The use of derivatives and its impact on firm value : evidence from Australian firms

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The use of derivatives and its impact on firm value : evidence from Australian firms


Author: Chan, Kai-cheong
Title: The use of derivatives and its impact on firm value : evidence from Australian firms
Degree: D.B.A.
Year: 2005
Subject: Hong Kong Polytechnic University -- Dissertations
Derivative securities -- Australia -- Case studies
Risk management -- Australia -- Case studies
Department: Graduate School of Business
Pages: ix, 117 leaves : ill. ; 30 cm.
InnoPac Record:
Abstract: The financial derivatives market has experienced phenomenal growth in the last two decades. Corporations, from large to small, are allocating substantial precious resources to manage their exposures in foreign exchange, interest rates and commodity prices. Yet, there is no single theory that can satisfactorily explain why firms hedge. Even worse, strong evidence supporting the hypothesis that hedging is beneficial to and can increase firm value is still lacking. The main objective of this study is to examine the two most fundamental questions related to corporate risk management, i.e. "Why Firms Hedge? " and "Does Hedging Increase Firm Value? " Using a panel data from a sample of Australian listed companies over a three years period between 2001 and 2003, this paper studies the relationship between the use of derivatives and firm characteristics (proxied by tax loss carryforward, leverage ratio, total assets, interest coverage, earnings to price ratio, capital expenditure to total revenues ratio, dividend payout ratio, directors' shareholding and directors' option holding) in order to test various hedging theories derived from the Shareholders' Value Maximization and Managerial Utility Maximization models. Generally speaking, we find evidence in support of the Minimization of Taxes and Reduction of Financial Distress Costs arguments for the use of derivatives to maximize shareholders' value. As for the Avoidance of Under-investment Problem motive for hedging, we find mixed results and are unable to support this theory. Neither is there evidence supporting that managers use derivatives for hedging in order to maximize their own utility.
In the study of the relationship between firm value, measured in terms of Tobin's Q, and hedging, proxied by the use of derivatives, we do not find evidence in support of a systematic positive relationship between them. Rather, there are some weak signs that the use of derivatives by our sample firms during the study period may have a negative impact on firm value. Judging from the higher percentage of firms reporting negative aggregate net fair value for their outstanding derivatives positions and a positive correlation between firm value and net fair value of derivatives, it suggests that the decrease in firm value may be caused by unfavourable hedging results. This paper adds further knowledge to the research on the use of derivatives and has important practical implications. In view of the increasing popularity of derivatives uses among firms nowadays but whether using derivatives for hedging is beneficial to a firm is yet to be verified, the possibility of a negative relationship between the use of derivatives and firm value should alert managers and investors to have a second thought when deciding to use derivatives or considering whether there should be a valuation premium for derivatives users.

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