Does Risk Management Add Value? A Survey of the Evidence

The fact that 92% of the world's 500 largest companies recently reported using derivatives suggests that corporate managers believe financial risk management can increase shareholder value. Surveys of finance academics indicate that they too believe that corporate risk management is, on the whole, a valueadding activity. This article provides an overview of almost 30 years of broadbased, stock‐market‐oriented academic studies that address one or more of the following questions:

• ? Are interest rate, exchange rate, and commodity price risks reflected in stock price movements?
• ? Is volatility in corporate earnings and cash flows related in a systematic way to corporate market values?
• ? Is the corporate use of derivatives associated with reduced risk and higher market values?

The answer to the first question, at least in the case of financial institutions and interest rate risk, is a definite yes; all studies with this focus find that the stock returns of financial firms are clearly sensitive to interest rate changes. The stock returns of industrial companies exhibit no pronounced interest rate exposure (at least as a group), but industrial firms with significant cross‐border revenues and costs show considerable sensitivity to exchange rates (although such sensitivity actually appears to be reduced by the size and geographical diversity of the largest multinationals). What's more, the corporate use of derivatives to hedge interest rate and currency exposures appears to be associated with lower sensitivity of stock returns to interest rate and FX changes. But does the resulting reduction in price sensitivity affect value—and, if so, how? Consistent with a widely cited theory that risk management increases value by limiting the corporate “underinvestment problem,” a number of studies show a correlation between lower cash flow volatility and higher corporate investment and market values. The article also cites a small but growing group of studies that show a strong positive association between derivatives use and stock price performance (typically measured using price‐to‐book ratios). But perhaps the nearest the research comes to establishing causality are two studies—one of companies that hedge FX exposures and another of airlines' hedging of fuel costs—that show that, in industries where hedging with derivatives is common, companies that hedge outperform companies that don't.     

Investor structure and the informational efficiency of commodity futures prices

This article investigates the impact of the trading positions of hedgers (i.e., producers, merchants, processors, or users of a commodity), speculators (i.e., commodity pool operators, trading advisors, or hedge funds), and swap dealers on the price formation process in the agricultural, metal, and energy futures markets. The hedgers' relative positions exert negative impacts on price efficiency in commodity futures markets. Hedgers are less likely to be information motivated, so their trading delays the price formation process. However, speculators' positions have positive impacts on price efficiency because speculators correct pricing errors. This study also offers evidence that the role of swap dealers, similar to speculators in futures markets, is to provide liquidity and cross-market arbitrage. These findings highlight the role of producers, hedge funds, and swap dealers in price formation processes in commodity futures—information that is beneficial to academics, practitioners, and regulators.     

Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers*

In this article, the authors summarize the findings of their recent study of the hedging activities of 92 North American gold mining companies during the period 1989‐1999. The aim of the study was to answer two questions: (1) Did such hedging activities increase corporate cash flows? (2) And if yes, were such increases the result of management's ability to anticipate price movements when adjusting their hedge ratios? Although the author's answer to the first question is “yes,” their answer to the second is “no.” More specifically, the authors concluded that:

• ? During the 1989‐1999 period, the gold derivatives market was characterized by a persistent positive risk premium— that is, a positive spread between the forward price and the realized future spot price—that caused short forward positions to generate positive cash flows. The gold mining companies that hedged their future gold production realized an average total cash flow gain of $11 million, or $24 per ounce of gold hedged, per year, as compared to average annual net income of only $3.5 million. Because of the positive risk premium, short derivatives positions did not generate significant losses even during those subperiods of the study when the gold price increased.
• ? There was considerable volatility in corporate hedge ratios during the period of the study, which is consistent with managers incorporating market views into their hedging programs and attempting to time the market by hedging selectively. But after attempting to distinguish between derivatives activities designed to hedge and those designed to profit from a view, the authors conclude that corporate efforts to time the market through selective hedging were largely if not completely futile. In fact, the companies' adjustments of hedge ratios appeared to consistently lag instead of leading the market.

