Journal of Insurance and Financial Management, Vol.

2, Issue 5 (2017) 92-101

Determinants of Hedging: A Review of

Theoretical Studies
Abdullah Bin Omar a,*, Kamarun Nisham B Taufil Mohammad b,
Norzalina c
a,b,c
School of Economics, Finance and Banking, University Utara Malaysia(UUM), Malaysia

ARTICLE INFO ABSTRACT

Article History Hedging instruments are deemed as value
Submitted 22 Jan 2017 enhancing tool for both financial and nonfinancial
Accepted 06 Feb 2017 firms. The aim of this study is to highlight those
Available online 12 Feb 2017
theoretical studies which are written in context of
JEL Classification hedging determinants. Theoretical studies argued
F31 that in a world with no taxes, no transaction costs,
G32 and with fixed investment policies, hedging with
derivatives is irrelevant to firm value. However,
Keywords some studies suggests that derivative instruments
Derivatives can increase firm value when the premises of a
Hedging
perfect market have been relaxed, since they can
Financial Risk
eliminate corporate tax liabilities, financial distress
costs, dependence on costly external financing, and
agency costs.

Journal of Insurance and Financial Management

*Corresponding Author:
[email protected]

Author(s) retain copyright of the submitted paper (Please view the Copyright Notice of JIFM).

This work is licensed under a Creative Commons Attribution 4.0 International License.

Journal of Insurance and Financial Management (ISSN-Canada: 2371-2112)

Omar A. B. et al. / Journal of Insurance and Financial Management, Vol. 2, Issue 5 (2017) 92-101 93

1 Introduction

Intense competition, market imperfections, and political uncertainties in the world bring forth
different types of risks attached with corporations subject to their environment in which they
operate. Management/operational risk, financial/liquidity risk, product & services risk, and
economic stability, political and market risk are the most common types of risk which are
faced by the companies as they operate in dynamic environment. To counter these risks,
corporate managers feeling a need to establish such a effective control system that manage
and measure the likelihood of risks to tolerable level and mitigate the adverse consequences
that arise due to exposure of these risks. This conceptual paper aims to provide deeper insight
to different types of concepts related to risk management and hedging through derivatives.

2 Risk Management

There is simultaneous increase in number of studies along with increased magnitude of firm’s
exposure addressing how, and at what extent, firms should do risk management. Different
authors set down different definitions and objectives of risk management. Kloman (1992, p.
302) defines risk management as “the art of making alternative choices, an art that properly
should be concerned with anticipation of future events rather than reaction to past events”.
He also states that to decrease fear of the unexpected and the unknown, and to establish self-
confidence for future are the true objectives of risk management. Head and Horn (1997) state
that risk management is a name of common sense to cope actual and possible daily calamity,
and major occasional disasters that increase the likelihood of financial losses and lead the
organizations and individuals to their unfulfilled plans. Stulz (1996, pp. 23-24) defines the
primary objective of risk management is “to eliminate the probability of costly lower-tail
outcomes—those that would cause financial distress or make a company unable to carry out
its investment strategy”. Likewise there are several authors who explain risk management, its
objectives and applying methods in their own words.

3 Financial Risk and its Types

Financial risk is generally comprised of cash flow/liquidity risk, credit risk, foreign exchange
risk, and interest rate risk. Foreign exchange risk is deemed as most baneful and lethal risk
whose effects are multidimensional. With the economic globalization in the world, volatilities
in foreign exchange rates influence both: domestic and, specially, multinational companies.
Due to foreign exchange variation, company’s cash flow likely to change (Jacque, 1981). By
the change of relative prices of foreign and domestic goods, foreign exchange rate
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fluctuations directly influence current and future expected cash flows of importing and
exporting companies (Géczy, Minton, & Schrand, 1997). Random variations in commodity
prices, interest rates and exchange rates not only affect firm’s earning but also determine the
firm survival. Over last two decades, financial risk has become one of the most awful
challenge for firms. It is no longer enough for firms to only equip with best sales and
marketing plans, cheapest and skilled workforce, or having advance technology because of
variations in exchange rates, commodity prices and interest rates that make it difficult for
them to do so, and more than that, these volatilities can put well-running firms out of
business.

