the underinvestment problem and corporate derivatives uses

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The underinvestment problem and corporate derivatives uses dansdeals pggm investments

The underinvestment problem and corporate derivatives uses

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Finally, hedging can increase firm value by reducing the compensation required by managers to bear their nondiversifiable claims on the firm. However, hedging will increase firm value only if it is cost-effective. Breeden and Viswanathan [11] and DeMarzo and Duffe [16] argue that managers may hedge so as to protect their reputation as good professionals, which is assessed by the job market based on their firms performance.

Froot et al. Their rationale is that market imperfections make external financing more costly than financing with internal funds. Additionally, the marginal cost of external financing increases with the amount already raised externally. They argue that a shortfall in cash may be costly to the firm not only because of expensive outside financing, but also because of some decrease in investment. Because of the diminishing marginal returns of investment, it is necessary to reduce the level of investment in order to compensate for the more expensive external financing, whose marginal costs increase with the quantity of outside money raised.

Therefore, hedging can increase the value of the firm by reducing variability in cash flows. Schrand and Unal [48] approach the multiple sources of risk which are bundled together in a single asset or liability and which affect the distribution of firms cash flows.

For example, one single asset can be subject to many risks such as: input and output price risk; foreign exchange rate risk; interest rate risk; credit risk; liquidity risk; market risk; regulatory risk; political risk; competition risk etc. However, firms can reallocate these risks using cash market or derivative instruments. Risk reallocation is desirable because firms have a competitive advantage in bearing risks related to their activities core-business risk but have no competitive advantage in bearing most financial risks homogeneous risk.

Schrand and Unal define coordinated risk management as the process of simultaneously increasing core-business risk and decreasing homogeneous risk to achieve or maintain a target total risk level. They provide empirical evidence of this happening in the savings and loan industry by examining firms which con verted from mutual to stock ownership structure.

Their findings indicate that firms may use hedging not only for risk reduction, but also for reaching a risk allocation that represents the most favourable risk-return trade-off. The theories above explain that cash-flow volatility is costly for the firm because of capital market imperfections. However, in the specific case of hedging interest risk with swaps, hedging can also be explained because it can lower the cost of debt financing.

Visvanathan [53] discusses many theories that explain the use of interest rate swaps. The assumption is that companies prefer long-term fixed-rate debt, but interest rates for this type of debt are very high. Therefore, companies borrow short-term floating-rate debt and then use interest rate swaps to create "synthetic" long-term fixed-rate debt. According to Flannery [19] , Diamond [17] , and Titman [51] borrowing firms with private information on their future performance may prefer short-term debt when they expect to obtain favourable results in the short term.

In fact, if results turn out to be favourable then they will be able to benefit from lower interest loans. The asymmetric information problem comes from the fact that prospective creditors may believe that companies seeking fixed-rate long-term debt may be not expecting favourable results so that the interest rate should account for a higher risk of default. Another explanation is that creditors are subject to agency costs of debt, such as the "underinvestment" and the "risk-shifting" problems.

Wall [54] points out that creditors would require a higher rate to compensate the higher risk of fixed-rate long-term debt. Therefore, in both cases above firms have an incentive to issue short-term debt and then use interest rate swaps to obtain a "synthetic" long-term fixed-rate debt which has a lower interest rate than the original long-term fixed-rate debt.

Important factors in interest rate hedging are: 1 the benefits of hedging for reducing the costs related to cash-flow volatility expected tax costs; costs of financial distress; agency and asymmetric information costs ; 2 the benefits of interest rate hedging in reducing the cost of interest expenses; 3 the extent of ex-ante interest rate exposure, i.

Empirical evidence of these theories is given by Saunders [47] , for interest rate swaps. DaDalt, Gay and Nam [15] provide empirical evidence that currency derivatives, besides interest rate derivatives, can also mitigate asymmetric information problems. They provide evidence that both the accuracy and consensus in market analysts earnings fore casts are higher for firms that use derivatives than for those that do not.

Two different dependent variables are used to measure interest rate risk hedging activity. The first dependent variable is the principal notional value of interest rate derivatives scaled by company size, which, as stated before, has been used by most previous studies on hedging demand. The choice of this dependent vari able by previous researchers was mainly due to the limited information required in financial reporting by accounting standards at the time previous studies were written.

The second dependent variable used aims to overcome this limitation and is based on the ratio of principal notional amounts of interest rate derivatives to total interest-rate-risk-bearing liabilities, as mentioned above. In fact, the measurement of interest rate risk exposures being hedged was only possible due to reporting requirements existing in Australia since However, this information is not available in electronic data bases and had to be collected manually from financial reports.

Table 1 gives details of the sample size, the company type investigated, the data source, the year the data sets refer to, the country from which companies are studied and the scope of financial instruments investigated. It can be seen that only 7 out of these 30 empirical studies were done with data sets from countries other than the United States. Regarding the demand for hedging with deriva tives, four previous studies include data from Australian companies One of the four studies, Bartram et al.

However, all of these four studies were unable to measure the risk exposures be ing hedged, so that the dependent variable used is the principal notional amount of derivatives scales by company size. The hypotheses tested empirically in this paper can be classified into the fol lowing groups: 1 Taxes; 2 Cost of Financial Distress 3 ; 3 Underinvestment Problem; 4 Economies of Scale; 5 Shareholders value creation.

The convexity of the effective tax function can create incentives for firms to hedge. However, the progressivity of corporate tax rates are not the only rea son for the convexity of the effective tax function. Tax preference items such as tax loss carry-forwards, investment tax credits and foreign tax credits can also affect the convexity of the effective tax function [Graham and Smith [27] ].

Therefore, there are two factors that can affect this convexity:. Therefore, tax issues provide the following hypothesis 4 in relation to corporate hedging:. The following proxy variables will be used to test this hypothesis in this paper:.