     

Managing Pension Risks: A Corporate Finance Perspective

Defined benefit (DB) pension plans of both U.S. and European companies are significantly underfunded because of the low interest rate environment and prior decisions to invest heavily in equities. Additional contributions and the recovery of stock markets since the end of the crisis have helped a bit but pension underfunding remains significant. Pension underfunding has substantial corporate finance implications. The authors show that companies with large pension deficits have historically delivered weaker share price performance than their peers and also trade at lower valuation multiples. Large deficits also reduce financial flexibility, increase financial risk, particularly in downside economic scenarios, and contribute to greater stock price volatility and a higher cost of capital. The authors argue that the optimal approach to managing DB pension risks relates to the risk tolerance of specific companies and their short and long‐term strategic and financial priorities. Financial executives should consider the follow pension strategies:

• Voluntary Pension Contributions: Funding the pension gap by issuing new debt or equity can provide valuation and capital structure benefits—and in many cases is both NPV‐positive and EPS‐accretive. The authors show that investors have reacted favorably to both debt‐ and equity‐financed contributions.
• Plan de‐risking: Shifting the pension plan's assets from equity to fixed income has become an increasingly popular approach. The primary purpose of pension assets is to fund pension liabilities while limiting risk to the operating company. The pension plan should not be viewed or run as a profit center.
• Plan Restructuring: Companies should also consider alternatives such as terminating and freezing plans, paying lump sums, and changing accounting reporting.

     

News‐Specific Price Discovery in Credit Default Swap Markets

We examine the lead and lag relation between equity and credit default swap (CDS) markets. We find that price discovery in equity markets only leads CDS markets following aggregate positive news and not so following other news. While difficult to reconcile with standard asset pricing theories, asymmetric price adjustment is common in goods markets, arising from intermediary power. We provide an explanation for this asymmetry based on dealers exploiting informational advantages vis‐à‐vis investors with hedging motives. Consistent with this explanation, we find that the patterns we document are related to firm‐level proxies for hedging demand, as well as economy‐wide measures of information asymmetries.     

Lessons in Structuring Derivatives Exchanges

The global deregulation of financial markets has created newinvestment opportunities, which in turn require the developmentof new instruments to deal with the increased risks. Institutionalinvestors who are actively engaged in industrial and emergingmarkets need to hedge their risks from these cross border transactions.Agents in liberalized market economies who are exposed to volatilecommodity price and interest rate changes require appropriatehedging products to deal with them. And the economic expansionin emerging economies demands that corporations find betterways to manage financial and commodity risks. The instrumentsthat allow market participants to manage risk are known as derivativesbecause they represent contracts whose payoff at expirationis determined by the price of the underlying asset a currency,an interest rate, a commodity, or a stock. Derivatives are tradedin organized exchanges or over the counter by derivatives dealers.Since the mid-1980s the number of derivatives exchanges operatingin both industrial and emerging-market economies has increasedsubstantially. What benefits do these exchanges provide to investorsand to the home country? Are they a good idea? Emerging marketscan capture important benefits, including the ability to transferrisks, enhance public information, and lower transaction costs,but the success of a derivatives exchange depends on the soundnessof the foundations on which it is built, the structure thatis adopted, and the products that are traded.      

The Promise of Credit Derivatives in Nonfinancial Corporations (and Why It's Failed to Materialize)