4 Risk Management and Firm Value

As we said earlier, that movements in foreign exchange rates, commodity prices and interest
rates can influence firm value adversely, then an involuntarily conclusion can be drawn here
that by managing these exposures firm value will essentially increase. But this conclusion
doesn’t follow directly that it is necessary condition for a firm to manage its strategic risks if
it is confronted them. But, however, the sufficient condition can be drawn that in response of
managing risk by a firm, the present value of future net cash flows should be increased.

5 Classical Financial Theory and Perfect Market Hypothesis

Classical financial theory assumes that there is absolute perfection in capital markets. This
states that capital markets are extremely competitive and participants of these markets are not
supposed to any frictions. Highly competitive capital market subject to atomistic competition
and there are a large number of firms and consumers which implies that no firm is in a
position to disturb the market equilibrium; i.e. all firms are market price taker (Danthine &
Donaldson, 2002). Absence of friction implies that there is no existence of any type of cost1.

While discussing the risk, we might observe an effect on firm’s value with the decrease in
discount rate of cost of capital of a firm. Shareholders, real owners of a corporation, are
individuals and individuals are usually risk averse, hence they want proper management of
financial risk. On the other hand, the firms, opposed to shareholders, believe that to stay away
from risk management may be the best policy for them. This will cut the cost and increase the
probability of their more earnings. As portfolio theory suggest that risks associated to
individuals are diversifiable and can be encountered by holding well-diversified portfolios.

1
Frictions such as progressive tax rates, information and contracting cost, commissions, transaction costs,
bankruptcy cost, agency cost, incomplete and asymmetric information, conflict of interest among stakeholders
and financial distress cost etc.
Omar A. B. et al. / Journal of Insurance and Financial Management, Vol. 2, Issue 5 (2017) 92-101 95

By relaxing this assumption, it can be said that if owners does not hold well-diversified
portfolios then risk aversion can be rationale for the firm.

6 Risk Management at Corporate Level

For individual investor, at firm level, decision of managing financial risk exposure may not
be a prudent decision since he/she can manage such risk more efficiently by appropriate
diversification of their investment portfolios. But, however, financial risk management can
make sense at corporate level as it adds value in company’s profile, not because it is
inherently essential to reduce risk by the firm whenever they face risk. So several researchers
tried to explore how risk management led the firm towards increase its value by increasing its
expected net cash flows. By recalling the basic canon of modern financial theories we can
understand how hedging can have favorable effect on firm’s real cash flows. The relationship
between financial policies and firm’s real cash flows has first established by Franco
Modigliani and Merton miller in 1958 which is known as M&M proposition.

7 Modigliani and Miller Model (1958)

Classical financial theory also relies on Modigliani and Miller (1958) (MM) model which
provides a deeper insight to the modern philosophy of capital structure. MM theory states that
risk management is insignificant to the firm hence shareholders can do at their own while
management efforts regarding managing risk cannot affect firm value. In perfect capital
market where there is no tax, no transaction cost, and symmetry information, MM model
shows that firm value is unaffected and independent to how any firm is financed, what is its
dividend policy and no matter how it raised its capital; either through stocks or debt. Risk
management at corporate level will only be valuable if there are market imperfections in
capital market like asymmetry information, limited commitments, financial distress etc.
Standard view of classical theory also based on MM model which suggest that decisions
regarding financial policy affect how firm value is divided among its stakeholders.

8 Frictions in Financial Markets

In real, the financial markets are supposed to face variety of frictions as it’s too hard to find
frictionless market. This divergence between reality and theory create path for researchers to
write extensively by relaxing the assumptions of MM model as they were questionable and
deemed unrealistic. Past studies justify that in presence of capital market imperfection risk
management can increase firm value. MM proposition can be used to determine the expected
effect of risk management on net cash flows. Several hedging theories introduce some
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frictions to classic MM model and arrive at optimal corporate hedging policies (Allayannis &
Weston, 2001).

Previous researchers put forward several arguments on the relationship between firm value
and corporate risk management by relaxing the assumptions in MM proposition. Past theories
suggest that financial derivative instruments are deemed as tool of value enhancing for the
firms, since they can bring reduction in expected tax liability (Smith & Stulz, 1985), reduce
the cost of financial distress (Mayers & Smith, 1982; Smith & Stulz, 1985), resolving
underinvestment problem (Froot, Scharfstein, & Stein, 1993; Géczy et al., 1997; Nance,
Smith, & Smithson, 1993; Smith & Stulz, 1985), dependence on costly external financing
(Froot et al., 1993; Gay & Nam, 1998), and agency cost (Smith & Stulz, 1985) etc. Some of
them are briefly described below.