The following studies use proxies to measure the effect of tax credits carried forward. Geczy et al. Nance at al. Two studies Fok, Carroll and Chiou [21] and Gay and Nam [24] do not scale the value of net operating losses. Nance et al.

The argument here for using the book value of as sets as a scaling factor is the assumption that expected taxable income and book value of assets should be proportional across firms. Any cross-section variation in this proportion should be small relative to the cross-section variation in future tax benefits. Graham and Smith [27] argue that the existence of NOL carry-forwards does increase the tax incentive to hedge for firms with expected profits.

However, they also argue that NOL carry-forwards provide a disincentive to hedge in the case of company with expected losses, which could make the impact of NOL carry-forwards on the decision to hedge ambiguous. Graham and Rogers [26] also point out that existent tax credits, such as NOL carry-forwards, can be a proxy for financial distress, rather than a tax motivation to hedge.

If hedging can reduce variability of future financial results then it can also reduce the expected costs of financial distress. As explained before, these costs can be classified as both direct and indirect bankruptcy costs. Therefore, expected costs of financial distress provide the following hypothesis in relation to corporate hedging:.

It is important to recognise two components of a companys expected costs of financial distress: 1 the extent of the exposure to financial risk; 2 the proba bility of adverse financial outcomes. Therefore, proxy variables used to test this hypothesis should be able to take these two components into account.

For example, if a company has a high financial leverage then the extent of its expected costs of financial distress will depend not only on the size of debt but also on the variability of total debt. Although leverage is a relevant proxy for expected financial distress costs, ideally one should also be able to measure other factors that could influence these costs. In fact, some of these factors can be diffcult to measure, for example: companys risk appetite, operational risk, regulatory risk, competition risk, regulatory risk, and political risk.

Also, at the empirical research level, it is diffcult to quantify important factors such as corre lations between assets and liabilities. These correlations are important to provide a measure of total financial risk. Therefore, despite the fact that financial leverage is generally accepted as a proxy for total financial risk, one should, where possible, quantify the original sources of financial risk and how they relate to each other.

An example is the case in which a company has a "not so high" debt-to-equity ratio but there is much mismatch between assets and liabilities. In this case there is also a high expected cost of financial distress due to the high probability that the payment of liabilities will not be honoured.

The level of debt risk also has to be considered. For instance, a company could have a "not so high" debt-to-equity ratio but most of its debt could be very uncertain, e. Here the probability of financial distress is high despite the fact that leverage is not so high.

Finally, one should ensure that leverage is measured before the company hedges, so that it reflects the companys ex ante financial risk. For example, in the case of insurers, leverage is affected after reinsurance is contracted, since there is a reduction in the outstanding claims reserve. The following proxy variable will be used to test hypothesis 2 H2 in paper:. All previous studies use some measure of financial leverage as a proxy for a firms financial distress.

This study measures leverage by the ratio of total liabilities to total assets, as also used by Graham and Rogers [26] , Nguyen and Faff [43] , Bartram et al. Other studies use proxies such as the ratio of capital to debt or the ratio of debt to equity.

The current ratio is used as a measure of financial liquidity and is equal to the ratio of current assets to current liabilities. It measures the firms ability to hon our its liabilities in the short run. This same liquidity measure was use by Nance et al. It is a measure of a firms liquidity after the firm has paid for everything, including investments. For example, Saunders [47] also free cash flow to measure liquidity and test the asset substitution hypothesis. Some previous studies classify liquidity as a "hedging substitute", instead of associating it directly to financial distress.

This is in line with the argument by Froot, Scharfstein and Stein [23] that external financing is costlier than internal financing. Therefore, it can be argued that less liquid firms have a smaller financial buffer and should then be more likely to hedge with derivatives. However, it is only true if we observe ex-ante liquidity. It is expected that after firms hedge they may obtain a higher level of ex-post liquidity. Because the data used in this paper contains only ex-post liquidity, the hypothesis here is that higher liquidity is related to more interest-rate-risk hedge 5.

Financial reports from Australian companies provide enough detail about finan cial assets and liabilities 6. This study also uses the ratio of financial assets to financial liabilities Financial Ratio to measure the firms financial strength. This proxy was not found in previous studies. Because interest rate is a financial risk, it makes sense to use a measure of financial strength based on financial assets and liabilities.

Because this study aims to analyse the corporate demand for interest rate hedg ing, it is important to use an explanatory variable which proxies for interest rate risk exposure. We use the ratio of floating interest rate to total interest-rate-risk bearing liabilities. Graham and Rogers [26] also use a similar explanatory variable, the sum of debt in current liabilities plus long-term floating debt, scaled by total debt.

Earnings per share EPS equal the net profit after tax, less outside equity in terests and preference dividends divided by diluted weighted number of shares outstanding during the year. Again, some previous studies classify dividend pay out as a "hedging substitute" item. However, the hypothesis here is that a higher dividend payout decreases the chance that funds will be available to pay fixed liabilities. Financially distressed firms may reject positive NPV projects because the bene fits would accrue mainly to bondholders at the shareholders expense.

Therefore, hedging can mitigate the agency cost of underinvestment through reduction of the probability of future financial distress. Theory indicates that the underinvestment problem is greatest for leveraged firms which have significant growth options in their investment set. This implies the following hypothesis:. The following proxy for growth opportunities is used:. Another common proxy variable used in previous studies is the market-to-book ratio. One possible reason for this is the diffculty in measuring the firms book value, used in the market-to-book ratio calculation.

For example, it is diffcult to value a firms intangible assets. Similarly, existing fixed assets are also diffcult to value unless a market for used equipment exists. Firm size is a proxy for many factors that impact the corporate demand for hedg ing. Yet, there is much controversy about the relation between these factors and firm size. For example, it is argued that even small bankruptcy costs can be suffcient to induce large firms to hedge, if the reduction in expected bankruptcy costs exceeds the costs of hedging.

