Derivatives, Hedging, and Risk Management Information by CIBC School of Financial Products

CLASS NOTES by CHARLES SMITHSON
THEORY V. PRACTICE
Does financial Risk Management increase shareholder value?
As financial risk management has moved from being a specialty discipline into the mainstream of activities within a corporate treasury, debate has arisen about whether it can and does increase shareholder value. Not surprisingly, the question has attracted the attention of academic researchers. In this column, I will first recapitulate the theoretical arguments and then summarise the empirical evidence.

The theoretical arguments
The relationship between the value of a firm and its financial policies was established by Modigliani & Miller (1958) in what has come to be called M&M Proposition I. ¹ With respect to Risk Management, this proposition can be paraphrased as follows: in a world with no taxes, no transaction costs and a fixed investment policy, investors can create their own "home-made" risk management by holding diversified portfolios. Consequently, if risk management were to affect the value of a firm by increasing its real cashflows, it would do so by affecting tax liability, transaction costs or investment decisions. Smith & Stulz (1985) and Froot, Scharfstein & Stein (1993) turned this general proposition into a specific rationale for the use of risk management: ²

Risk management could add value by reducing taxes. Smith & Stulz demonstrated that, if the firm's effective tax function is convex and if the firm is subject to financial price-induced Volatility in its pre-tax income, hedging will reduce its tax liability. ³

Risk management could add value by reducing the cost of financial distress. Smith & Stulz noted that, by reducing volatility, risk management can reduce the probability that the firm will encounter financial distress, so it could reduce the expected cost of such distress. For example, consider a firm that provides service agreements or warranties to its customers. If the firm is less viable, consumers place less value on the service agreements and warranties and are more likely to turn to a competitor. If the firm can convince potential consumers that the likelihood of financial distress has been reduced, it can increase consumers' valuation of its service agreements and warranties. This perceived increase in value will be reflected in the cashflows to the firm and in the price the consumers will be willing to pay for the product.

Risk management could add value by facilitating optimal investment. Smith & Stulz reminded us that conflicts between bondholders and shareholders ⁴ can lead a firm to "underinvest", ie, turn down positive-net-present-value projects.

In 1990, Lewent & Kearney of Merck & Co provided a real-world example of how Volatility in earnings can lead to underinvestment: "Merck's earnings are denominated in US dollars. Consequently, its pre-tax income fluctuates with the value of the dollar. If the dollar is weak (strong), the dollar value of net income received from foreign operations will be high (low). Looking at its behaviour in the past, Merck discovered that this volatility in earnings had impacted its investment decision. When the dollar was strong and pre-tax income was low, Merck had cut back the rate of growth of research and development spending. Since there is a well-established relation between research and development activity and value for pharmaceutical firms, there was a clear reason Merck would want to manage its foreign exchange risk."

If Risk Management permits the firm to undertake positive-net-present-value projects that would otherwise be deferred, its net cashflows will necessarily rise.

Froot, Scharfstein & Stein generalised the underinvestment problem introduced by Lewent & Kearney. Noting that firms simultaneously choose the optimal levels of investment and financing (subject to an expected profit constraint), they proposed that financial price risk management should have a single overriding goal: to ensure that a company has the cash available to make value-enhancing investments. This risk management paradigm rests on the basic premises that the key to creating corporate value is making good investments and the key to making good investments is generating enough cash internally to fund those investments.

The empirical evidence
The preceding theoretical arguments are undoubtedly elegant. However, it the behaviour of firms consistent with these theoretical arguments?
To answer this question, the theoretical arguments had to be translated into testable hypotheses. The argument for tax reduction rests on the firm having a convex effective tax function. A firm would have a convex effective tax function if it had tax preference items (eg, tax loss carry forwards or tax credits) or if it had income in the progressive region of the statutory tax schedule. With respect to the argument about Risk Management reducing the cost of financial distress, the benefit from hedging would be greater for firms with a higher probability of encountering distress, eg, those with less interest coverage, more interest rate or foreign exchange rate risk, more Leverage and lower credit ratings. Finally, with respect to risk management facilitating optimal investment – whether the result of the shareholder/bondholder conflict introduced by Smith & Stulz or the investment/financing rationale suggested by Froot, Scharfstein & Stein – hedging will be of more value to firms with greater research and development expenditure (a proxy for more R&D projects) or whose ratio of market to book value is higher. These testable hypotheses are summarised in table 1.

We focus on nine empirical studies that have examined the use of Risk Management by non-financial firms. ⁵ Table 2 summarises the results of these analyses. The main findings are:

Risk management to reduce taxes The available evidence is consistent with the Smith & Stulz "tax convexity" argument – firms that have more convex effective tax functions are more likely to use risk management. Dolde (1995) reported a positive and significant relation between tax loss carry forwards and the use of risk management instruments. Both Nance, Smith & Smithson (1993) and Mian (1994) found a statistically significant positive relationship between tax credits and the use of risk management instruments.

Risk management to reduce the cost of financial distress. The available evidence is consistent with the arguments by Smith & Stulz and Froot, Scharfstein & Stein that firms with a higher probability of encountering financial distress are more likely to use risk management products: Mian and Geczy, Minton & Schrand (1996) found a statistically significant, positive relation between the level of the firm's foreign operations (a proxy for its foreign exchange rate exposure) and the use of risk management instruments. Dolde and Samant (1996) both found a statistically significant, positive relationship between the use of risk management and Leverage.

