Thursday, December 15, 2005

Taking a View: Corporate Speculation, Governance and Compensation by Christopher Geczy, Bernadette Minton, Catherine Schrand

SSRN-Taking a View: Corporate Speculation, Governance and Compensation

You know the standard class spiel:
"... identify your core business exposure, then find ways to hedge it by taking a derivatives position that moves in the opposite direction. In this way derivatives are not bets on market movements, but as an insurance policy against things outside the firm's control (i.e. macro risk factors."
The problem is that firms regularly ignore this advice and speculate by making bets as to which way the asset price will move beleiving that they have an ability to "beat the market".

Geczy, Minton, and Schrand examine this "market view" of derivative use and find that it can be tied to the poor governance and option based executive pay. Moreover, they report that current accounting standards do not allow outsiders to correctly judge how derivatives are being used.

A few "look-ins"

* "Taken together, these characteristics of speculators are consistent with the following scenario. Firms are motivated to use derivative instruments to hedge. Once the fixed costs of a derivatives operation are in place, however, some firms extend their derivatives program to include speculation. The firms that start speculating have (or believe they have) a comparative information advantage relative to the market such that they view speculation as a positive NPV activity."

* "The firm characteristics that measure incentives to increase convexity, however, are significantly associated with other proxies for potential risk-seeking activities of the sample firms –lower diversification and higher stock return volatility. Thus, while the sample firms that we identify as risk-seekers engage in other risk-seeking activities, they do not seem to consider actively taking positions in derivatives based on a market view as similarly risk-seeking."

* "Greater managerial power measured by the Gompers, Ishii, and Metrick (GIM, 2003) governance index is positively associated with frequent speculation. These results are particularly strong for firms that rely less on the market for corporate control as an ex post monitoring mechanism to prevent excessive risk-taking."

HOWEVER, these firms do not give managers' totally free reign:

"The speculating firms, however, have more frequent and scheduled reports of their activities to the Board of Directors, more sophisticated methods of and more frequent valuation, and stated policies that limit counterparty risk"

* "we show that market participants could not have discerned the activities of the frequent speculators from publicly available documents (e.g., 10-K filings). This result is not necessarily evidence of accounting fraud because speculation, as we have defined it, may not meet the requirements for reporting under generally accepted accounting principles (GAAP). Nonetheless, irrespective of whether we do not observe disclosure because the accounting rules do not require it or because firms are not implementing the rules properly, the end result is that the financial statements do not provide an accurate picture of the firm’s speculative activities."

Caveat: As the authors readily acknowledge, this is based on survey data, but the data has been used before AND the questions appear innocuous in the sense they do not readily "lead" the response. Morever, given the finding that accounting numbers are insufficient to find the usage, survey data may be all there is.

Wharton's Knowledge has a great summary of the article with interviews! "One quote from this article:
"Executives in charge of derivatives speculation tend to feel they have some unique insight into currency and interest-rate markets, even though their firm's main business may be entirely different, Geczy says. "They really believe they can make money. They feel like they can identify opportunities and/or trade with the advantage of low costs of leverage."
VERY Cool article! It will definitely be used in class!


The Role of Derivatvs in Corporate Finances: Are Firms Betting the Ranch?

Geczy, Christopher Charles, Minton, Bernadette A. and Schrand, Catherine M., "Taking a View: Corporate Speculation, Governance and Compensation" (November 2005).

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