In the last two decades, the use of derivative contracts by firms has increased sharply. Surprisingly, although data on derivatives usage are more widely available, the empirical evidence on the effects of derivative use on firms’ risk and value is still mixed (despite the fact that anecdotal evidence on its detrimental effects is widespread). For example, using a sample of firms that initiate derivative use, Guay (1999) finds that the total risk, idiosyncratic risk, and risk exposures to interest rate changes of these firms decline, but he finds no significant change in the market risk of these firms. In contrast, Hentschel and Kothari (2001) find that the difference in risk for firms that use derivatives is economically small compared to firms that do not use them. Allayannis and Weston (2001) present evidence that hedging foreign currency risk is associated with large (approximately 4%) increases in market value; Graham and Rogers (2002) find that hedging can add an economically significant 1.1% to their market value by allowing firms to increase their debt capacity. However, Guay and Kothari (2003) show that the magnitude of the cash flows generated by hedge portfolios is modest and unlikely to account for such large changes in value. Consistent with this, Jin and Jorion (2006) use a sample of oil and gas producers and find insignificant effects of hedging on market value.
One factor that affects the interpretation of these results, and may generate some of the differences in these studies, is endogeneity. That is, a significant difference in the risk measures of hedging and non-hedging firms could be due to omitted control variables that determine firm risk and risk management; alternatively, omitting these variables may mask important differences among firms that arise because of differences in hedging behavior. Endogeneity also affects the interpretation of results: hedging behavior may be driven by, rather than a determinant of, differences in risk. As a result, riskier firms may hedge so that their (after-hedging) risk profile is indistinguishable from inherently less risky non-hedgers. The papers cited above use different approaches to control for endogeneity. Some authors use econometric procedures such as simultaneous equations to account for this problem (see, e.g., Graham and Rogers (2002)). Others choose samples to mitigate selection bias. Jin and Jorion (2006), for example, control for any significant difference in the hedging propensity of firms across industries by examining firms in a single industry. By examining only firms that initiate derivative use, Guay (1999) uses the same firm prior to derivative use as a control. Of course, although these choices reduce selection bias, they also impose constraints on the data, beyond the usual ones of data availability.
In this paper, we also examine the effect of derivative use on firms’ risk and market values. We use a new, larger dataset that includes 6,888 non-financial firms headquartered in 47 different countries. In addition to providing greater statistical power for our tests, our dataset covers a wide range of derivative use and risk measures. Specifically, we investigate the impact of the use of exchange rate (FX), interest rate (IR) and commodity price (CP) derivatives on cashflow volatility, the standard deviation of stock returns, and market betas, as well as market values. The dataset also allows us to measure the effect of derivative use on firms during a sample period that includes a sharp market correction: the global recession of 2000-2001. Consequently, we are able to examine the extent to which firms, either through their use of derivative contracts or other methods (e.g., operational hedges), can mitigate a market-wide decline.
Figure 1 illustrates our primary findings by plotting the time series of cumulative returns for users of derivatives (hedgers) and nonusers (nonhedgers) from 1998 through the end of 2003. The graph shows that hedgers’ returns are less volatile than the returns of non-hedgers. Hedgers also have a lower sensitivity to market returns (i.e., a lower market beta) than nonhedgers. This is especially apparent in the 2000-2001 period when sharp sell-offs in the market lead to substantially larger declines for nonhedgers as compared to hedgers. Over the 1998-2003 period the stocks of nonhedgers perform slightly better than those of hedgers, although it is not clear from the graph if this outperformance is enough to compensate for the apparently higher risk of nonhedgers.
Univariate results also strongly suggest that firms use derivatives to reduce risk. Users of derivatives are more exposed to exchange rate risk (due to more foreign sales, foreign income and foreign assets) and interest rate risk (due to higher leverage and lower quick ratios) before considering the potential effects of hedging. They are also more likely to belong to commodity-based industries that are exposed to commodity price risk. Nonetheless, derivatives users exhibit unconditional aver-age cashflow volatility that is almost 50% lower than non-users and stock return volatility that is on average 18% lower than the return volatility of non-users. In addition, firms that use derivatives have market betas that are on average 6% lower than non-users. Consistent with other papers, we also find that, on average, derivative users tend to be larger and older firms. Consequently, the unadjusted Tobin’s q of the average derivative user is approximately 17% lower than the average firm that does not use derivatives.