Risk management to facilitate optimal investment. As is predicted by theory, Nance, Smith & Smithson; Geczy, Minton & Schrand; and Dolde all find a statistically significant, positive relationship between the firm's R&D expenditure and its use of risk management products. The evidence is mixed with respect to the market-to-book ratio. Samant finds a statistically significant positive relationship while, in contrast to the theoretical predictions, Mian reports a statistically significant negative relationship between the market-to-book value ratio and the use of risk management. ⁶

Conclusion
An established body of finance theory indicates that financial price risk management can increase shareholder value. However, the question of more immediate concern to practitioners is whether risk management does increase shareholder value. This column has summarised the theoretical arguments and the available empirical evidence. Table 3 compares the theoretical predictions in table 1 with the empirical evidence in table 2. It shows that firms' behaviour is consistent with the theoretical predictions.

The available empirical evidence provides a crucial link: theory indicates how firms should be behaving if they are increasing shareholder value via Risk Management; the empirical evidence indicates that they are behaving in that manner. However, the evidence reported in this column must be regarded as indirect. It demonstrates that firms are behaving as if they are increasing value but it does not directly demonstrate the relation between the use of risk management and increased share value. While it is too early for a full discussion of the empirical evidence on whether risk management increases shareholder value, preliminary research does link risk management with increased share value. ⁷

This article is an extract from The impact of financial price risk management on non-financial firms, a working paper co-authored with Chris Turner

Citations
¹ The rationale of the original M&M Proposition I, which focused on the firm's debt-equity ratio is that, because (under their assumptions) Leverage by an individual is a perfect substitute for corporate leverage, an investor will not pay the firm for corporate leverage. Modigliani & Miller extended the proposition to dividends in 1961, with the argument that "homemade" dividends can be created as the investor sells the firm's stock Back

² Additional theoretical insights about the rationale for Risk Management were provided by DeMarzo & Duffie (1991) Back

³ A convex tax schedule is one in which the firm's average effective tax rate rises as pre-tax (financial statement) income rises. If the effective tax function is convex, a mathematical theorem – Jensen's inequality – guarantees that a reduction in the Volatility of the firm's pre-tax income will result in lower taxes Back

⁴ The shareholder/bondholder conflict results from differences in the kind of claims the parties hold – bondholders hold fixed claims, while shareholders hold claims that are equivalent to a Call Option on the value of the firm. This conflict is one of the "agency problems" first introduced by Jensen & Meckling (1976) Back

⁵ In addition to the empirical analyses that examined the use of derivatives by non-financial firms, we are aware of seven empirical analyses that have examined the use of Risk Management by financial institutions and two that examined the use by insurance companies Back

⁶ The positive relation between the firm's market-to-book ratio and its use of risk management reported by Geczy, Minton & Schrand becomes stronger when that variable is interacted with Leverage. Geczy, Minton & Schrand interpret this to mean that firms with more growth opportunities and more constraints on financing are more likely to use derivatives Back

⁷ For example, some "first offer" empirical evidence on the share price reaction to financial price Risk Management is contained in the full version of this paper. Back

References
DeMarzo, P, and D Duffie, 1991, Corporate financial hedging with proprietary information, Journal of Economic Theory 45, pages 261–286
Dolde, W, 1995, Hedging, Leverage and primitive risk, Journal of Financial Engineering 4, pages 187–216
Froot, K, D Scharfstein and J Stein, 1993, Risk Management: co-ordinating corporate investment and financing policies, Journal of Finance 48, pages 1,629–1,658. A more accessible version of this paper appeared as A framework for risk management in Harvard Business Review, Nov–Dec 1994

Geczy, C, B Minton and C Schrand, 1996, Why firms use currency derivatives, Journal of Finance, forthcoming

Hentschel, L, and S Kothari, 1995, Life insurance or lottery: are corporations managing or taking risks with derivatives?, University of Rochester, unpublished paper

Jensen, M, and W Meckling, 1976, Theory of the firm: managerial behavior, agency costs and ownership structure, Journal of Financial Economics 3, pages 305–360

Lewent, J, and A Kearney, 1990, Identifying, measuring and hedging currency risk at Merck, Journal of Applied Corporate Finance 2, pages 19–28

Mian, S, 1994, Evidence on the determinants of corporate hedging policy, Emory Business School, Emory University, working paper

Modligliani, F, and M Miller, 1961, Dividend policy, growth and the valuation of shares, Journal of Business 34, pages 411–413

Modligliani, F, and M Miller, 1958, The cost of capital, corporation finance and the theory of investment, American Economic Review 53, pages 261–297

Nance, D, C Smith Jr and C Smithson, 1993, Determinants of corporate hedging, Journal of Finance 48, pages 267–284

Samant, A, 1996, An empirical study of Interest Rate Swap usage by nonfinancial corporate business, Journal of Financial Services Research 10, pages 43–57

Smith Jr, C, and R Stulz, 1985, The determinants of firms' hedging policies, Journal of Financial and Quantitative Analysis 20, pages 391–405

Tufano, P, 1996, Who manages risk? An empirical examination of Risk Management practices in the gold mining industry, Journal of Finance, forthcoming

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Wysocki, P, 1996, Managerial motives and corporate use of derivatives: some evidence, Simon School of Business, University of Rochester, working paper