The determinants of corporate hedging for U.S. and U.K. non-financial firms

Abstract

Empirical studies show that the use of derivative instruments has been increasing during the last decade, making it an important part of the firm’s overall risk management profile. Financial theory suggests that risk management decisions only matter when markets are imperfect. The standard view is that firms will benefit from hedging, because hedging reduces the variability of the costs of financial distress, agency costs, and the expected tax liabilities. This thesis attempts to provide evidence on these hypotheses. This study investigates the determinants of corporate hedging by using a comprehensive dataset of US and UK non-financial firms. The two countries are of particular research interest since they have almost similar legal system for the conduct of business and their market-based financial systems and equity markets are well developed with good investor protection. The study focuses on the decision of whether or not non-financial firms from both countries benefit from corporate hedging during the period 2002-2011. The study is motivated by the idea of whether or not the hedging policies of non-financial firms depend on the financial characteristics of those firms and the strength of their corporate governance. Indeed, our empirical results show that corporate hedging decision is closely associated with firms’ financial characteristics and the strength of their corporate governance. In particular, firms are more like to engage in hedging if they have high expected tax liabilities, high expected cost of financial distress, and high expected agency costs. Firms choose to hedge to reduce the variability of cash flows in order to protect growth opportunities. More interestingly, US firms provide stronger evidence in support of for corporate hedging when the overinvestment problem exists, while UK firms provide stronger evidence for the underinvestment problem. Hedgers tended to be high-rated firms and larger firms which have a cost advantage in hedging due to economies of scale. This finding provides an explanation of why the small firms, which have more volatile cash flows, higher costs of bankruptcy, more growth opportunities, tend not to engage in hedging. We believe that this is very informative as it suggests the costs of hedging and market price dynamics alter the optimal hedging policies of those firms. Hedging is more costly for small firms; so they have different hedging policies and respond differently to hedging. We also find that the board structure influence hedging decisions and a large board tend to be negatively associated with corporate hedging. The tendency to hedge increases as the number of non-executives grows. In addition, firms with strong corporate governance tend to hedge to reduce the variability of cash flows and the costs of financial distress. These results have theoretical and practical implications.