Söhnke M. Bartram and Gordon M. Bodnar
Based on basic financial models and reports in the business press, exchange rate movements are generally believed to affect the value of nonfinancial firms. In contrast, the…
Abstract
Purpose
Based on basic financial models and reports in the business press, exchange rate movements are generally believed to affect the value of nonfinancial firms. In contrast, the empirical research on nonfinancial firms typically produces fewer significant exposures estimates than researchers expect, independent of the sample studied and the methodology used, giving rise to a situation known as “the exposure puzzle”. To this end, this paper aims to systematically analyze the existing empirical evidence of the exposure phenomenon and to attempt to understand the possible source of the exposure puzzle.
Design/methodology/approach
The paper provides a survey of the existing research on the exposure phenomenon for nonfinancial firms. A simple model of exposure elasticity is also used to demonstrate the substantial impact of operational hedging on exposure elasticities. Furthermore, the evidence on the nature of firms’ financial derivative usage is considered.
Findings
It is suggested that the exposure puzzle may not be a problem of empirical methodology or sample selection as previous research has suggested, but is simply the result of the endogeneity of operative and financial hedging at the firm level. Given that empirical tests estimate exchange exposures net of corporate hedging, both firms with low gross exposures that do not need to hedge and firms with large gross exposures that employ one or several forms of hedging, may exhibit only weak exchange rate exposures net of hedging. Consequently, empirical tests yield only small percentages of firms with significant stock price exposures in almost any sample.
Originality/value
If firms react rationally to their exposures, most firms will either have no exposure to start with, or reduce their exposure to levels that may be too small to detect empirically. Consequently, the exposure puzzle may not be a problem with methodology or theory, but mainly the result of endogeneity of operative and financial hedging at the firm level.
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This paper investigates the motivations and practice of nonfinancial firms with regard to using options in their risk management activities.
Abstract
Purpose
This paper investigates the motivations and practice of nonfinancial firms with regard to using options in their risk management activities.
Design/methodology/approach
The paper provides a comprehensive account of the existing empirical evidence and analyzes data on the use of derivatives in general and options in particular by nonfinancial corporations across different underlyings and countries.
Findings
Overall, a significant number of 15‐25 per cent of the firms outside the financial sector use options. This reflects the fact that options are very versatile risk management instruments that can be used to hedge various types of exposures, linear as well as nonlinear. In particular, options are a useful component of corporate risk management if exposures are uncertain, e.g. due to price and quantity risk. Depending on the correlation between price and quantity risk, the optimal hedge portfolio consists of a varying combination of linear and nonlinear risk management instruments. Moreover, the accounting treatment as well as liquidity effects can impact the choice of derivative. At the same time, there may be agency‐related incentives to use options because of their role to present dual bets on both direction as well as future volatility of the underlying.
Practical implications
The findings are important with regards to assessing whether the full potential of derivative financial instruments is being realized, since not all firms use these instruments and not all of them use all types and, more importantly, whether they are used appropriately.
Originality/value
The paper provides an up‐to‐date analysis of the motivations for nonfinancial firms to use financial derivatives in general and options in particular as well as comprehensively characterizes the extent of their use in practice.
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Kevin Aretz, Söhnke M. Bartram and Gunter Dufey
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…
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.
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Jonathan A. Batten and Samanthala Hettihewa
Country‐specific information on risk management is increasingly important, not only for investors and decision makers in international markets but also, for those in national and…
Abstract
Country‐specific information on risk management is increasingly important, not only for investors and decision makers in international markets but also, for those in national and regional markets. This study reports the results of a cross‐sectional survey of risk management practice and derivatives use by a sample of Australian firms. Overall, the results suggest that firm‐specific factors appear to have some influence on risk management practice with the industry of the respondent being the most important, while the degree of international exposure has the least. Larger and more internationally exposed firms are likely to have more frequent reporting of derivatives use, and are more likely to use swaps and options to manage risks than other types of firms. Issues and implications for international firms are discussed.