Wednesday, November 24, 2004

The value of hedging revisited...

Does Hedging with Derivatives REDUCE THE MARKET Risk Exposure by Bali, Hume, and Martell

Put your thinking caps on for this one!

Short version: Hedging, at least as it is currently being done, may not add to firm value.

Longer version:

In a Modigliani and Miller world nothing really matters. This includes dividend policy, capital structure, and hedging. Hedging is the idea that by buying or selling various assets (be them real (physical) or financial) in an attempt to lower the volatility of the firm.

However, when we leave the MM world, we largely have seen that hedging does matter. In fact, it is by now fairly standard to discuss hedging in advanced corporate finance classes. This discussion typically begins:

Teacher: If we consider a levered firm as a call option, you might ask, “why hedge?” Doesn’t hedging hurt shareholders (by reducing volatility)?"

The standard response (as well as the preponderance of academic research) says that hedging does in fact increase shareholder wealth.

How? The increase is often explained along contracting and information asymmetry lines. For instance from my class notes:
Firms might hedge because:

  1. Lower borrowing costs—Bondholders do not like risk. May be cheaper to hedge for firm than it is for Bondholders.
  2. Allows managers to worry about what they have control over and not things outside their control.
  3. Easier to monitor and to contract with management since you can tell what is their fault and what is not.
  4. Lower expected taxes—Because of progressive taxes.
  5. Reduce labor and payroll expenses since these undiversified stakeholders do not like risk.
  6. Less likely to have to go to capital markets in a “bad” time
  7. Operationally, it may make long term contracts easier to enter and customers will know you are going to be around.

These explanatoons had all been fairly well established in the financial literature. But then this paper from Bali, Hume, and Martell comes along and makes us rethink what we are teaching. It finds that firms are not doing what we had thought!!! and moreover, it may not matter!

Because of the large endogenity problem in derivative use (for example firms select when and if to hedge), the paper “introduces a bivariate econometric framework to consider the effects of changes in macroeconomic factors on market risk exposure simultaneously.”
Then (in what I think is a really cool part of the paper, the authors use a

“modified two-stage market model to include a firm’s risk exposure levels relative to returns in the first stage regression. In that stage, our model estimates an individual firm’s risk exposures:

(i) currency exposure is the sensitivity of the firm’s value as proxied by the firm’s stock return to the unanticipated change in an exchange rate index (currency beta);

(ii) interest-rate exposure is the sensitivity of the firm’s value to the unanticipated change in an interest rate index (interest rate beta);

(iii) commodity exposure is the sensitivity of the firm’s value to the unanticipated change in a commodity index (commodity beta).

In the second stage, the impact of hedging is tested by the hypotheses that currency, interest rate, and commodity
exposures are negatively related to derivatives use and positively related to the levels of a firm’s real operations....Real operations are proxies for a firm’s need to hedge and determine a firm’s exposure level.

So once this is done what do they find? Not what one might have thought!
For the univariate tests, the authors find that hedging rarely reduced exposure and in some cases actually increased the risk! (Which suggests that the firms may have been speculating—a definite no-no!).

Again in the author’s words:
"Our empirical findings do not generally support the hypothesis that derivatives positions offset risk movements….Further, the empirical results do not support a positive association between real operations and exposures.”

“Except for one year for interest rate exposure, there
is little evidence that derivatives use reduces risk exposures for the firms studied. There is some evidence that user firms are increasing risk exposure in the use of commodity derivatives.”

“To the extent that there is no change in market risk exposure, then this suggests that:

1) firms use other forms of risk management such as operational hedging from global diversification, or production management, or;

2) firms do not fully hedge the extent of the effect of exchange rate movements, or;

3) interest rate, exchange rate and commodity risks are economically insignificant relative to the firm’s return, or;

4) firms do not have an economic justification for derivatives hedging if they are large, diversified, and of good credit quality, except in special cases, or;

5) they use derivatives to facilitate internal contracting, or informational asymmetries."

Which simplified means that firms we expect to hedge, are not hedging (or at least did not from 1995-1998) and moreover are not hedging like we would have counseled. WHY? Maybe because the firms studied were large and the diversification and operational hedges available to the firms off-set the need to hedge using derivatives.

VERY INTERESTING!! I will be watching this one for paper updates etc.

BTW This may have been the most difficult paper I have summarized in a while. It was rather complex and to make this summary understandable for all, I left quite a bit out. I HIGHLY recommend you download and read the actual paper!!

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