However, Warner [55] finds that bankruptcy costs are less than proportional to firm size, so that the reductions in expected bankruptcy costs are greater for small firms, which, for this reason, should be more likely to hedge. In the case of reinsurance, Mayers and Smith [38] argue that bankruptcy costs should have a higher impact on smaller firms, and that small firms are less likely to have the "specialized internal talent" available in larger firms, so that they would tend to reinsure more.

Cummins et al. However, on the other side, Block and Gallagher [7] and Booth, Smith and Stulz [10] argue that hedging programs exhibit informational scale economies and that larger firms are more likely to hedge. Also, in the case of derivative markets, there are significant scale economies in the structure of trans action costs, implying that large firms are more likely to hedge with these in struments.

Thus, despite the fact that most empirical results show a significant relation between hedging and company size, it is argued that the relation be tween hedging and firm size is theoretically undetermined. Almost all previous empirical studies also use some proxy for company size.

Instead, Fok et al. Most other empirical studies measure company size by using the market value of equity plus the book value of debt. Risk management at the firm level is only economically feasible if the increase in firm value is greater then the hedging costs, and if shareholders cannot benefit from a similar increase in value by managing risk on their own account at a lower cost.

Therefore, if firms hedge, it is expected that hedging is being used to increase firm value through reduction in taxes, costs of financial distress and agency costs. Therefore, the following hypothesis is assumed:. This study uses the annual log return in stock prices to proxy the increase in firm value. The rationale is that more interest-rate-risk hedging is associated with higher annual increase in share price. Finally, Table 2 summarizes the hypotheses to be tested and the expected esti mation results in this paper.

When mentioning the previous empirical studies on interest-rate-risk hedging, it is important to take into account the accounting standards in force at the time the studies were written. In fact, despite the substantial improvements in hedg ing reporting, the accounting standards in the U. An important limitation was the unavailability of quantified financial risk exposures.

With this, the principal notional amount of derivatives scaled by company size was the most used proxy for hedging activity in previous studies. Fortunately, since the Australian accounting standards require detailed information on interest risk exposures of Australian corporations and on the hedging instruments used to manage these exposures. Because of this, this study is able to show the improvements in empirical analysis that are possible when one is able to quantify the exposures being hedged.

Most previous studies on the corporate demand for hedging with derivatives are based on reported data from US companies in the s, when disclosure of derivative financial instruments became compulsory. However, the extent of informational disclosure on derivatives differed substantially in the US and in Australia until the convergence of accounting standards in January In particular, since Australian companies have started to report more de tailed information about the hedging of interest rate risk with derivatives.

An important difference from the US reporting requirements was that Australian companies had to report interest rate risk exposures, measured by interest-rate risk-bearing item, besides the notional amount of derivatives used. Since the FASB had required US companies to report the notional amounts of derivatives used, but not the value of hedged items. Thus, most previous studies based on US companies could not measure ex-ante risk exposures directly, so that the "hedge ratio" could also not be precisely calculated.

This fact explains why most previous empirical studies on the corporate demand for hedging with derivatives by US companies were based primarily on the no tional amount of derivatives scaled by company size. In fact, this was the best proxy available for hedging activity at the time they were written. Exceptions to this are previous studies based on the commodity price hedging in the gold industry Tufano [52] and in the oil and gas industry Haushalter [29] and Lookman [36] , in which proxies for the hedge ratio are built based on the level of expected future production.

However, for these proxies to be appropriate, the level of production must be close to the level of sales the sales revenue is the hedged item. Furthermore, these previous studies on commodity price risk provide results that cannot be generalized to all companies since they refer to risks specific to the gold mining and the oil and gas industries.

More general results are obtained with studies on foreign exchange risk or interest risk, since they are common in all types of companies. Table 3 shows previous studies on hedging with derivatives since The ta ble shows the authors names; the year of publication; the data source, the time range and the country from which data was collected; and the dependent vari able used in the studies. It can be seen that, with the exception of Haushalter [29] and Lookman [36] , all other previous studies used the ratio of notional value of derivatives to asset value as a proxy to the hedge ratio.

With this statement, in US companies were required to report notional principal amounts of financial instruments with off-balance-sheet risk i. This standard applied primarily to swap contracts and required disclo sure of the face or contract amount and the nature and terms of the instrument.

Therefore, with this state ment the fair value of derivative financial instruments had to be reported. However, the data sets available in the U. Hentschel and Kothari [30] p. In their conclusions they comment that Our data show the considerable limitations of the deriva-tives disclosures under the current US accounting standards. Firms do not have to disclose the sign or the magnitude of their derivative exposures, only the notional principal of their positions.

The crudeness of the information makes it diffcult to determine whether an individual firm is reducing or taking risks with derivatives. It was applicable to derivative financial instruments such as futures, forwards, swaps, option contracts and other financial instruments with similar characteristics.

Also, for the first time this standard required a distinction to be made between financial instruments held or issued for trading purposes and financial instruments held or issued for purposes other then trading. This time, disclosures applied in determining the fair value of a financial instrument, with detailed information required not only for derivative instruments, but also for the hedged items. Therefore, this statement required the identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the hedging instruments effectiveness in offsetting the exposure to changes in the hedged items fair value attributable to the hedged risk was assessed.

The AASB , also issued at that time, defined the more general requirements for the financial reports. Although AAS 33 did not require very detailed information on derivative in struments in general if we compare with the equivalent requirements made at that time by the FASB in the US , this accounting statement did require enough detailed information about interest rate risk exposures and their management with derivatives.

Since December , Australian companies had to show in their annual reports their interest rate risk exposures and hedges by class of asset and liability. These classes are: 1 floating interest rate risk bearing; 2 fixed interest rate risk bear ing; and non-interest rate risk bearing e.

