important in explaining transaction exposure hedging. Importantly, the existence of loan covenants accounts for translation exposure hedging, suggesting that firms hedge translation exposure to avoid violating loan covenants.     

Do artificial income smoothing and real income smoothing contribute to firm value equivalently?

This paper examines the potential impacts of artificial smoothing (abnormal accruals) and real smoothing (derivatives) on firm value. We find that the value of the firm decreases with the magnitude of abnormal accruals and increases with the level of derivative use. Moreover, the accrual discount is more pronounced in firms with weak investor protection and the hedging premium is greater for poorly governed firms. These results suggest that although managers can engage in real smoothing to improve the informativeness of firms’ earnings and thus reduce agency costs, they might use artificial techniques to cosmetically improve the income stream in order to expropriate minority shareholders. In further support of agency theories, we report that poor corporate governance motivates the use of abnormal accruals and discourages derivative use.     

Corporate risk management and firm value: evidence from the UK market

The paper evaluates the effect of corporate risk management activities on firm value, using a sample of large UK non-financial firms. Following recent changes in financial reporting standards, we are able to collect detailed information on risk management activities from audited financial reports. This enables us to gain a better understanding of risk management practices and to investigate value implications of different types of hedging. Overall 86.88% of the firms in the sample use derivatives to manage at least one type of price risk. The hedging premium is statistically and economically significant for foreign currency derivative users, while we provide weak evidence that interest rate hedging increases firm value. The extent of hedging and the hedging horizon have an impact on the hedging premium, whereas operational risk management activities do not significantly influence the market value of the firm.     

Corporate Hedging Policy and Equity Mispricing

We show that firms’ use of derivatives is negatively associated with stock mispricing. This result is consistent with the notion that hedging improves the transparency and predictability of firms’ cash flows resulting in less misvaluation. Furthermore, we show that the negative relationship between mispricing and hedging is particularly strong when market value is below fundamental value, which is consistent with prior evidence that hedging has a positive impact on firm valuation. Finally, we provide evidence that a “spread‐out” hedging policy that entails the use of a variety of derivative contracts can be more effective in reducing mispricing.     

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.     

Does Hedging Affect Firm Value? Evidence from the US Airline Industry

Does hedging add value to the firm, and if so, is the source of the added value consistent with hedging theory? We investigate jet fuel hedging behavior of firms in the US airline industry during 1992–2003 to examine whether such hedging is a source of value for these companies. We illustrate that the investment and financing climate in the airline industry conforms well to the theoretical framework of Froot, Scharfstein, and Stein (1993). In general, airline industry investment opportunities correlate positively with jet fuel costs, while higher fuel costs are consistent with lower cash flow. Given that jet fuel costs are hedgeable, airlines with a desire for expansion may find value in hedging future purchases of jet fuel. Our results show that jet fuel hedging is positively related to airline firm value. The coefficients on the hedging variables in our regression analysis suggest that the “hedging premium” is greater than the 5% documented in Allayannis and Weston (2001), and might be as large as 10%. We find that the positive relation between hedging and value increases in capital investment, and that most of the hedging premium is attributable to the interaction of hedging with investment. This result is consistent with the assertion that the principal benefit of jet fuel hedging by airlines comes from reduction of underinvestment costs.     

Capital expenditures,financial constraints,and the use of options

This paper analyzes why gold mining firms use options instead of linear strategies to hedge their gold price risk. Consistent with financial constraints based theories, the largest and least financially constrained firms are the most likely to hedge with insurance strategies (put options), while more constrained firms finance the purchase of puts by selling calls (collars). The most financially constrained firms use strategies that involve selling calls. Firms with large investment programs are also more likely to use insurance rather than linear strategies. Firms’ hedging instrument choices are also correlated with current market conditions, suggesting that managers’ market views partially drive hedging instrument choices.     

Policy Uncertainty and the Dual Role of Corporate Political Strategies

Firms use active political strategies not only to mitigate uncertainty emanating from legislative activity, but also to enhance their growth opportunities. We find that a firm's systematic risk (beta) can be hedged away by employing various political strategies involving the presence of former politicians on corporate boards of directors, contributions to political campaigns, and corporate lobbying activities. The hedging effect is greater when firms operate in more uncertain industries. In addition, active political strategies are associated with greater firm heterogeneity and make real options more value relevant as potential drivers of competitive advantages in uncertain environments.     

The Real and Financial Implications of Corporate Hedging

We study the implications of hedging for corporate financing and investment. We do so using an extensive, hand‐collected data set on corporate hedging activities. Hedging can lower the odds of negative realizations, thereby reducing the expected costs of financial distress. In theory, this should ease a firm's access to credit. Using a tax‐based instrumental variable approach, we show that hedgers pay lower interest spreads and are less likely to have capital expenditure restrictions in their loan agreements. These favorable financing terms, in turn, allow hedgers to invest more. Our tests characterize two exact channels—cost of borrowing and investment restrictions—through which hedging affects corporate outcomes. The analysis shows that hedging has a first‐order effect on firm financing and investment, and provides new insights into how hedging affects corporate value. More broadly, our study contributes novel evidence on the real consequences of financial contracting.     

The effects of executive share options and investment opportunities on firms’ accounting performance: Some Australian evidence

This paper provides evidence that firms with high investment opportunities and share options are associated with lower agency costs measured in terms of better accounting performance. The results of this study of 753 observations of 251 Australian firms over the three years 1998–2000 show that firms with high growth and executive share option plans are associated with better firm performance. In addition, this study shows that executives have greater risk-bearing preferences at higher option levels. That is, it is the combination of both high growth opportunities and high levels of options that is associated with higher financial performance. The results of this study suggest that it is economically irrational for low growth firms to use options as a means to motivate executives to increase firm performance. Further analysis revealed that these associations are not endogenously determined.