PDF Ebook International Evidence on Financial Derivatives Usage
The use of financial derivative contracts by non-financial corporations has grown rapidly over the last two decades, yet to date there is little consensus regarding both how and why firms use derivatives. Especially lacking are comprehensive data on the use of derivatives by non-financial firms outside of the United States even though these firms represent the majority of users. This paper takes a step toward filling the gap by examining the use of financial derivatives by 7,309 companies in 48 countries including the U.S.—the largest and broadest sample of firms studied to date.
This research has four main objectives. First, we seek to document the usage of foreign exchange (FX), interest rate (IR), and commodity price (CP) derivatives and compare characteristics of users across countries and firm type. Our results show that in many countries outside the United States firms commonly use derivatives. Across all countries, more than half of the sample firms (54.3%) use some type of financial derivative. More precisely, 35.9% of the firms use FX derivatives, 32.0% interest rate derivatives, and 9.2% use commodity price derivatives. For the 2,243 U.S. firms in the sample, the rates are similar: 59.3% of firms use some type of derivative with 30.9% using FX derivatives, 39.8% using interest rate derivatives and 15.2% using commodity derivatives. We find that the type of derivatives used varies across the different classes of financial risk. For example, 28.1% of firms use forwards to hedge FX risk and 10.8% use swaps. Usage rates are reversed for interest rate derivatives where swaps are the most popular risk management instrument (used by 28.6% of firms) and forwards are used by only 0.8% of firms. The use of non-linear derivatives varies less across types of risk: 9.4% of firms use FX options, 7.4% of firms use some type of non-linear interest rate derivative (e.g., option, cap, floor, and/or swaption). In contrast to the low usage rates for FX and interest rate futures contracts, commodity price risk is most frequently managed with futures (which are used by 3.1 % of firms or roughly a third of commodity price derivatives users).
Our second objective is to use a large and diverse sample of international firms to increase the power of tests examining the motivations for derivative use. Since prior research and anecdotal evidence suggests that corporations use derivatives primarily for financial risk management theories of financial risk management. For example, financial theory suggests that corporate risk management is apt to increase firm value in the presence of capital market imperfections such as bankruptcy costs, a convex tax schedule (Smith and Stulz, 1985), or underinvestment problems (Bessembinder, 1991; Froot, Scharfstein, and Stein, 1993). While recent empirical studies provide some evidence in support of these theories (Nance, Smith and Smithson, 1993; Mian, 1996; Géczy, Minton, and Schrand, 1997; Allayannis and Ofek, 2001, among others), some findings suggest that risk management may arise from principal-agent conflicts between managers and shareholders or additional factors not well motivated by existing risk management theory such as earning management and speculation (Tufano, 1996; Brown, 2001; Core, Guay and Kothari, 2002).
We find that derivatives use appears consistent with some theories of shareholder value maximization. At a fundamental level, we find strong evidence that the use of derivatives is, in fact, risk management rather than simply speculation. For example, firms that use FX derivatives have higher proportions of foreign assets, sales, and income and firms that use interest rate derivatives have higher leverage. In line with the financial distress hypotheses, tests indicate that derivatives users have significantly higher leverage and income tax credits as well as lower liquidity (as measured by quick ratios and coverage ratios). However, we also find some support for the management incentives rationale as hedgers more frequently have stock options and multiple share classes. We document little support for the underinvestment hypothesis. The striking result from this analysis is how similar the determining factors are across different countries.
Our third objective is to examine the use of derivatives at the country level and determine what country-specific factors, if any, are important for explaining cross-sectional variation. We find that hedging is more common in smaller but developed economies with less international trade. Firms located in civil law countries with weaker creditor rights are also more likely to use derivatives. While important, country-specific factors do not dilute the importance of firm specific factors.
Our fourth objective is to determine if derivative use is associated with higher firm value. A limited amount of recent research has started to examine this important issue (Allayannis and Weston, 2001; Schrand and Unal, 1998; Graham and Rogers, 2002). Our comprehensive sample allows for more powerful tests regarding the relation between risk management and firm value. Consistent with the findings of Allayannis and Weston (2001) we find some evidence that FX derivative use by U.S. firms is associated with higher firm value. These results are fairly weak in our later sample period and are not present in the sample of international firms. We do find strong results indicating that interest rate risk management by firms with high leverage is associated with elevated firm value for both U.S. and international firms. Overall, the results of our analysis show that studying companies headquartered in the U.S. is not sufficient for understanding the risk management practices of non-financial firms.
The remainder of the paper is organized as follows: General motivation as well as a summary of the evidence from related studies is presented in Section 2. Section 3 details the theory and hypotheses that are tested in this study. The data are described in Section 4. Empirical results are presented in Section 5 while Section 6 concludes.
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PDF Ebook International Evidence on Financial Derivatives Usage
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