Therefore, with quantified interest rate risk exposures, by class of liability, and the corresponding notional principal amounts of derivatives used, it is possible to measure ex-ante interest rate risk exposure and the extent of ex-post hedging positions of Australian companies.

An important thing is that it was possible to first identify whether companies were actually subject to interest rate risk because they had to report interest rate risk exposures even if they did not hedge these risks. Therefore, the classification of companies between hedgers and no-hedg ers is more accurate. Additionally, Statement AAS 33 required entities to state the objectives for holding or issuing derivative financial instruments, the context needed to understand those objectives, and their strategies for achieving those objectives.

Therefore, this requirement made it possible to verify whether companies were using derivatives and if their reasons for using derivatives were for hedging or trading purposes. A significant number of companies report their interest rate risk exposures together with the principal notional value of derivatives used to hedge them, which makes it possible to measure the size of hedges.

It is a requirement that all reporting entities in Australia adopt the standards as they have replaced the previous Australian standards. While significant progress towards international convergence is expected to be made in the next few years, the volume and complexity of issues implied that many differences between IFRS and the US GAAP remained beyond January However, the remaining differences in the reporting of derivatives and hedging are not substantial enough to cause any significant dis advantages between future studies that may be based on either IFRS or on the US GAAP.

For example, the IFRS provides enough detail on how to recognise identify and measure quantify financial assets and liabilities; derivatives including embed ded derivatives ; hedging instruments derivative or non-derivative ; and hedged items. Additionally, companies need to report hedging effectiveness, i. Also important for future research on corporate risk management, the IFRS requires more detailed information about executives remuneration.

Statement AASB , operative since June , requires companies to properly identify and quantify the following components of executives remuneration: 1 primary benefits cash salary, bonuses and profit-sharing ; 2 post-employment benefits; 3 equity compensation shares and options ; 4 any other remuneration. It can be noticed that, in relation to the previous accounting standards, the IFRS provides substantial improvement on hedging reporting.

An important point is that researchers will be able to have a clear idea of measurable risks faced by companies and how much of these risks are being hedged with financial or non financial instruments. Therefore, future research will benefit from the availability of "hedge ratio" of each hedged risk exposure in a given company.

As shown before, the appropriate measurement of the "hedge ratio" is important for the robustness of empirical analysis of the demand for hedging, in the sense of correctly identifying which factors drive the corporate use of hedging instruments to manage different risk exposures. Table 6. The first panel data set contains financial information from companies, which are classified into hedgers and non-hedgers. This data set is used to analyse the corporate decision to hedge interest rate risk.

The second data set contains only interest rate risk hedging companies. This data set contains observations from 78 companies, with detailed information about the interest rate risk exposures being hedged. In fact, this study focuses on corporate interest rate risk hedging because interest rate risk exposures are the only financial risk exposures that can be properly measured given the information available in the annual reports of Australian companies.

Although other risks such as foreign currency risk and commodity price risk are reported, they are not reported in enough detail to be associated with the financial derivative instruments used to hedge them. On the other hand, Australian companies do report detailed information about their interest risk exposures and about the interest rate derivatives used. Moreover, a previous survey by Benson and Oliver [4] shows that interest-rate-risk management is relatively more important for Australian companies than the management of foreign currency and commodity price risks.

A possible reason for this is that Australian companies tend to borrow money locally, so that most of the loans are in local currency. Interest rate risk exposures and hedging information are manually collected from annual reports provided by Connect4 9. Some exclusions were necessary from the original data set. Judge [33] , p. However, in this study only financial institutions which provide interest rate risk instruments, such as banks, are excluded from the sample, so that financial institutions that do not provide them, such as insurers, are not excluded.

Other companies were also excluded because there was not enough financial information about them, or because financial information was available only for a very limited number of years. In late and early , Brazil suffered from a financial crisis that led to its currency, the real, being fully floated on January 15, As part of the plan, important regulatory changes were introduced in the financial markets to reduce controls on capital flows and improve the access of corporations to foreign currency debt from international capital markets.

A crawling peg exchange rate regime was adopted for the real, with preannounced narrow bands within which the exchange rate was maintained. In this paper, we refer to the period before January as the "fixed exchange rate regime. The years leading up to saw financial crises affect Mexico , East Asia , and Russia The Brazilian economy was severely affected by the Russian crisis of August, , and suffered substantial capital outflows.

External aid from the IMF and the G-7 provided a breather, but capital outflows increased again in January, , leading to the fixed exchange rate regime being abandoned in favor of a floating regime. There were continued shocks to the economy in the floating exchange rate period, with the Argentinian crisis of having a ripple effect throughout Latin America, and a presidential election in contributing to political uncertainty. Further, compared to the orderly change in the value of the real in the fixed exchange rate regime, in the floating era the real was significantly more volatile.

As seen from the figure, GDP growth was very low immediately before and after the decision to float the real and , respectively as well as in the period , but was stronger in and The intermediation efficiency of the domestic banking sector in Brazil has typically been poor, compared both to developed markets as well as other comparable developing economies.

This is about ten times higher than the average spread in developed countries and about three times higher than the average spread in Latin American countries Sobrinho As a consequence, the nominal interest rate charged to commercial borrowers has remained high as compared to other countries.

Inflation-adjusted short-term interest rates in Brazil have also been high. For example, based on IMF data, Rogoff shows that the inflation-adjusted short-term interest rate in Brazil was 9. Several reasons have been proposed for the inefficiency of banking sector in Brazil.

Nakane, Afanasieff and Lhacer and Gelos point to a government subsidy to poorly performing sectors of the economy, high default rates on corporate loans, high operating costs of banks, and onerous reserve requirements in addition to overall macroeconomic instability. Sobrinho shows that a government policy requiring banks to make unprofitable loans to selected riskier borrowers leads to disproportionately higher rates on the other loans.