9 Tax Reduction

Smith and Stulz (1985) and Graham and Smith (1999) show that in the presence of a convex
corporate tax function the firm's expected tax liability can be reduced by hedging. The more
convex the tax schedule the greater the incentive to hedge. The factors that cause convexity in
the effective tax function are progressivity in the statutory tax code and tax preference items
such as tax loss carry-forwards, investment tax credits and foreign tax credits. Risk
management can make possible of lesser tax amount by reducing the variability in taxable
income by falling the highest possible corporate taxable income in optimal array of tax rate
(Graham & Smith, 1999). Past evidences are consistent with Smith & Stulz’s Tax Convexity
argument that those firms are more likely of derivative users that have more convex tax
function. Mian (1996) and Nance et al. (1993), for example, found positive and significant
relationship between use of derivative instruments and tax credits. Additionally, Dolde
(1995) reported a significant and positive relationship between financial derivative
instruments and tax loss carry forwards.

10 Underinvestment

Froot et al. (1993), Smith and Stulz (1985), Mayers and Smith (1987), Bessembinder (1991)
argue that through effective risk management, the potential problem of underinvestment is
reduced which normally arise between management and bondholders when management
want to maximize its wealth at the cost of bondholders and refuses to invest in low-risk
projects. Although low risk projects assure more security to bondholders, but, on the other
hand, excessive return cannot be obtained through low risk projects which is the primary
Omar A. B. et al. / Journal of Insurance and Financial Management, Vol. 2, Issue 5 (2017) 92-101 97

objective of management in selection of high risk projects. Consequently, likelihood of the

project rejection is increased, notwithstanding it can enhance overall firm’s value. This
conflict sometimes also arise due to cash flow variation and high cost of external financing
between shareholders and debt holders but can be resolved by hedging (Mello, Parsons, &
Triantis, 1995).

11 Cost of Financial Distress

Risk management can reduce the probability of firm’s financial distress cost by reducing cash
flow volatility. How much benefit can get by reducing this cost from risk management
depends on two factors: the likelihood of encountering distress (if firm doesn’t hedge), and
financial distress cost (if it occurs). The greater the possibility of distress the greater the
benefits from risk management. Stulz (1996), Leland (1998) and Ross (1998) suggest that
with the reduction in probability of financial distress, the financial distress cost can also
reduced. It increases the firm’s propensity of higher leverage which ultimately yields a
benefit of greater tax shield which in turn increase firm value. The empirical evidences by
Froot et al. (1993) and Smith and Stulz (1985) provide support to theoretical arguments that
high probability of financial distress increase the likelihood of financial derivative use.

12 Foreign Exchange Rate Risk

High level of fluctuations in accounting earnings and greater variation in firm’s cash flows
arise from foreign exchange rate risk. This risk can be significantly countered by using
foreign currency derivatives. Suppose, firm’s cash flow volatility is directly related to the
probability of controlling financial distress (Smith & Stulz, 1985). The firm value which is
influenced by changes in exchange rate is heavily depends on several factors such as import
and export activity level, foreign operations involvement, the currencies of its competitors
and output/input market competitiveness. In the light of cash flow models, it can be argued
that foreign currency exposure should be related to net foreign currency which is equal to
total revenues minus total cost.

13 Managerial Risk Aversion

There are several ways through which shareholders can make sure whether or not managers
are acting in the best interest of a firm (i.e. maximizing firm’s value). One method is a
managerial compensation which yields managers a large stake that how much firm can
performs well. If personal wealth of a managers increase with the increase of firm value then
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managers will get more earnings if the performance of a firm gets better. Consequently,
managers motivate to work more and more in order to increase value of a firm.

In contrast, if managerial incentives are closely attached with the share price, this can raise
serious problems and put adverse impact on managers. In actual, managerial incentives that
are heavily depend on stock returns, either partially or fully, can be out of control for the
management and can be counterproductive. If a firm having large amount of raw material, for
example, which would be used in production process, then in the absence of effective risk
management, the raw material value can be fluctuate over the time period. Variations in the
prices of raw material can be the primary source of change in stock prices. As the prices of
raw materials are out of management control, therefore, managerial compensation closely
associated with the prices of the stocks may force to managers to bear risk. But, in result, it
would not provide any incentive to managers and would not provide motivate managers for
hard work.

