«José Luiz Rossi Júnior Ibmec São Paulo Juliana Laham Ibmec São Paulo Abstract This paper examines the impact of company’s hedging activities on ...»
The Impact of Hedging on Firm Value: Evidence from Brazil
José Luiz Rossi Júnior
Ibmec São Paulo
Ibmec São Paulo
This paper examines the impact of company’s hedging activities on firm value for a sample of non-financial
Brazilian companies from 1996 to 2005. The results show that hedging activities do increase the firm value.
The result is robust with respect to the period and the econometric method adopted in the analysis.
Key-words: Hedging, Foreign Currency, Derivatives, Firm Value, Emerging Markets, Brazil.
JEL Codes: G32, G30, G15.
1. Introduction The derivative market has had a rapid expansion over the last years. The latest data related to the use of derivatives published by the Bank of International Settlements shows that the notional amount outstanding of over-the-counter derivatives increased from US$257.9 billion in December 2004 to US$415.8 billion in the same month in 2006 (BIS, 2007). Part of this increase is attributed to a greater use of these financial instruments by the companies as a way to manage the risks involved in their operations.¹Although the data show the speed of this evolution, the corporate finance literature has not yet reached a consensus on whether hedging activities add value to the firm or not. 1 Supposing Modigliani and Miller’s (1958) hypotheses are valid, companies’ financial policies do not have any impact on its value. If financial markets are efficient, hedging activities by the firm does not add any value because the investor would then be able to build such a diversified portfolio that would allow them to eliminate the risks and would make the payment of a premium for the firm adopting a hedging policy unnecessary. Yet, when some of the hypotheses made by Modigliani and Miller (1958) are relaxed, it is possible to show that company’s hedging policy would add value to the firm. 2 Whether hedging policy has or not impact on firm value needs an empirical answer. The literature, however, has not reached a consensus. The empirical results found show divergences with respect to the impact of the use of currency derivatives on firm value for developed countries. In the United States case, Allayannis and Weston (2001) found a positive relation and a hedging premium of nearly 5% for the firms that use currency derivatives. Jin and Jorion (2004), studying the same country, but limiting the study to firms in the oil and gas sector, showed a negative and statistically non-significant relation between the use of commodity derivatives and firm value. Clark et. al. (2006), using a sample of French companies, showed evidence that the use of currency derivatives does not affect firm value. However, Hagelin et. al. (2004), in a similar study for Swedish firms, found evidence that the use of derivatives has a significant and positive impact on firm value. 3 This paper casts light on this question by analyzing the impact of hedging activities on firm value in a sample of non-financial Brazilian firms from 1996 to 2005. The Brazilian case is unique when compared with the previous literature that analyzes the impact of hedging activities on firm value. The high volatility in macroeconomics variables, especially in the exchange rate, together with the fact that most firms present some kind of exposure to the exchange rate makes the foreign exchange risk first in importance to the Brazilian firms, exactly the type of environment where the hedging policy would generate more significant gains. 4 In this way, in emerging countries like Brazil, the identification of the impact of derivative use in a sample comprised by firms that act in different sectors would be easier given the high volatility of the exchange rate and the greater homogeneity of the firms with relation to their foreign exchange exposure. 5 The results found confirm that company’s hedging activities have a positive impact on its value. From 1996 to 2005, the results indicate that the firms that use currency derivatives are negotiated with a premium with relation to the companies that do not use them. The results are robust concerning the period of estimation, econometric method used and likely problem of endogeneity in the estimation.
This paper is organized as follows. Section 2 presents a review of the literature that analyzes the use of derivatives and its impact on the firm. Section 3 reports and discusses the data. Section 4 shows the methodology and results. Section 5 concludes.
In this paper, it is considered that companies use derivatives as a way to reduce the volatility of their cash flow and not for 1 speculative reasons. Therefore, sometimes the word hedging will be used as a synonimous for derivative use.
2 Smith and Stulz (1985) discuss that tax reasons and the possibility of incurring in costs of financial distress would lead hedging to add value to the firm. Yet, Froot et. al. (1993), financial market imperfections and the problem of underinvestment would cause hedging to have a positive impact on firm value.
3 Other examples of this literature are Carter et. al. (2004), Lookman (2004) and Chang et. al. (2005).
4 Rossi (2005) using a similar sample to that of this study showed that nearly 60% of the Brazilian publicly traded firms were exposed to exchange rate movements in the period 1996 – 2002.
5 Unlikely in the developed countries, depreciation of the domestic currency are generally followed by economic crisis in developing
2. Literature Review
2.1 Theoretical Literature Modigliani e Miller (1958) showed that with a fixed investment policy in an economy without any friction (transaction costs, agency costs and taxes), in a scenario where all rational investors have the same access to market prices and to information without any cost, the firm’s financial policy will be irrelevant. If the markets are perfect and complete, firm value will be independent of hedging. In this outline, an investor will be able to eliminate the exchange rate risk from its portfolio through diversification, eliminating the gains of an active hedging policy by the firm.
In this way, hedging will only add value to the firm if some hypotheses of the model presented by Modigliani e Miller (1958) are relaxed. Smith e Stultz (1985) showed that the companies may have some benefits by reducing the volatility of their cash flow, given the structure of the taxation or the existence of costs of financial distress.
The authors showed that in a progressive taxation system, hedging might reduce the expected payment of taxes, increasing firm’s after-tax income, thus producing a positive impact on firm value. The authors also showed that in case of existence of bankruptcy costs, hedging would reduce the likelihood of paying these costs, which would add value to the firm.
