Cash flow hedging reduces firms’ precautionary demand for cash and allows firms to rely more on bank lines of credit. Moreover, cash flow hedging has a positive effect on firm value.
The authors use a theoretical model to demonstrate that corporate hedging enables a greater reliance on cost-effective, externally provided liquidity than on internal resources. By testing that model with a new empirical approach, the authors find that cash flow hedging reduces firms’ precautionary demand for cash and that the firms can thus rely on bank lines of credit. The authors also find that cash flow hedging has a significant positive effect on firm value.
How Is This Research Useful to Practitioners?
Uncertain cash flows and the risk of adverse cash flow shocks are vital concerns in corporate finance. Alleviating cash flow risks can increase the value of a firm. From an investment practitioner’s perspective, understanding the impact of cash flow risks and the benefit of hedging those risks is very useful in terms of determining firm valuation.
The existing research shows that hedging has no discernible impact on firm value. The authors attempt to clarify this issue by using the data generated after a change in accounting standards. Although previous researchers have focused on the total level of derivatives hedging, the new accounting standard requires separate disclosure of cash flow hedging activity and fair value hedging activity. Fair value hedging activity appears to have little impact on firm value because it does not affect the cash flows of the firm. Cash flow hedging is shown to affect the cash flows of the firm and to increase firm value by reducing the riskiness of the firm. The less risky the cash flows of the firm, the less likely the firm is to violate covenants on its debt. Firms with more stable cash flows are also less likely to have covenants required to access the debt markets.
The use of fair value hedges is unrelated to cash holdings and bank lines of credit. Firms using cash flow hedging tend to hold less cash on the balance sheet and to make greater use of bank lines of credit. Holding greater amounts of cash at low yields entails high opportunity costs, so firms that do not need to hold high levels of cash as a precaution can increase firm value by reducing suboptimal investments. Greater access to credit lines can be used to fund profitable new investments. More stable cash flows are also shown to increase the market-to-book-value ratio of the firm.
There are also firm-specific determinants of cash holdings relative to lines of credit. Firms with larger asset betas hold more cash because their riskiness tends to increase the cost of debt. Firms without derivatives hedges tend to hold as much as three times more cash than firms that use both hedges and lines of credit. Firms in such industries as consumer nondurables, manufacturing, or chemicals are more likely to use cash flow hedges than firms in such industries as energy, retail, or telecommunications because the nature of some businesses makes derivatives hedges more feasible, necessary, or predictable.
How Did the Authors Conduct This Research?
Because of a 2001 change in accounting standards (SFAS No. 133), firms are required to differentiate between cash flow hedging (use of derivatives to hedge against cash flow risk) and fair value hedging (use of derivatives to hedge against valuation shocks). The authors use this change in accounting standards to test their hypothesis that cash flow hedging reduces firms’ precautionary demand for cash and has a positive effect on firm value. By separating cash flow hedging from fair value hedging, the authors are able to distinguish between the implications of these two types of hedging on a firm’s liquidity needs and overall valuation.
The authors use data from three different sources: a hand-collected dataset on the hedging practices of a large sample of US industrial firms, DealScan for data on bank lines of credit, and Compustat for firm-level data (total assets, cash holdings, sales, cash flows, and so forth). The time period of the study is 2002–2007, beginning after SFAS No. 133 came into effect in 2001.
The use of derivative instruments as a risk management tool is pervasive. Having a proper understanding of the implication of these hedging instruments as it concerns the rationale for the hedge (cash flow versus fair value hedging) is important to accurately determine firm value. The authors attempt to shed new light on this subject matter, which is useful given the 2001 change in accounting standards that requires distinguishing between cash flow hedging and fair value hedging. Future research could build on this research and determine other areas, apart from valuation, that are affected by firms’ hedging choices.