This study assesses the relative and incremental explanatory power of the prediction that firms’ derivatives use can be related to specific firms’ financial characteristics, as well as to market risk and to idiosyncratic sources of risk.
University of Edinburgh
École De Hautes Études Commerciales du Nord (EDHEC)
University of Kent
University of Bristol
The study finds that there is a relatively strong and robust association between both the propensity to use derivatives and the level of use of derivatives with a range of firm-specific idiosyncratic and financial risk factors. It predicts that these relationships hold for interest rate and foreign currency derivatives and help explain changes in the use level of derivatives. The findings both clarify and condition the results on the overall use of derivatives.
The study estimates the cost of capital for EU firms under various assumptions about the methodology of estimation as well as different currency denominators of the investor in these firms. Using the full information beta (FIB) approach overcomes the limitations of the CAPM and FF3F methodologies in not recognising the differential costs associated with sales when segmented into domestic, EU/US and other markets. The cost of capital for heavy users of derivatives of various types is in many cases significantly higher than for low users of derivatives.
Overall, there are strong traces of support for the view that derivatives use by complex multinationals performs a risk-management role in mitigating sources of idiosyncratic risk and incentive problems. Many of the factors associated with derivatives use also imply that the capital structure policy of large conglomerates can be best viewed from an integrated and dynamic corporate financial perspective.
Overall, the study finds a fairly robust relationship between both the propensity to use derivatives and the amount of use, and various financial characteristics of firms, although both the statistical strength and direction of these relationships vary considerably across the regions in which these firms are based.
In particular, the finding that EU firms tend to view derivatives use much more liberally than that implied by the relatively narrow and specific focus on derivatives qualified for hedging treatment raises important questions concerning the corporate governance and accountability of these organisations to their shareholders and other stakeholders.
These findings must be viewed with caution, however, given the relatively short time-frame between the initial adoption of IAS by large European firms, and the implementation of costly and complex associated requirements of derivatives reporting. The sample period was not sufficiently long to undertake robustness tests on the effects of changes in fundamental economics affecting the provision of and demand for derivatives use, and various accounting and regulatory factors which control and mitigate the overall predicted relationships. Further research is needed to update and validate the overall results reported, particularly in the light of more recent changes to derivatives reporting after the latest financial crisis.