Although industrial companies played a big part in the growth of foreign exchange, interest rate, and commodity price derivatives, such companies have had almost no role in the growth of credit derivatives. As the authors point out, industrial corporates are exposed to credit risk in a variety of ways, including customer accounts receivable, longer‐term supply contracts, loans to customers and vendors, and counterparty exposures. Credit derivatives, moreover, would allow corporate users to avoid a number of drawbacks associated with other methods for managing credit risk, including credit insurance, factoring, and surety bonds or securitization. But, as both surveys and interviews with credit derivatives dealers suggest, corporates' direct use of credit derivatives has been very limited, accounting for less than 5% of the credit protection purchased using credit derivatives. As the surveys and interviews also indicate, there are a number of reasons why corporates may be reluctant to use credit derivatives: (1) Unlike the cases of interest rate or currency risk, credit risk management is typically the purview of business units rather than the corporate treasury, and the business units tend to have considerably less experience with derivatives. (2) The protection provided by a credit derivative is unlikely to provide a perfect match for the loss that would be suffered by a corporate in the event of a default. (3) The liquidity in credit derivatives tends to be greatest in maturities that are much longer than those of most corporate credit exposures. (4) It is harder for a corporate to determine how much protection to buy than for a financial. (5) While the existing credit derivative documentation (which is based on loans or bonds) works well for banks and investors, it is less satisfactory for the credit risk faced by corporates, which is often based on “payment.” (6) While accounting standards require that credit derivatives be marked to market, the inability of corporates to mark to market their underlying exposure being hedged leads to unwanted volatility of earnings. Nevertheless, as the authors predict in closing, if the corporate demand for credit risk transfer becomes large and urgent enough, these obstacles will likely turn out to be temporary roadblocks.     

Speculators,commodities and cross-market linkages

We use a unique, non-public dataset of trader positions in 17 U.S. commodity futures markets to provide novel evidence on those markets' financialization in the past decade. We then show that the correlation between the rates of return on investible commodity and equity indices rises amid greater participation by speculators generally, hedge funds especially, and hedge funds that hold positions in both equity and commodity futures markets in particular. We find no such relationship for commodity swap dealers, including index traders (CITs). The predictive power of hedge fund positions is weaker in periods of generalized financial market stress. Our results support the notion that who trades helps predict the joint distribution of commodity and equity returns. We find qualitatively similar but statistically weaker results using a proxy for hedge fund activity based on publicly available data.     

Australian and US interest rate swap markets: comparison and linkages

We investigate and compare the determinants of US and Australian interest rate swap spreads and the linkages between these markets. The slope of the risk‐free term structure is the most significant determinant and its importance is greater for longer terms to maturity. Interest rate levels and, in Australia, the default premium also have some impact. The influences of interest rate volatility, the liquidity premium and (in the USA) the default premium are small or negligible. We hypothesise, and our evidence confirms, that the US swap market significantly affects the Australian swap market but not vice‐versa.     

Property Derivatives and Index-Linked Mortgages

Economists have forcefully argued for the introduction and use of property derivatives as a hedge against house price risk (e.g. Shiller and Weiss, J. Real Estate Finance Econ., 19(1):21–47, 1999). The rationale for these financial instruments seems clear, as many households are heavily invested in housing and standard financial instruments offer a poor hedge. In practice, however, most of the property derivatives available have been targeted to meet the needs of institutional investors, not those of owner-occupiers. Building on the recent launch of the first Swiss property derivative, we here propose index-linked mortgages tailored to retail consumers. The payments of these mortgages depend on the corresponding housing market performance. We further price the instruments, discuss the stabilization of the homeowner’s net wealth, and quantify the expected decrease in the mortgage default risk achieved by this immunization effect.

Hedge Fund Involvement in Convertible Securities

Convertible arbitrage hedge funds combine long positions in convertible securities with short positions in the underlying stock. In effect, hedge funds use their knowledge of the borrowing and short‐sale market to hedge themselves while distributing equity exposure to a large number of well‐diversified investors through their short positions. The authors argue that many “would‐be” equity issuers that would otherwise pay high costs in a secondary equity issue choose instead to issue convertible debt to hedge funds that in turn distribute equity exposure to institutional investors. This allows companies to receive “equity‐like” financing today at lower cost than a secondary equity offering. The authors' findings also suggest that more convertibles will be privately placed with hedge funds when issuer and market conditions suggest that shorting costs will be lower.     

