Abstract
Financial risk hedging and corporate management are important tools for non-financial corporations. Following the theories of Modigliani and Miller corporate risk management is an irrelevant activity. However, the presence of market imperfections can explain the corporate use of derivatives. Hedging can contribute to the firm value, when firms face a progressive tax rate and when in the presence of the expected costs from financial distress. Moreover, hedging can lower agency costs of debt. The use of derivatives can be also explained by the managers’ behaviour towards risk. The aim of the paper is to evaluate the theoretical and empirical literature on the financial risk management strategies. Most of the empirical findings for the theoretical hypotheses are inconclusive despite the fact that corporate risk management can potentially increase firm value. Firm size has been considered as the most relevant factor of derivatives’ use for the purpose of this paper.
Financial Risk Management
Financial risk management and corporate risk analysis are important aspects of a firm’s overall business strategy. Corporate risk management is the process of trying to influence the effect of the risk exposures on the firm value, while hedging a risk exposure is the process of reducing the dependence of the firm value on this risk exposure. The use of derivatives by firms for hedging purposes in order to maximize shareholder wealth or for opportunistic speculation is indeed very relevant especially in the light of the recent increase in the use of derivatives by corporations. Much of the current debate on the use of derivatives focuses on the purpose of derivatives, in particular it explores whether firms use these instruments for hedging purposes in order to maximize shareholder wealth or for opportunistic speculations.
According to Modigliani and Miller (1958), financial decisions have no impact on the firm’s value. Value is created by undertaking profitable investments, while the way these investments are financed is completely irrelevant. The financing policy only defines the way in which value is distributed among the different subjects. As a consequence, there is no use for corporate risk management in the unrealistic Modigliani-Miller world. If shareholders want to change their personal exposure to some particular risks, they can do it on their own, in particular by modifying their asset allocation.
A broad literature shows that hedging with derivatives can increase firm value by reducing expected taxes, expected costs of financial distress, underinvestment costs associated with investment opportunities in the presence of financial constraints, and agency costs. The main reason for corporate risk management to hedge is that hedging adds value to the firm in a way shareholders cannot do on their own. This happens due to the market imperfections that are not considered in the Modigliani-Miller world, thus the corporate risk management can only be relevant if markets are imperfect.
According to Smith and Stulz (1985), hedging can increase firm value in three cases: 1) when a firm faces a progressive tax rate, 2) if there are expected costs from financial distress, and 3) when hedging can mitigate agency problems. These three reasons fit well in the behavior of shareholder value maximization. Therefore, when these market frictions exist, hedging may become a value-increasing strategy for a corporation. Another reason for hedging is of a somewhat different category. It is argued that the risk attitude of managers may explain the use of derivatives within the risk management program of different firms.
According to Hentschel and Kothari (1995) the users and non-users of derivatives exhibit few measurable differences in their approach to risk. The authors claim that this approach is usually consistent with the firms’ use of derivatives or hedge rather than speculation. However, the research does not properly address the key factor that may influence the use of derivatives. In particular, managers’ risk patterns and their incentives for the use of derivatives are not thoroughly examined. Therefore, the use of derivatives for hedging purposes could possibly benefit risk-averse managers at the expense of diversified shareholders.
This paper aims to present several arguments for and against hedging in managing financial risks. In particular, it analyzes how hedging with derivatives can increase firm value if firms face a progressive tax function, lower the expected costs of financial distress, mitigate suboptimal investment policies, affect the risk attitude of managers.
Smith and Stulz (1985) state in their paper that hedging pre-tax income can increase firm value. This will only happen when the firm faces a progressive effective marginal tax rate (convex tax function). The bigger the convexity of the effective marginal tax schedule, the higher the possible benefits from hedging. The convexity of the tax function is increased by tax preferences, such as investment tax credits, tax loss carry backs, and carry forwards. Those tax losses tend to decrease the tax liability, since the gains in one year can be eliminated by the losses in another year. This fact makes the marginal tax schedule convex over a bigger area, which adds value to hedging. Firms with more tax preference items tend to opt for hedging their pre-tax income. Considering that small firms are more likely to be in the progressive region of the tax schedule, they are also keener to hedge. Moreover, the higher is the volatility of the pre-tax income flow, the greater are the advantages of hedging. Small firms with tax preference items and with a volatile EBIT can be expected to gain most from hedging pre-tax income. However, if the expected gain from hedging pre-tax income depends on transaction costs, larger firms are expected to gain more from hedging because transaction costs usually show scale economies. Moreover, larger firms are probably in a stronger position of bearing the costs of a risk management program. In this case, larger firms can be expected to enter into hedging activities. Therefore, it is impossible to suggest a clear relation between the firm size and hedging activities.
It can be stated, however, that firms are more likely to hedge if they are in the progressive region of the marginal tax schedule and if they have more tax preference items. Considering the existence of tax credits, different analysis seem to confirm the theory that firms use derivative tools in order to reduce the expected tax payments (Smith and Stulz, 1985; Guay and Kothari, 2002). On the other hand, some other researchers (Bodnar, Hayt, and Marston, 1996) have used survey analysis to determine, whether firms hedge in order to minimize expected tax payments. From their research it can be inferred that the main target of these firms is hedging by managing cash flows, which seems consistent with the standard economic explanations of the potential benefits of hedging, such as the reduction of expected taxes.