Belaisch finds some evidence of oligopolistic behavior in the Brazilian banking sector. Arida, Bacha, and Lara-Resende suggest that high credit spreads for Brazilian firms are a result of a crowding-out effect due to rising government debt in the aftermath of the currency crisis. Inefficiencies in the banking sector have resulted in limited access to bank credit as well as a high cost of bank loans. Figure 3 displays the evolution of the "Selic," the Brazilian Central Bank's overnight lending rate, from the period through Overall, during the period of our study, the Brazilian economy was passing through an extremely turbulent phase.

The change in exchange rate regime especially provides us with a well-structured setting to study the effect of currency risk hedging on firm value. We collect data from two sources. First, we obtain financial statement and market value information for all Brazilian firms listed in the Economatica database as of August, This comprises a list of more than firms. The database over-represents large firms and potentially suffer from a survivorship bias: we have no data on firms that may have gone bankrupt or been acquired.

If non-hedgers are more likely to fail, the bias works against our finding any value to hedging. We exclude financial firms, which may use currency derivatives to hedge operational rather than financial risk. We also exclude state-owned and foreign-owned firms, both of which may have deep pockets. For each of the firms contained in the database in , we obtain annual financial statements and equity market values for the period through from Economatica.

While Economatica computes equity market values for many firms, there are several missing values. As a second way of determining equity values, we also determine for each firm, and each class of share it has issued, the average daily closing price for the last five trading days of each year.

We then determine the value of each class of share for each firm by multiplying the average price times the number of shares outstanding, and add across the classes to determine the overall market value of equity for the firm. As a cross-check, we find a high correlation between the market values from the two methods, when both are available. We obtain the following items of information for each firm-year from the footnotes to the balance sheet: whether a firm uses foreign exchange derivatives, whether it is an exporter, whether it has dollar assets, and the amount of foreign debt outstanding.

Following regulation CVM No. Many non-users explicitly mention that they do not use derivatives, whereas many firms do not mention derivatives at all. The latter are treated as missing values. Since we only know the kinds of derivative contracts used e.

The most common hedge contracts among firms in our sample are currency swaps and forward contracts. Similarly, we create a dummy variable set to 1 if a firm is an exporter, and zero otherwise. On exports, some firms disclose data on exports as part of the annual report.

In other cases, firms mention they are exporters but do not disclose information about foreign sales. The dummy is set to 1 in each case. We also create a dummy variable set to 1 if a firm holds assets denominated in or indexed to US dollars. Such assets include cash and deposits in foreign currency and government bonds treasury notes and central bank bonds indexed to the dollar. Finally, in many cases, firms report the currency composition of their debt, from which we determine the foreign to total debt ratio for each firm.

Our basic measure of value is Tobin's , or the ratio of a firm's market value to its book value, where market value is determined as the sum of book value of debt and market value of equity, and book value is the sum of book value of debt and book value of equity. We remove observations with missing values for market value of equity, book equity, cash holdings, and derivative usage.

Our final data set is an unbalanced panel containing firms and 1, observations firm-year pairs. Figure 4 shows the number of firms in each year of our sample. The number of derivative users grows for the first four years and levels out between 53 and 58 over the last four years.

The total number of firms grows for the first three years, and is between and over the last five years. We start with a description of the key statistics of our sample firms and a univariate comparison of derivative users and non-users. Table 1 presents some descriptive statistics.

Panels A and B provide the mean, median and standard deviation of key firm characteristics of hedgers and non-hedgers respectively, and Panel C provides the corresponding statistics for all firms. Apart from the usual caveats that apply to univariate tests, in our exercise we also need to keep in mind the effect of pooling observations across different years. There was considerable inflation in Brazil during the period of analysis.

In our formal empirical analysis, we explicitly control for this effect. The univariate analysis shows some obvious differences in firm characteristics across the two groups. Hedgers are much larger firms, both in terms of their revenue and market capitalization. The median hedger firm's book leverage Noticeably, while the domestic leverage i. The median hedger firm has a foreign currency leverage of Further, we find that hedgers keep significantly higher cash-balances as compared to non-hedgers.

We also investigate the operating profitability and capital expenditures of the two groups. Finally, we find that the median market-to-book ratio for hedgers is 1. Overall, our univariate results show that hedgers are large firms with high leverage, especially high foreign currency debt.

They seem to have similar operating profitability as non-hedgers, but are able to invest more via capital expenditures. In addition, their market value is significantly higher compared to their non-hedger counterparts. In the rest of this Section, we try to tease out the effect of derivatives on firm value more precisely. To isolate the effects of derivatives on firm value, we need to control for other known drivers of value. Consider a simple dividend or earnings growth model of firm valuation.

Any variables that potentially affect either the firm's current or future cash-flows or its cost of capital may in turn affect value. In particular, we include the following controls: i the firm's operating profit margin, which is a measure of its current earnings ii the log of sales revenue, which we use as a proxy for firm size throughout the paper iii the growth in sales revenue, which proxies for the current growth rate of the firm, iv capital expenditure, which proxies for the expected future growth rate, v the cash balance of the firm, which accounts for an important alternative means of hedging vi financial income to total assets, which captures the mechanical effects of increased cash flow in bad states due to the hedge vii financial expenses which include interest expenses to total assets, which proxies for the extent of debt, and viii industry and year fixed effects.

We now describe the role of each of these. The operating profit margin of a firm measures its profitability prior to financial income or expenses, and corresponds to the numerator in an earnings growth model of firm value. Since derivatives directly affect financial income, we use operational earnings as our profitability control. The particular measure we use is a firm's earnings before interest and taxes scaled by total assets.

Next, we control for firm size. Large firms are likely to have lower risk, and thus a lower cost of capital. Especially during an economic downturn, large firms are expected to better withstand adverse shocks. This could happen, for example, due to their ability to access external capital markets relatively easily or due to their more competitive positions in product markets, as compared to small firms.