14 Other Risk Management Theories

Apart from different aforementioned theories of risk management like taxes,

underinvestment, external financing, financial distress and contracting cost; there are some
other theories that can influence firm’s decision to hedge and may impact on financing
strategy of a firm. These theories are given below.

14.1 Firm Size

The relationship between derivative use and firm size is still ambiguous empirically. The vast
majority of the researchers indicated that in order to mitigate variability in equity prices and
cash flows, the small firms having larger incentives to hedge. Moreover, as Altman and
Hotchkiss (2006) stated, large firms may be able to find cost-effective substitutes for
derivatives to hedge away the risk through line-of-business and geographic diversification.
On previous empirical researches on the area of derivatives, Smith and Stulz (1985) states
that smaller firms get more benefits from hedging as compared to large firms if the
bankruptcy cost is less than proportional to firm size and if the cost of using derivatives is
proportional to firm size. It can be argued from these evidences that firm size and derivative
use should be negatively related with each other. Some other cross-sectional studies on
derivatives determinants, for example, states that firm size and derivative use are positively
related with each other. A vast variety of researches support this view. For example, Nance et
al. (1993) and Géczy et al. (1997) argued that size of a firm is highly related with substantial
Omar A. B. et al. / Journal of Insurance and Financial Management, Vol. 2, Issue 5 (2017) 92-101 99

information and transactional cost scale economies to establish derivative use for speculation
or hedging. Conversely, small firms are having fewer resources to hedge their risk; therefore,
it is difficult for them to afford hedging cost. Since, smaller firms are not likely to hedge their
risk through derivatives.

14.2 Substitutes for Hedging

Some studies showed that decision of a firm regarding derivative use is also affected by the
decision of option other financial policies. Instead of hedging through derivatives, for
example, the financial price risk on balance sheet could be reduced by restructuring its
liabilities and assets to mitigate its economic exposure i.e. movements its financial prices.
Therefore, with the help of reducing debt amount in capital structure, a firm can reduce
conflict between bondholders and shareholders as an alternative means of hedging. However,
these mechanisms can mitigate the incentives of derivative use. On the other hand, reducing
debt/equity ratio can be less attractive due to reduction in debt associated benefits such as
advantage of tax shield and ultimately it will increase firm’s tax liability. As Nance et al.
(1993) suggested, a firm can smooth away the agency problems through convertible debt or
preferred stock rather than straight debt so as to reduce the conflict between shareholders and
bondholders. Convertible debt helps to manage the conflicts of interest among stockholders
and bondholders and thereby reduces the incentives to hedge. Instead of reducing the
variability of the firm's equity by reducing the variance of the firm's net cash flows as the
hedging instruments do, convertible debt involves an embedded option on the firm's assets
which makes this liability more sensitive to firm-value changes and thereby reduces the
sensitivity value to firm-value changes. In a similar fashion, preferred stock decreases the
likelihood of encountering financial distress. Although similar to debt, preferred stock pays
periodic dividends rather than interest. Thus, while preferred shares do not produce tax
shields, firms can omit a preferred dividend payment without being forced into bankruptcy.
In contrast, a bankruptcy filing is virtually inevitable if an interest payment on debt is not
met.

14.3 Speculation

As the prior sections showed, previous empirical studies incorporate the use of derivatives
into their hedging definition. However, derivatives can also be used for speculation. Adam
and Fernando (2006) identifies the incentive for speculation. Given these incentives it is
possible that derivative users are speculating rather than hedging. Much of the recent debate
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on derivative use has focused on whether firms use these instruments for hedging purpose or
for speculation. Therefore, the issue is whether these studies are measuring hedging or
speculation on the use of derivatives. If the incentives for optimal hedging and speculation
are correlated empirical results might not distinguish between these two activities.

15 Conclusion

The purpose of this article is to take a brief theoretical review of hedging motives. Firms do
hedging to mitigate their risk whether they are small or large, national or international and
domestic or foreign. Among large number of risk types, financial risk is considered as most
dangerous risk. Several theories were presented in past that describes the factors which
motivate firms to hedge. Some says that there should be absolute perfection in the market;
otherwise firms will tend to hedge. Authors introduced some frictions which lead towards
hedging. Tax motives, underinvestment problem, financial distress, foreign exchange rate
risk, managerial risk aversion, firm size substitutes of hedging and speculation intentions are
those factors that determine the use of financial derivatives.
Omar A. B. et al. / Journal of Insurance and Financial Management, Vol. 2, Issue 5 (2017) 92-101 101

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