Why hedge? Rationales for corporate hedging and value implications.

Abstract

Purpose--In the presence of capital market imperfections, risk management at the enterprise level is apt to increase the firm's value to shareholders by reducing costs associated with agency conflicts, external financing, financial distress, and taxes. The purpose of this paper is to provide an accessible and comprehensive account of these rationales for corporate risk management and to give a short overview of the empirical support found in the literature.

Design/methodology/approach--The paper outlines the main theories suggesting that corporate risk management can enhance shareholder value and briefly reviews the empirical evidence on these theories.

Findings--When there are imperfections in capital markets, corporate hedging can enhance shareholder value through its impact on agency costs, costly external financing, direct and indirect costs of bankruptcy, as well as taxes. More specifically, corporate hedging can alleviate underinvestment and asset substitution problems by reducing the volatility of cash flows, and it can accommodate the risk aversion of undiversified managers and increase the effectiveness of managerial incentive structures through eliminating unsystematic risk. Lower volatility of cash flows also leads to lower bankruptcy costs. Moreover, corporate hedging can also align the availability of internal resources with the need for investment funds, helping firms to avoid costly external financing. Finally, corporate risk management can reduce the corporate tax burden in the presence of convex tax schedules. While there is empirical support for these rationales of hedging at the firm level, the evidence is only modestly supportive, suggesting alternative explanations.

Originality/value--The discussed theories and the empirical evidence are described in an accessible way, in part by using numerical examples.

Keywords Corporate finances, Risk management, Foreign exchange

Paper type Research paper

1. Introduction

Nonfinancial firms increasingly employ risk management to shield their performance against financial risks, such as foreign exchange and interest rate risk, as several surveys indicate (e.g. Berkman et al., 1997; Bodnar el al., 1998). Corporate risk management can be implemented in many ways, such as derivatives, foreign currency debt, operative hedging, etc. (Levi, 1996). While risk management at the firm level appears to lower the exposure of firms to exchange rate risk (Allayannis and Ofek, 2001), neo-classical finance theory seems to purport that corporate hedging cannot increase firm value, as explained below. Recent research, however, shows that in the presence of realistic capital market imperfections, i.e. agency costs, costs of external financing, direct and indirect bankruptcy costs, as well as taxes, corporate hedging will enhance shareholder value.

This paper provides a comprehensive and accessible overview of the existing positive rationales for corporate risk management in general and hedging in particular [1]. Specifically, it is discussed how corporate risk management can reduce agency conflicts such as underinvestment, asset substitution, or dysfunctional managerial behavior resulting from underdiversification or non-effective incentive structures. Moreover, external financing costs can be reduced through corporate hedging by aligning the availability of and need for investment funds. Finally, corporate hedging can lower the probability of future financial distress, thus enabling a firm to decrease its expected tax burden. Subsequent to the discussion of these rationales, a brief account of the empirical evidence is provided. There exists some empirical support for these theories, such as firms with high leverage being more likely to hedge. At the same time, there is also evidence that runs counter to theoretical predictions, such as larger and more profitable firms having a higher propensity to engage in hedging. Similarly, only some studies are able to find that firm value, as measured by Tobin's Q, is higher for firms that hedge.

The paper is structured as follows: Section 2 establishes the case for corporate hedging, while Section 3 introduces and explains the existing positive rationales for corporate risk management. Section 4 reviews the empirical evidence on these rationales, and, finally, the last section summarizes and concludes.

2. The case for value creation through corporate risk management While it can be observed that corporations are frequently devoting intellectual and financial resources to financial risk management, it is by no means a trivial task to make a case for corporate risk management at the firm level. In particular, if parity relationships between prices of inputs, interest rates, and exchange rates hold, a change of one of these variables, potentially initiated through an external shock, will be rapidly offset by a related change in the other variables, thus reestablishing equilibrium. Furthermore, it could be argued that corporate hedging has no impact on firm value, as investors can achieve risk reduction at least as efficiently themselves through diversification or hedging. The hedging of risks that investors cannot diversify in financial markets (systematic risk) may also not increase shareholder value, as investors receive an appropriate return for holding securities of inherently risky businesses. Therefore, corporate hedging of market risks simply shifts firms along a line that reflects the risk/reward tradeoff in the market (Dufey and Srinivasulu, 1983).

However, on close inspection, it appears important to differentiate between the nature of the risks nonfinancial firms face, in particular between business risk and financial risk. Business risk is at the core of a firm's operations and arises from uncertainties with respect to product quality, input costs, technological factors, changes in customer demand, etc. This risk is difficult and often impossible to hedge and indeed should not be hedged as nonfinancial firms typically have a competitive advantage in managing their business and the associated risks, while they generally do not have a competitive edge in managing financial risks, such as unexpected changes in exchange rates, interest rates, or commodity prices. As a result, it is economically sensible for nonfinancial firms to hedge their exposure to financial risks by "selling" them into the broader markets. Due to capital market imperfections--such as agency costs, costs of external financing, bankruptcy costs, and taxes--corporate hedging by nonfinancial corporations can increase their firm value, as discussed in the following section.

3. Rationales for corporate risk management

3.1 Mitigating the underinvestment problem

In a world of imperfect contracts, the interests of a firm's stakeholders, such as managers, shareholders, bondholders, and employees, might be incongruent, especially when the firm is highly leveraged and when information asymmetries exist. In particular, firms with risky debt outstanding and low firm value may not exhibit optimal investment behavior. This stems from the fact that, if fixed …