Literature Review on Risk Management and Hedging

Introduction

M & M – Risk management is irrelevant to the firm, shareholders can themselves eliminate any risk they do not wish to be exposed too (through diversification for example). However, studies have found that by introducing some level of market friction, taxes, managerial risk aversion or information assymetry for example, that there exists benefits to corporate risk management.

Literature on reasons for hedging

Firm value maximising: firms hedge to reduce the costs that are involved with volatile cash flows of operation. Three lines of explanation:

Reduces expected costs of financial distress: Mayers and Smith (1982), Smith and Stultz(1985), Visvanathan (1998), Haushalter (2000)

Tax incentives, reduce tax when firms are exposed to convex tax function or increase a firms debt capacity: Mayers and Smith(1982), Smith and Stultz(1985)

Reduce Underinvestment problem: Froot, Scharfstein and Stein (1993), Geczy, Minton, and Schrand (1997)

Managerial personal utility maximisation: risk averse managers who have their wealth and human capital largly invested in the firm will hedge if they find the cost of personal risk management is greater then the cost of hedging at the firm level: Stultz (1984), Smith and Stultz(1985), Tufano (1996)

OTHER: DeMarzo and Duffie (1995) – private information

Should split up this section to first describe the theoretical reasons then give empirical results.

Theoretical Literature

In a world with perfect capital markets, free of taxes, information asymmetries or transaction costs, Modigliani and Miller show that risk management activities should be irrelevant. Hedging should not create value for a firm as shareholders can themselves undertake whatever risk management activities they desire at the same cost. The question of why firms undertake risk management activities, such as hedging, can be explained through either shareholder value maximisation theories, or managerial utility maximising theories.

Theories of firm value maximisation explain that firm’s hedge in order to reduce any costs associated with volatile cash flows of operating. There exists a strong body of research in support of the firm value maximisation motive for hedging, with differing explanations to where the value added is created. Mayers and Smith (1982) and Smith and Stultz (1985) show that by reducing the probability of bankruptcy and hence the expected costs of financial distress, hedging contributes positively towards value creation for shareholders. The costs associated with volatile cash flows, and financial distress, was expanded in later literature by Froot, Scharfstein and Stein (1993) to include underinvestment costs; the costs of failing to invest in positive net present value projects due to financial constraints. Froot, Scharfstein and Stein (1993) illustrated that hedging can help alleviate the underinvestment problem, and hence increase value for a firm, by generating extra cash flow in times when cash flow is low and reducing the need for firms to raise external capital. Stultz(1996) something related to underinvestment… Hedging can create value by decreasing the expected tax liability of firms that are exposed to convex tax functions; a progressivity of tax payable in which when income is low the effective tax rate is low, but when income is high the tax rate is also high (Graham & Smith, 1995)(Mayers and Smith(1982)) (Smith and Stultz(1985)). Leland (1998) also demonstrated that hedging can inflate the tax advantage of leverage by allowing a firm to increase its debt capacity beyond what would be feasible without cash flow hedges in place.

The counter to shareholder value maximisation explanations of corporate hedging are theories of managerial personal utility maximisation, which state that hedging is motivated by managers seeking to increase their personal utility functions. These theories state that managers who have large proportions of wealth and human capital invested in a firm will establish corporate hedging if they find the cost of personal risk management greater then the cost of hedging at the firm level (Stultz (1984), Smith and Stultz(1985)). Demarzo and Duffie (1995) put forth a further explanation for corporate hedging, stating that hedging may be optimal at the firm level if managers hold superior or private information which would make them more informed of firms hedging needs then private investors

Empirical Literature

Initial empirical research in the area focused on attempting to identify which motive explained why firms undertook risk management activities.

Risk management is more prevalent in large firms, dispite smaller firms more likely to experience financial distress (Mian (1996)). Economics of scale in hedging.

Positive relationship between hedging and leverage, consistent with the theory that hedging can decrease the costs of financial distress. Dolde (1995) and Haushalter (2000).

Graham and Rogers show that firms hedge to increase debt capacity, but expected savings due to tax convexity are not a factor

Hedging decreases the underinvestment problem as firms whio hedge seem to have more growth opportunities. Nance et al (1993) and Ge`czy et al (1997)

In recent years the literature has attempted to more directly and empirically answer the question of whether hedging increases the market value of a firm. Tufano (1996) studied North American gold miners over a period of 3 years in an attempt to observe whether academic theory on the reasons behind hedging could explain differences in risk management activities. Tufano (1996) found little empirical support for the theory of hedging to maximise shareholder value, instead evidence was found for a managerial utility maximising motive as firms whose managers held more options in the firm hedged less and firms whose managers held more stock in the firm hedged more.

Traditionally direct empirical studies of whether hedging increases value in a firm, and the size of any observed hedging premium, was hindered by the lack of reported data and hence the reliance of surveys [1] . This problem was alleviated in the late nineties with changes in accounting laws requiring more detailed and precise disclosure of derivative use.

Allayannis and Weston (2001) examined the effect of using currency derivatives on firm value, introducing the Tobin’s Q proxy for firm value into this area of the literature. They found a positive relationship between hedging with currency derivatives and Tobin’s Q and hence found evidence that hedging increases firm value by approximately 5 percent. Jin and Jorion (2006) argue that the evidence of increased firm value from hedging found in Allayannis and Weston (2001) may be due to sample selection, in particular that firms in the sample are exposed to different risk rather than one uniform risk over a whole industry. Jin and Jorion (2006) studied the hedging activities of 119 oil and gas producers over a three year period in the US and found that hedging reduces the volatility of firms stock prices, but failed to find a positive relationship between hedging and the market value of firms. In an ongoing working paper Jin and Jorion (2007) confirm the results of their 2006 paper by showing that no positive relationship exists between hedging activities and firm value for a sample of 44 North American gold mining firms from 1991 to 2000. Carter et al. (2006) investigated jet fuel hedging in the US over an 11 year period up to 2003 and found that a positive relationship existed between jet fuel hedging and firm value and quantified the hedging premium at up to 10 percent, significantly higher than the premium found in Allayannis and Weston (2001). They also concluded that the majority of the hedging premium was due to the interaction of hedging with capital investment and hence provided evidence that the value added from hedging stems from decreasing underinvestment costs.

Hedging and Competition

Conclusion

It is evident that current research is providing inconsistent results, with evidence both for and against a hedging premium. A criticism commonly voiced in this type of study is inappropriateness of sample selection, due to non uniform risks across the sample, or the study of an industry in which hedging practises do not differ between firms (Jin & Jorion, 2006).The inconsistency in findings may also be due to the accuracy and completeness of the models used to investigate the effect of hedging. The hope of this paper is to extend the current model used in Allayannis and Weston (2001), Jin and Jorion (2006) and Carter et al. (2006) in an attempt to more effectively capture the factors relevant to a firms value and ultimately reach a more informed conclusion of whether hedging increases firm value.