The network structure of the CDS market and its determinants

This paper analyses the network structure of the credit default swap (CDS) market and its determinants, using a unique dataset of bilateral notional exposures on 642 financial and sovereign reference entities. We find that the CDS network is centred around 14 major dealers, exhibits a “small world” structure and a scale-free degree distribution. A large share of investors are net CDS buyers, implying that total credit risk exposure is fairly concentrated. Consistent with the theoretical literature on the use of CDS, the debt volume outstanding and its structure (maturity and collateralization), the CDS spread volatility and market beta, as well as the type (sovereign/financial) of the underlying bond are statistically significantly related—with expected signs—to structural characteristics of the CDS market.     

交易商持仓行为对期货市场的影响

金融危机发生之后,CFTC将原有的交易商持仓报告(Commitment of Traders,简称"COT")进行了扩容,新版的COT报告包含现货交易商、互换交易商、管理基金的持仓情况。分析COMEX铜和NYMEX原油的COT报告,可以发现,互换交易商的持仓占比最高,超过30%;具有现货背景的套期保值持仓保持一定比例,大约为20%~50%。现货交易商持仓占比的增加,有助于缓解价格的波动;而互换交易商持仓占比的提高,却加剧了市场的波动。由于互换交易商享有投机持仓豁免的权利,金融危机发生后,CFTC对互换交易商的监管更趋严格。     

Statement of the Financial Economists Roundtable* Reforming the OTC Derivatives Markets

In investigations of the causes of the crisis, a major focus has been the role of derivative securities, particularly credit-default swaps (CDS). Despite widespread claims to the contrary, however, the 51 economists who signed this statement begin by asserting that CDS and other derivatives contracts were not a primary cause of the financial crisis. At the same time, derivatives markets are said to play an important economic role by shifting risks from businesses and individual investors to parties more willing (and generally better able) to bear them. But, as illustrated during the crisis, derivatives also can be used to transmit risk in ways that have the potential to pervade the entire financial system. With the aim of limiting systemic risk associated with the use of derivatives, the statement recommends the following:

• • measures that encourage migration of more derivatives transactions to central-clearing facilities, including higher capital requirements and stricter criteria (including segregation) for the collateralization of positions that are not cleared;
• • data reporting and repository requirements designed to help regulators and market participants to understand systemic risk exposures in the financial system;
• • post-trade price transparency for all sufficiently standardized OTC products;
• • continued migration of trading in actively traded OTC products to exchanges.

Finally, although the economists support regulations against market manipulation, they oppose potential restrictions on speculative trading, including the holding of “naked” CDS, while affirming that both hedging and speculation are important and socially beneficial activities in our financial system.     

Derivatives, Portfolio Composition, and Bank Holding Company Interest Rate Risk Exposure

This article examines the role played by derivatives in determining the interest rate sensitivity of bank holding companies' (BHCs) common stock, controlling for the influence of on-balance sheet activities and other bank-specific characteristics. The major result of the analysis suggests that derivatives have played a significant role in shaping banks' interest rate risk exposures in recent years. For the typical bank holding company in the sample, increases in the use of interest rate derivatives corresponded to greater interest rate risk exposure during the 1991–1994 period. This relationship is particularly strong for bank holding companies that serve as derivatives dealers and for smaller, end-user BHCs. During earlier years, however, there is no significant relationship between the extent of derivatives activities and interest rate risk exposure. There are two plausible interpretations of the relationship between interest rate derivative activity and interest rate risk exposure in the latter part of the sample period: one interpretation suggests that derivatives tend to enhance interest rate risk exposure for the typical BHC in the sample, while the other suggests that derivatives may be used to partially offset high interest rate risk exposures arising from other activities. The analysis provides support for the first of these two interpretations.     

Risk Management with Derivatives by Dealers and Market Quality in Government Bond Markets

This paper investigates how bond dealers manage core business risk with interest rate futures and the extent to which market quality is affected by their selective risk taking. We observe that dealers use futures to take directional bets and hedge changes in their spot exposure. We find that, cross‐sectionally, a dealer with longer (shorter) risk exposure sells (buys) a larger amount of exposure the next day. However, this risk control takes place via the futures market and not the spot market. Finally, we find strong support for the price effects of capital constraints emphasized by Froot and Stein (1998).     