Another reason for hedging is the management of expected costs during a financial distress. Nance, Smith, and Smithson (1993) show that hedging can increase firm value, whenever there are expected costs of a financial distress. The expected costs of a financial distress are a positive function of the probability of encountering financial distress if the firm does not hedge, and of the costs imposed by a possible bankruptcy. These costs can be relevant not only because of the direct bankruptcy costs, but especially because of the indirect costs. Therefore, it can be stated that hedging can lower the expected costs of a financial distress and can increase firm value as long as the hedging itself is not too expensive.
According to Warner (1997) smaller firms can face higher costs of financial distress. Therefore, small firms are more likely to hedge. Because the possibility of a bankruptcy is larger when firms have more fixed claims, firms with higher debt ratios are also more likely to hedge. Moreover, a high volatility of income flow results in a high possibility of a financial distress. Thus, the higher the volatility of income, the greater the advantages of hedging are.
Finally, the lower the credit rating of a firm is, the higher is the probability of entering in a financial distress. Therefore, small firms with high debt ratios, low credit ratings, and a volatile income flow are expected to gain the most from hedging. On the other hand, if smaller firms face higher costs of hedging, they are less inclined to hedge. Therefore, there is no single rule to describe whether smaller firms should hedge more or less than larger firms. In general, it is possible to conclude that hedging can lower the expected costs of a financial distress. The value of hedging is greater for smaller firms, and for firms with a higher financial leverage. It seems that empirical evidence suggests that firms with a higher leverage and a lower interest coverage ratio hedge more, although the empirical relations are not very strong. Moreover, the abovementioned research does not provide very strong support for the hypothesis that corporate managers try to increase firm value by hedging, in order to minimize the expected costs of a financial distress.
Hedging can also be a value-increasing strategy if it mitigates suboptimal investment policies thus reducing agency costs of debt. This inefficiency can result from adverse selection, brought by specific risk-sharing relations between financing participants in financially distressed firms. Firms with high financial leverage are more likely to use derivatives in order to reduce the volatility of the firm, increasing firm value. Moreover, since firms with more growth possibility in their investment opportunity set are more likely to suffer from the underinvestment problem, they have a greater advantage to undertake a hedging program, which reduces the volatility of the firm. It can also be assumed that firms with a higher market-to-book ratio use more derivatives to hedge their risks. Firms spending a lot on research and development activities are expected to experience more growth in the future. Therefore, firms with a higher ratio of R&D to firm value should use more derivatives to hedge the volatility of their firm value. Thus, highly-levered firms with a relatively large amount of growth possibilities are expected to gain the most from hedging. Therefore, it is possible to suggest that hedging can increase firm value if it can decrease the agency costs of debt. However, it can be argued that agency costs are more distinct when a firm has a higher level of financial leverage, and when a firm has more growth opportunities. Hence, the evidence regarding leverage is also inconclusive.
In their survey Bodnar, Hayt, and Marston (1996) have found that US non-financial firms use derivatives in order to reduce the agency costs of debt. Therefore, the empirical evidence supports the theory regarding hedging as a mechanism to reduce agency costs of debt. Firms with more growth opportunities and low accessibility to external financial capital tend to hedge cash flows in order lower agency costs of debt.
Finally, for hedging the corporate risk can be explained through managerial utility maximization. Smith and Stulz (1985), as well as Tufano (1996) state that managers’ risk attitude can explain the corporate use of derivatives, if their expected utility depends on the distribution of future firm value. Corporate risk management modifies the distribution of future firm value and management’s expected utility. Managerial utility maximization varies with the relationship between personal wealth and the firm value. If managers own a significant portion of the firm, it can be expected that the firm will hedge more of its risks. This fact gives an incentive for closely-held corporations to hedge as the managers that are also owners do not hold well-diversified portfolios. Therefore, assuming risk aversion, they have incentives to reduce the volatility of firm value. Thus, one may expect closely-held firms to favor hedging programs. For widely-held firms the situation is reversed. If a manager is compensated in a way that his/her salary is positively correlated with firm’s value, one may expect the firm to hedge. However, the more call-option like features are present in the incentive scheme, the less the firm is expected to hedge. It may even be advantageous for managers to increase the firm’s financial and business risks. Based on the above facts it is possible to conclude that managers can use derivatives in order to maximize their own expected utility of wealth. They might be prone to that because they have a large amount of their wealth invested in the firm. However, when managers’ compensation contracts contain a relatively large proportion of call-option like features, they will be inclined to hedge less.
As a final point, it is possible to conclude that there is no clear relation between a firm size and its corporate risk management. Smaller firms are more likely to be in the progressive region of the marginal tax schedule, which makes their potential tax advantages by hedging stronger. Moreover, smaller firms face relatively high costs of financial distress. This fact also supports the assumption that smaller firms should gain more from hedging than larger firms. However, because smaller firms probably face substantially higher transaction costs of hedging, it may also be possible that larger firms are more likely to use derivative instruments in their risk management programs. We can conclude that explanation of transaction costs dominates the motives for reducing expected taxes and costs of financial distress. Previous researches seem to confirm the direct correlation between firm size and the use of derivative. Larger firms are probably in a better position of setting up a risk management program and contracting specialized employees. Thus, although firm size provides a good explanation for the corporate use of derivatives, it is difficult to find a clear relation of the firm size with the hedging benefits explained by the tax level and by the reduction in the expected costs of financial distress. Firms with more growth options, instead, tend to hedge more in order to minimize the agency cost of debt, while there is no clear correlation can be found between the use of derivatives and managers’ expected utility maximization.
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