We include the log of the firm's sales revenue as a control for market size. We find similar results for an alternative definition of firm size based on the log of total assets of the firm. In the spirit of the dividend growth model, we need a proxy for the expected growth rate in the firm's earnings. In the absence of direct growth forecasts, we use two proxies to capture growth rates.

First, we consider the firm's sales growth, which is computed by measuring the year-by-year percentage growth in a firm's sales revenue. This measure is a proxy for the current growth rate of a firm and to the extent current growth rate is correlated with future growth rate, it controls for expected growth in firm's earnings. Our second measure of growth is the capital expenditure of the firm scaled by its total assets.

Higher levels of capital expenditure are typically associated with better investment opportunities and a higher anticipated earnings growth rate for a firm. Cash represents the ultimate hedge, suggesting that hedging via derivatives will be less valuable to firms with high cash balances. To control for this, we include the ratio of cash to total assets as a right-hand side variable in the regression. Through the bulk of our sample period, the value of the real was falling relative to the US dollar see Figure 1.

Thus, firms that hedged against such a fall will have increased cash flow as a result of the hedge, and hence a higher value. Gains from financial derivative transactions are reported in financial income losses are reported in financial expense. We include the ratio of financial income to total assets as a variable, to account for the extra cash flow generated by the hedge as the real depreciates.

The capital structure of a firm can affect its value through several channels. An immediate effect of debt is its impact on firm-value through higher tax-shields. In addition, leverage can have indirect valuation implications through its effect on agency costs.

To control for these effects, we include the firm's financial expense to total assets on the right-hand side. Since our dependent variable includes the book value of debt in both numerator and denominator, we prefer this variable over a direct leverage ratio in our regression specification, to avoid any mechanical correlation between the dependent and explanatory variable.

Financial expense includes interest expense, losses from derivatives, and bank fees. Finally, we control for industry and year fixed effects. Based on their primary industry classification, we group firms into 16 industry groups and include these dummies in the model. It is very likely that industry affiliation captures a large component of a firm's growth opportunities as well as its risk, and therefore its cost of capital.

Year dummies are included to control for significant changes in macro-economic conditions from year-to-year, most notably inflation. Table 2 provides the basic regression results for the effect of currency derivative usage on value. In Models 1 and 2, we provide results from pooled OLS regression estimation with firm-level clustered standard errors. For both of these models, we find that firm value is higher for large firms and firms with better operating profitability. High sales growth firms and firms with high capital expenditure also have higher value, but these results are statistically weak.

In Model 2 that includes the effects of cash balance, financial income, and leverage, we find that firms with higher cash balances have larger value. In both models, we find a positive and significant coefficient on , the dummy variable representing the hedger firms. The coefficient estimates from the OLS model are large, in the range of Since these effects are economically large, we next turn to identifying their source.

An immediate possibility is an omitted variable problem; that is, we find these effects because we have not controlled for some firm-specific factor that creates higher value and that is also positively correlated with derivative usage. For example, better managerial ability, which is unobservable, could be one potential candidate for an alternative interpretation of our results. To deal with this concern, we exploit the panel nature of our data and estimate a firm fixed effects model.

In such a model, any firm-specific omitted factor that is constant from year-to-year, including unobservable managerial skill, is automatically controlled for. Models 3 and 4 of Table 2 provide regression estimates from the fixed effects model. Since we have firm fixed effects, we drop industry dummies from these models. To account for correlated errors across firms in the same industry, we adjust standard errors for clustering of residuals at the industry level. We find a positive coefficient of 7.

The fixed effects model suggests that derivative users seem to gain value when they begin using derivatives. Since firm fixed effects implicitly control for various unobserved characteristics of the firm, we are closer to a causal link from hedging to firm value.

Compared to the OLS models, we find that the point estimate of has dropped by approximately a half in this specification, consistent with the idea that the firm-specific unobservable factors do contribute significantly to the OLS point estimates. The fixed effects regressions also show that firm value increases significantly with operating profitability, capital expenditure, and cash balance.

Unlike the pooled OLS model, the effect of size has become insignificant in the fixed-effect model. This suggests that some unobservable firm-specific characteristic is correlated both with value and size. Overall, then, we establish a significant association between firm value and derivative usage.

Why should hedging add value? Motivated by previous studies, we now explore two channels via which this value creation may be taking place: a the effect of derivatives on a firm's capital expenditure plans Froot, Scharfstein, and Stein , and b its effect on a firm's debt capacity Leland Froot, Scharfstein, and Stein suggest that hedging minimizes the frictions associated with volatile cash flows and thereby allows a firm to maintain a smooth investment policy.

In particular, the sensitivity of investment to a firm's internal profit before hedging should be lower for hedgers as compared to non-hedgers. The key assumption of costly external financing underpinning the theoretical model of Froot, Scharfstein and Stein is likely to be especially true in our sample, when the entire economy was passing through a major transition. During such a period, scarcity of internal funds and poor health of the domestic banking sector have the potential to severely hamper a firm's investment policy.

We estimate the effect of currency derivative usage on a firm's capital expenditure scaled by beginning-of-the-year total assets. We include year and industry dummies to capture the effects of the macroeconomic environment and industry-specific investment opportunities. The results are presented in Table 3. The coefficient on in Model 1 suggests that hedgers invest about 1. The univariate results in Table 1 show that the mean level of capital expenditure for non-hedger firms in our sample is about 5.

The other coefficients in Model 1 indicate that firms invest more when they have higher internal profits and higher size, though the latter results is statistically insignificant. In Model 2, we drop the operating margin from the regression, and instead include two interaction variables in the model: a operating margin interacted with and b operating margin interacted with. The first interaction term captures the sensitivity of capital expenditures to internal profits for derivative users, whereas the second term does that for non-users.