Stulz (1984) related the preferences of firm managers and the hedging practices. If managers were risk-averse and their income were linked to the firm results, they would have the incentive to protect themselves through hedging operations since these would reduce the firm’s cash flow volatility, reducing their exposure to the currency risk. It is interesting to observe that in this case hedging would not add value to the firm, because it would only benefit the manager and not the shareholder.
Froot et. al. (1993) showed that the intensity of using derivatives would be related to the existing correlation between the firm’s cash flow and its future investment opportunities. The authors developed a model where inefficiencies in the financial market make the cost of capital proportional to its cash flow. Thus, the firm must protect its cash flow from fluctuations, because in case there is a negative shock, the firm either would borrow at a higher rate to keep its investment or should reduce its investment, causing an underinvestment problem.
DeMarzo and Duffie (1995) showed that even if the shareholders could have the protection by themselves, hedging is optimal when the managers have private information about the firm’s profits and want to demonstrate it to the shareholders: the quality of information received by the shareholders may affect the value of their choice whether to continue the investment project or not. The optimal hedging would then be the result of the trade-off between the level of information on profits and the costs of hedging.
2.2 Empirical Literature The literature trying to discriminate among various theories on determinants of hedging activities is extensive (Wysocki (1995), Mian (1996), Geczy et. al. (1997), Graham and Rogers (2000), and Allayannis and Ofek (2001), among others). Judge (2003) summed up the results of 15 studies on the topic. In general, he found low support for the importance of taxes, or the managers’ risk-aversion, or the presence of bankruptcy costs to determine the use of derivatives. 6 The study also pointed that the results related to the importance of imperfections in the finance market is mixed. Half of the studies confirmed the existence of a relationship between growth opportunities and the use of derivatives. The authors found strong evidence that scale economies and the volatility of cash flow in foreign currency are important determinants of derivative use.
Larger companies, exporting companies or companies with subsidiaries abroad use derivatives more intensively.
6 Only 2 out of 15 studies showed a significant relation between taxes and hedging. 3
The literature that covers the efficiency in the use of derivatives can be divided in two branches. The first branch analyzes the impact of the use of derivatives on the firm returns, examining if the use of derivatives affects the sensibility of the return to movements in the exchange rate. In general, the literature finds that the use of derivatives reduces the firm return sensibility to variations in the exchange rate, indicating that hedging is efficient to reduce its exposure to exchange rate.
On the other hand, several studies directly analyze the impact of the use of derivatives on firm value.
The present study follows this line. Allayannis e Weston (2001) confirmed the existence of a positive and significant relation between the use of currency derivatives and firm value for a sample of American firms. The authors found a nearly 4.87% hedging premium. Similar result was found by Carter et. al.(2006). In the study, the authors showed that hedging with relation to oil prices in the airlines industry is positively related to firm value and the hedging premium reaches over 5%. The authors showed evidence that the greatest benefit of hedging in this sector would be the reduction in underinvestment costs because the fuel price is highly correlated to the investment opportunities in the sector.
However, Jim and Jorion (2004) analyzing the behavior of American companies in the oil and gas sector from 1998 a 2001 found that the impact of using derivatives on firm value is statistically insignificant if not with the signal contrary to the expected. Lookman (2004) in his analysis of the sample of oil and gas producers observed that hedging would aggregate value only to companies where the commodity risk is secondary and hedging would have a negative impact on the firms where the commodity price is a primary risk. He argued that these results derive from the fact that hedging is a proxy for management quality or agency costs, and once controlling for these facts the hedging effect would be insignificant.
Hagelin et. al. (2004), in a study for Swedish companies, found evidence that hedging activities increase firm value. The authors found that companies that use currency derivative are negotiated with premium when compared to those that do not use them. In addition, they showed that if management has an option plan for company’s stock, many times, they use hedging tools to protect their remuneration and not the shareholder’s. In this case, hedging shows a negative relation with firm value. Also using a sample of Swedish companies, Pramborg (2004) found a positive impact of hedging on firm value in case the firms use it to hedge its transaction exposure and an insignificant impact in case they use it to hedge its translation exposure.
Clark et. al. (2006) investigated the use of currency derivatives for non-financial firms in France from 2003 to 2005. The authors found evidence that the use of currency derivatives is not significant for firm value.
Similar results were found by Dan et. al. (2005) for a sample of Canadian firms in the oil and gas sector.
There is no evidence on the direct impact of the use of currency derivatives on firm value for emerging markets. Rossi (2002) observed a reduction in the Brazilian firm’s foreign exchange exposure in the shift from the fixed exchange regime to the flexible exchange regime. The author verified that this change occurred due to the fact that many firms started using currency derivatives to manage their exchange rate risk and to reduce the currency mismatch in their balance sheets.
3. Data The database used examines all non-financial Brazilian firms listed in the São Paulo Stock Exchange from 1996 to 2005. The accounting and financial data were collected from the Economática site. All companies under judicial administration were excluded from the sample. The number of firms varies in each year included in the study, but on average 212 firms were under analysis. 7 All the variables used are evaluated at the end of the fiscal year.
Tobin’s Q was used as a proxy for firm value. This is defined as the ratio of the firm market value to the replacement cost of assets. The firm market value is calculated as the book value of total assets plus the market value of the equity minus the book value of the equity. The replacement cost of assets is calculated as In an exercise of robustness, the analysis involved only firms that were in the sample in 1996 and remained until 2005, totaling 165 7