Corporate Hedging and Speculation with Derivatives (Summary)

The use of financial derivatives among large corporations is common. Different stakeholders want to know the rationale behind nonfinancial firms’ derivatives use, which can alter the risk profile of a company’s common equity and affect its value. Derivatives use is also of interest to regulators, given the effect derivatives can have on overall financial market stability and their possible misuse in hiding financial misdeeds on balance sheets.

A sample of 6,896 nonfinancial firms in 47 countries forms the basis for the study. The dataset includes all nonfinancial firms with accounting data for either 2000 or 2001 in the Thomson Reuters analytics database, with an annual report in English for the same years in the Global Reports database, and with at least 36 nonmissing daily stock returns and capital market data on Datastream for the year of the annual report. An annual report search categorizes the firms as users or nonusers of derivatives. This large sample includes more than three-quarters of the market capitalization of global nonfinancial listed companies.

The author employs regression of derivatives use on firm traits via a probit model. Setting forth a number of hypotheses, the author tests whether firms with greater distress costs—such as more leverage and lower profitability, tax incentives to hedge, greater financial restrictions (e.g., no dividend payments), underinvestment issues (e.g., higher leverage), managerial hedging incentives (e.g., multiple share classes, no stock options), greater country risk, and underlying gross exposure in the form of foreign sales—have a greater tendency to use derivative instruments.

Statistical analysis confirms the widespread use of derivatives across regions. Over 75% of derivatives users are concentrated in such industries as automobiles, utilities, aircraft, and defense. Regarding underlying assets, machinery, automobile, aircraft, and tobacco companies use foreign exchange products the most. Aircraft, tobacco, and utility companies are frequent interest rate derivatives users. Finally, utility, precious metal, and oil companies commonly employ commodity price derivatives. Hedging is more prevalent in countries where derivatives markets are available, with over 60% of companies in OECD countries trading derivatives and less than 40% of companies in non-OECD countries trading derivatives.

The likelihood that a company will use derivatives is a direct function of the company’s gross foreign exchange exposure. Derivatives users may or may not be subject to greater country risk than nonusers. On balance, firms that use derivatives exhibit less net financial risk, such as lower stock return volatility. Overall, companies employ financial derivatives to hedge rather than increase exposure to financial risk. No evidence exists that firms without international operations use derivatives to gain foreign currency exposure. Overall, corporate governance does not drive firms’ decision to use derivatives, because their use to hedge is common in countries with both strong and weak shareholder rights. Finally, firms using derivatives in countries with generally weaker credit rights and easier access to derivatives experience greater risk reduction.

Nonfinancial firms’ use of derivatives to hedge can enhance shareholder value by reducing financial distress and the risk of bankruptcy. It may also serve an important risk management function through better alignment of investing and financing activities to specify correct funding needs and lessen potential underinvestment. A more complete understanding of such firms’ derivatives use would be critical to the work of fundamental analysis and portfolio management, where more precise valuation can lead to more effective inputs in the money management process.