That is, the investment-cash-flow sensitivity of derivative users is zero, whereas it is positive for the non-users. Consistent with Froot, Scharfstein, and Stein , we find that derivative users' capital expenditure policy is insulated from the availability of internal funds, whereas the same is not true for non-users. A large literature has investigated the sensitivity of investments to cash flows.

Alternative interpretations have been offered to the empirical finding of a positive coefficient on internal cash flows in an investment regression, including i firms face financial constraints, and therefore depend on internal funds to undertake capital expenditures, and ii when cash-flows are high, firms have better investment opportunities, which in turn produces a positive correlation between investments and cash flow.

In our regressions, we control for industry-specific effects, so it is hard to argue that high cash flow proxies for a better investment opportunity set only for non-hedgers. Summarizing the results from capital expenditure regressions, we find that a derivative users invest more than non-users, and b their investment plans are less sensitive to their own operating funds before the effect of hedging.

In the next sections, we explore a channel via which derivative usage may allow a firm to smooth its investment policy. We show first that foreign currency debt is a cheaper source of capital than domestic debt for firms in our sample. Then, we show that derivative users have better access to foreign currency debt. Access to the local currency debt market may be limited for all firms in the period of the economic crisis, so that access to foreign currency debt mitigates the effects of credit rationing.

This, in turn, allows them to invest more and make their investment less sensitive to internal cash-flows. Since foreign debt is cheaper, derivative users can further avail of a larger proportion of operating profit. We explore this channel of value creation in detail in the rest of the paper. As discussed earlier, at the macroeconomic level there is evidence that a domestic credit was scarce in Brazil during the period of study, and b domestic interest rates were very high during this period.

Thus, access to foreign debt can allow firms to benefit both via the greater quantity and reduced cost of debt financing. In the remainder of the paper, we explore these two channels in more detail at the micro-economic level using our sample. We proceed in two steps. First, we show that foreign currency debt is indeed a cheaper source of capital as compared to domestic debt. Next, we show that hedging not only leads to a greater proportion of foreign debt for firms as a proportion of total debt , but also allows firms to increase their foreign leverage i.

We do not have direct data on the interest rates or loan spreads charged to firms for foreign versus domestic loans, or, indeed, on the cost of the foreign currency hedge. We therefore adopt a different approach: we analyze the income statements of firms and relate their interest expenses and net profitability to their domestic and foreign leverage.

Our first test is designed to directly assess the costs of domestic and foreign debt. Brazilian firms report their interest expenses under the item "financial expenses. Lacking a finer break-up of interest expenses, we take financial expenses as a proxy in our empirical exercise.

We take the average values of the beginning and the end of the year debt levels since we are regressing a flow variable interest expense on level variables. The estimated coefficient in this model can be interpreted as the average firm's interest cost for every real of debt. Thus the estimated coefficients are closer in interpretation to interest rate on the debt of an average firm.

We provide estimation results in Table 4. In all three models, we include year dummies to remove time-specific variation in the cost of debt, and industry dummies to partly control for variation in operational risk. Across the three models, the average cost of domestic debt varies from In Model 1, the cost of foreign debt is estimated at a much lower value of The difference between these estimates is highly significant unreported in the table.

In Model 2, we break foreign currency debt into two groups by interacting the level of foreign currency debt with the currency hedging dummy. We include two variables in the regression: i , which takes the value of foreign currency debt for hedgers, and zero otherwise, and ii , which takes the value of foreign currency debt for non-hedgers, and zero otherwise. Though approximate, our estimates of interest rates are in line with the overall interest rate environment in the economy.

Our estimate is in line with this number. The cost of foreign debt for hedged firms is significantly lower. As a further test, we analyze the effect of foreign currency debt on net profit, given a level of operating profit. We regress a firm's net income to total asset ratio on domestic leverage, foreign leverage of hedgers and non-hedgers, and several control variables.

We compute domestic leverage as the ratio of local currency debt to the book value of total assets. Foreign leverage, , is constructed as the ratio of foreign currency debt to total assets. Again, we take the beginning and the end of the year average values of these leverage ratios for our regression model, and we interact with and its complement. In these regressions, we control for other components of net income, including EBITDA, depreciation and amortization, and investment income from subsidiaries, all scaled by total assets.

We include firm size on the right-hand size to account for the effect of economies of scale: Larger firms may have a lower per dollar cost of raising external funds, which in turn may lead to better profitability. Table 5 provides the regression results. The associated t-statistics are reported after clustering standard errors at the firm level.

As expected, we find that firms with higher operating profits, lower depreciation and amortization expenses and higher investment income have higher net income. In Model 1, the coefficient on implies that, controlling for these effects, derivative users have a net income to total assets ratio higher by 1.

In Models 2 and 3, we explore the effect of the cost of domestic and foreign debt on profitability. Overall, therefore, our results suggest that the foreign debt of hedger firms has a lower cost than either domestic debt or the foreign debt of non-hedgers. In the long run, the cost of the hedge should equalize the effective cost of foreign debt for hedgers and non-hedgers.

However, we analyze a short period of time and especially a period during which the Brazilian currency underwent large depreciation, which may have led to high costs of foreign debt for non-hedgers. Of course, in a frictionless market, the cost of hedged foreign debt and domestic debt should also be equal. The high spread between lending and domestic rates, mentioned in Section 2. Note that firms were selling reais and buying US dollars.

It is likely that a foreign bank taking the other side of the transaction also had branches in Brazil, and thus benefitted from acquiring reais at low deposit rates. Next, we analyze the effect of hedging on the debt-mix i. We note that firms are likely to use dollar derivatives and foreign currency debt in conjunction, and therefore these two decisions are determined jointly.

Later in the paper, in Section 4. We defer a serious discussion of endogeneity to the later section. We model the ratio of foreign debt to total debt for each firm in each year as a function of currency derivative usage and several control variables. Our control variables are motivated by two broad economic arguments. First, a firm may have natural hedges in the form of foreign currency cash flows that reduce the dollar risk arising from its debt portfolio.

