The authors investigate the relationship between hedging and payout policy decisions, both of which affect financial flexibility—that is, the ability to avoid underinvestment as well as financial distress. They study whether firms exchange financial hedging for a more or less flexible payout structure and whether that payout structure affects hedging decisions. To evaluate whether payout flexibility varies with hedging, they examine both financial and nonfinancial firms. Payout flexibility is defined as the ratio of repurchases to total payout. Although dividends are seen as sticky, repurchases can be more variable, which allows a more flexible way for firms to return cash to shareholders.

The authors extend the growing body of literature that suggests that managers substitute operational hedging for financial hedging. The authors’ objective is to investigate the effects of payout flexibility and financial hedging on each other and to determine whether payout decisions and hedging are independently or jointly determined.

Hedges can be used to reduce the volatility of cash flows. Hedging can overcome the cash flow constraints created when dividends are seen as fixed costs. A strong negative relationship is found between hedging and payout flexibility. An empirical analysis of financial firms suggests that payout and hedging decisions are jointly determined, which seems to confirm that payout flexibility is used as a risk management device. The authors find that hedging and payout policies are substitutes, which is contrary to the belief that causality runs only from hedging cash flow volatility to payout policy.

They test whether their results apply to all publicly traded firms and find a negative relationship between hedging and payout flexibility over both the short and long term. The results provide evidence that the authors’ conclusion—that hedging can serve as a substitute for payout flexibility—also applies to nonfinancial firms.

In sum, bank holding companies and nonfinancial firms use payout policy and risk management as substitutes, thereby adding to financial flexibility. A firm’s payout policy and its financial flexibility must be considered within the context of the firm’s related hedging decisions.

The authors use Federal Reserve filings data to study hedging and present summary statistics on their measures of hedging and payout and on control variables. The primary sample is derived from Federal Reserve quarterly Y-9C filings, which include the complete universe of bank holding companies with total consolidated assets of $150 million or more between 1995 and 2008.

Next, they present empirical support on the relationship between risk management and payout policy for their primary sample of bank holding companies and extend the analysis to nonfinancial firms. They investigate the difference in hedging and payout policies between firms with high cash flow volatility and firms with low cash flow volatility. They find that high-volatility firms, on average, have greater payout flexibility and are significantly more likely than low-volatility firms to hedge. They conclude that payout flexibility and hedging might enable firms with high cash flow volatility to meet their financial flexibility needs.

The authors then study the effects of prior dividend decisions on a firm’s risk management response to a cash flow volatility shock. They expect that dividend-paying firms will be more sensitive to volatility increases and thus more likely to increase hedging in response to a shock. Their results confirm this prediction and support the theory that high-dividend firms increase hedging most.

Before presenting their results from the large sample of bank holding companies, the authors discuss the relationship between (1) shocks to payout policy costs and discrete shifts in payout policy and (2) hedging. They give examples to illustrate and provide consistent evidence that supports payout flexibility and financial hedging being substitutes.

To further investigate the relationship between hedging and payout flexibility in a multivariate context, the authors model payout flexibility as a function of interest rate hedging and then study whether causality runs in the other direction. The results indicate a negative and significant relationship, which runs in both directions, between the level of interest rate hedging in bank holding companies and their payout flexibility. This negative relationship supports the idea that hedging substitutes for financial flexibility in payout policy. Using two alternative measures of payout flexibility, the authors continue to find results consistent with substitution.

Finally, they evaluate nonfinancial firms in a multivariate context, similar to the way they conducted their research on bank holding companies. The regression models confirm hedging’s relationship with less payout flexibility, and vice versa. Causality is also demonstrated to run not only from hedging to cash flow volatility to payout policy but also in the opposite direction.

Financial analysts have a keen interest in evaluating a firm’s ability to avoid underinvestment and financial distress (i.e., financial flexibility) when deriving a firm’s intrinsic value. Given that payout policy and hedging affect financial flexibility, analysts would likely appreciate the authors’ extension of the current literature on payout policy, hedging, and the broader issue of financial flexibility.