Morgan Stanley Roundtable on The State of Global Private Equity

In this discussion led by Alan Jones, Morgan Stanley's head of Global Private Equity, the University of Chicago's Steve Kaplan begins by surveying 25 years of academic research on private equity. Starting with Kaplan's own Ph.D. dissertation on leveraged buyouts during the 1980s, finance academics have provided a large and growing body of studies documenting the ability of private equity firms to make “sustainable” (that is, maintained over a three‐ or four‐year period) improvements in the operating performance of their portfolio companies, whether operating abroad or in the U.S. Even more impressive, the findings of Kaplan's new study (with Tim Jenkinson of Oxford and Bob Harris of the University of Virginia) suggest that these improvements have been large enough to enable PE funds raised between 1990 and 2008 to deliver returns to their limited partners that have averaged 300 to 400 basis points higher per year than the returns to the S&P 500. And given the “persistence” of PE fund returns—the tendency of the funds of the same PE firms to show up in the top quartile of performers year after year—that Kaplan has documented in earlier work, the performance of private equity seems notably different from that of mutual funds and hedge funds, where there has been little if any consistency in the returns provided by the top performers. Following Kaplan's overview of the research, four representatives of today's leading private equity firms explore questions like the following:

• ? How do the best PE firms, after paying premiums to acquire their portfolio companies and collecting large management fees, provide such consistently high returns to their limited partners?
• ? How did PE portfolio companies perform during the last recession, when many popular business publications were predicting the death of private equity—and what, if anything, does that tell us about how private equity adds value?
• ? What can PE firms do to avoid, or at least limit the damage from, the overpricing and overleveraging that tend to occur near the end of the boom‐and‐bust cycle that appears to be a permanent feature of private equity?

As Jones notes in his opening comments, the practitioners' answers to such questions “should help investors distinguish between the alpha that the firms represented at this table have generated through active management from the ‘closet beta’ that critics say results when private equity firms simply create what amounts to a levered bet on the public equity markets.”     

THE LIQUIDITY ROUTE TO A LOWER COST OF CAPITAL

The managements of many public companies do not pay much attention to the liquidity of their securities. Many if not most CEOs and CFOs feel powerless to affect what goes on in financial markets, and a common attitude among top executives is that maintaining liquidity is the concern of the securities exchanges and the Securities and Exchange Commission. This approach may work for those companies whose stocks are already highly liquid—a group made up mainly of large‐cap companies, as well as a number of smaller high‐flying, high‐tech firms. But, for the vast majority of public companies—especially smaller and mid‐sized firms—this is likely to be the wrong policy. As the authors of this article demonstrated in their pioneering study (published in the Journal of Financial Economics in 1986), liquidity appears to be a major determinant of a company's cost of capital. As their theory suggests and their empirical tests confirmed, the more liquid a company's securities, the lower its cost of capital and the higher its stock price. And, as discussed in this article, academic research since then has produced a large and impressive body of evidence linking greater liquidity to higher stock prices. Although recent technological innovations such as Internet‐based trading have increased liquidity generally, not all companies appear to have benefited equally. The authors offer a number of suggestions for companies intent on increasing the liquidity of their stock. Specifically, they propose that managers do the following: (1) consider measures, such as stock splits, designed to increase their investor base by attracting small investors; (2) seek trading venues for their securities that promise to increase liquidity; and (3) take advantage of the new Internet technology to provide more and better information to investors. Moreover, for smaller companies with little or no analyst coverage, the authors offer the radical suggestion that such companies actually pay analysts to cover their stock, much as companies pay Moody's or Standard & Poors to rate their bonds. This, in the authors' view, would be a more efficient alternative to the current practice of using stock splits to encourage intermediaries to make markets in the firm's shares.