We include a dummy variable that equals one if a firm reports export income in its footnotes, zero otherwise. Several Brazilian firms also hold financial assets linked to the US dollar. These include foreign currency accounts as well as domestic bonds indexed to the US dollar.

We include a dummy variable that equals one for firms with dollar assets, zero otherwise. Our second set of controls are motivated by the studies on the determinants of leverage in general see Titman and Wessels and Graham, Lemmon and Schallheim for example , and are included in the regression to ensure that our results are not simply driven by incentives to raise more debt. These control variables capture the effects of firm size, growth options, profitability, asset tangibility and non-debt tax shields enjoyed by the firm.

As a proxy for growth options, we include sales growth, measured as the year-by-year percentage growth in sales revenue. Asset tangibility is captured by the ratio of property, plant and equipment PPE to total assets. We include depreciation and amortization scaled by total assets as a control for non-debt tax shields. Table 6 provides the regression estimates. In Models , we provide OLS estimates with standard errors adjusted for clustering at the firm level.

Industry and year fixed effects are included as well. We find a positive and significant coefficient on suggesting that derivative users have higher foreign debt in their liability. In Model 4, we estimate a firm fixed effects model and obtain a coefficient of 6. The firm fixed effects model suggests that our results are not driven by a firm-specific omitted variable.

Having established that foreign currency debt for hedger firms is cheaper than domestic debt and that hedgers use more foreign debt in their debt-mix, we now turn to the level of debt for hedged firms. Our univariate results in Table 1 indicate clearly that hedgers have greater foreign leverage and approximately similar domestic leverage as compared to non-hedgers. For a more formal analysis, we regress foreign currency leverage foreign currency debt scaled by total assets on and other control variables.

The regression results are provided in Table 7. In the regression, we control for the well-known determinants of leverage described earlier for the debt-mix regression. In Models 1 and 2 we regress the ratio of foreign currency debt to total assets on and control variables. We include year and industry dummies in the estimation and report standard errors clustered at firm-level.

In the univariate tests of Table 1 , we find that the total leverage of the average hedger firm is Thus, it is unlikely that the foreign leverage is substituting domestic debt. To rule out this possibility, we regress domestic leverage on and control variables and report the results in Table 7 , under Models 3 and 4. We do not find any meaningful association between the hedging dummy and domestic leverage.

These results, taken together with the debt-mix results, suggest that hedger firms have a higher leverage than non-hedgers. Further, fixing the level of leverage they have a larger quantity of foreign currency debt in their liabilities. Thus hedging seems to benefit the firm both through the well-known higher debt capacity channel as well as through a lower cost of debt. It is plausible that our results relating debt-mix and debt-capacity to hedging suffer from a simultaneous equations bias: Firms with large foreign debt are more likely to hedge.

We next use an instrumental variable model to address this issue and to estimate the effect of derivatives on foreign currency debt net of a reverse causation effect. We model the foreign currency debt ratio and currency derivative usage both as endogenous variables.

The first-stage regression the equation requires a reasonable model of the derivative usage decision. As a precursor to our instrumental variable regression, therefore, we next estimate a hazard rate model of the determinants of derivative usage. Much of our empirical understanding about why firms use derivatives is driven by studies based on US firms such as Geczy et al. Bartram, Brown, and Fehle provide evidence from international data by investigating derivative usage across number of countries.

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You can help adding them by using this form. If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services. Economic literature: papers , articles , software , chapters , books. FRED data. Gay Jouahn Nam. We analyze the underinvestment problem as a determinant of corporate hedging policy.

We find evidence of a positive relation between a firm's derivatives use and its growth opportunities, as proxied by several alternative measures. For firms with enhanced investment opportunities, derivatives use is greater when they also have relatively low cash stocks.

Firms whose investment expenditures are positively correlated with internal cash flows tend to have smaller derivatives positions which suggests potential natural hedges. Our findings support the argument that firms' derivatives use may partly be driven by the need to avoid potential underinvestment problems. Gerald D.

Handle: RePEc:fma:fmanag:gay98 as. Download full text from publisher To our knowledge, this item is not available for download. To find whether it is available, there are three options: 1. Check below whether another version of this item is available online.

The overall findings are consistent with the independent director responsibility hypothesis, which suggests that independent directors play a monitoring role in managers' cash spending behavior and avoiding underinvestment problems.

Corporate governance and cash holdings: evidence from the U. Using data from , we find that callable bonds are often issued by firms with both information asymmetry and underinvestment problems. However, risk-shifting does not appear to be a major factor. Callable bonds revisited. Hedging, financing, and investment decisions: a simultaneous equations framework.

Given that high-growth firms are more likely to have underinvestment problems , debt may lead to financial constraint in those firms. Are debt and incentive compensation substitutes in controlling the free cash flow agency problem? This article shows that both over and underinvestment problems may arise when asset reconstitution is risky. Insurance, bond covenants, and under- or over-investment with risky asset reconstitution.

These results support the prediction of Myers that debt maturing after the expiration of the growth option causes underinvestment problems. High-growth opportunity firms are more likely to face an underinvestment problem compared with low-growth opportunity firms and, thus, the negative effect of longer debt maturity on investment should be stronger for high-growth opportunity firms.

Debt maturity structure and firm investment. The preceding proposition shows that although participating policies mitigate the risk-shifting and underinvestment problems that arise because of shareholder-policyholder incentive conflict, they exacerbate the shareholder-manager agency conflict by reducing the manager's incentive to exert effort.

Agency theory and participating policy usage evidence from stock life insurers. Firms that have valuable investment opportunities should be concentrated in the HIGH Q subsample, so evidence consistent with underinvestment problems should appear in that subsample. CEO incentives, cash flow, and investment.

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