Ebook Capital Expenditures, Financial Constraints, and the Use of Options
The use of options as risk management tools is widespread among corporations. For example, the Wharton/CIBC 1998 risk management survey reports that 68% of non-financial firms that use derivatives also use options. The gold mining industry is no exception: 62% of derivatives users hedge their gold price exposures with options, and the average fraction of the future gold production that has been hedged with options is 33%.
Options positions are clearly an important part of the risk management strategies of many firms. However, our knowledge as to why and how firms use options is limited. To shed light on this area, this paper comprehensively evaluates options strategies in the North American gold mining industry, and focuses on three main questions: First, are there cross-sectional differences between firms that use options strategies and firms that use linear hedging strategies? Second, among option users why do some firms buy options while others sell options? Third, do market conditions affect firms’ hedging instrument choices?
There are several theoretical models that predict when firms should use options to hedge their risk exposures. For example, Froot, Scharfstein, and Stein (1993) show that if a firm is financially constrained and if its future capital expenditures are a non-linear function of some risk exposure, then options can be necessary to achieve the value-maximizing hedge. Adam (2002) extends the Froot, Scharfstein, and Stein (1993) model to an inter-temporal setting, and shows that financially less constrained firms tend to buy options, while financially more constrained firms tend to sell options. Adler and Detemple (1988) show that borrowing and short-selling constraints can cause exposures to be non-linear and hence create a demand for options. Stulz (1996) argues that large, financially stable firms are the most likely to incorporate market views into their hedging programs. Since options strategies allow a hedger to maintain significant exposures, firms that incorporate their market views could find options strategies particularly useful.
In addition to these financial constraints-based theories, a few authors have examined the impact of non-hedgeable risks and real options on the demand for options. Adler and Detemple (1988), and Moschini and Lapan (1995) show that the optimal hedging portfolio contains options if hedgeable and non-hedgeable risks are correlated. Brown and Toft (2002) show that this result can hold even if hedgeable and non-hedgeable risks are uncorrelated. Finally, Moschini and Lapan (1992) consider a firm’s option to choose certain production parameters after product prices are observed. Assuming hedging is desirable, hedging this production flexibility (a real option) optimally requires non-linear hedging instruments, i.e., options. Common to all of the above theories is the general insight that if the exposure is non-linear then the optimal hedging strategy is also non-linear.
In order to test the empirical relevance of the above theories, I examine the use of options strategies in the North American gold mining industry over a 10-year horizon, between 1989 and 1999. The gold mining industry represents an excellent laboratory for studying hedging instrument choices because gold mining firms share a relatively simple risk exposure, the future price of gold, while employing a range of different hedging strategies. Therefore, differences in hedging strategies are more likely the result of differences in certain firm-specific characteristics rather than differences in exposures. Furthermore, to my knowledge no other industry reveals similarly detailed information about their derivatives portfolios that would allow a detailed study of instrument choice.
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