The Determinants of Off-Balance-Sheet Hedging in the Value-Maximizing Firm: an Empirical Analysis

The observed use (and indeed tremendous growth in volume) of forward contracts, futures, options, and swaps as hedges against interest rate risk, foreign exchange risk, and commodity price risk indicates that hedging does add value to the firm. The purpose this research was to empirically examine the value of off-balance-sheet hedging. The benefits of off-balance-sheet hedging were found to accrue from reducing (1) taxes, (2) expected financial distress costs, and (3) agency costs. Taxes. Hedging reduces the firm's tax liability by reducing the variability in taxable income. The value of hedging to the firm is a positive function of the convexity of the tax function and the variability of taxable income. Expected Financial Distress Costs. The value of hedging is a positive function of the degree to which hedging reduces the probability of financial distress and the costs of financial distress. Agency Cost. Due to the fact that bondholders and some managers hold fixed claims while shareholders hold variable claims, shareholders desire more risky projects than do bondholders or managers. Hedging reduces this conflict by allowing shareholders to undertake higher risk projects while protecting the holders of fixed claims. Firms can achieve the same benefits of hedging by using alternative strategies. Among the various alternatives to hedging are modifying the firm's capital structure, purchasing insurance, and modifying dividend policy. The amount of off-balance-sheet hedging activity undertaken by a specific firm is therefore a function of the value of hedging to the firm and the degree to which the firm has used alternatives to hedging. Using a regression analysis, this paper provides empirical evidence on the preceding relations. This study provides (1) the first empirical evidence into the reasons for a value-maximizing firm using off-balance-sheet hedging instruments, and (2) empirical insights into the way in which the firm's hedging decision interrelates with the capital structure, dividend, and insurance decisions

TAX PROGRESSIVITY AND CORPORATE INCENTIVES TO HEDGE

If a company faces some form of tax progressivity-that is, its marginal tax rate increases over the firm's expected range of reported taxable income-corporate hedging can reduce the firm's expected tax liability by reducing the volatility of pre-tax income. In a study described in this article, the authors used simulation methods to investigate the extent to which tax progressivity arises from various provisions of the tax code, such as the AMT and tax carryforwards and carrybacks. Based on their analysis of over 80,000 COMPUSTAT firm-year observations, the authors find that, in about 50% of the cases, corporations face effective tax functions that exhibit progressivity. The other 50% of cases are about evenly divided between firms that are tax neutral and those facing tax schedules that are "regressive" (again, over the relevant range of expected reported income). 2000 Morgan Stanley.

On the Determinants of Corporate Hedging.

Finance theory indicates that hedging increases firm value by reducing expected taxes, expected costs of financial distre ss, or other agency costs. This paper provides evidence on these hypothe ses using survey data on firms' use of forwards, futures, swaps, and options combined with COMPUTSTAT data on firm characteristics. Of 16 9 firms in the sample, 104 firms use hedging instruments in 1986. The data suggest that firms which hedge face more convex tax functions, have less coverage of fixed claims, are larger, have more growth options in their investment opportunity set, and employ fewer hedgin g substitutes. Copyright 1993 by American Finance Association.

BEHIND THE CORPORATE HEDGE: INFORMATION AND THE LIMITS OF "SHAREHOLDER WEALTH MAXIMIZATION"

The article begins by setting out three alternative conceptions of the corporate objective function. Relying on this framework, it shows that legal analyses tend to neglect conflicts between the interests of the corporate entity and the interests of shareholders over the amount of corporate risk-taking. Financial analyses tend to ignore both constraints on managerial discretion imposed by law and a fundamental ambiguity the author identifies in the "shareholder wealth maximization" assumption that underlies such analyses. 1996 Morgan Stanley.

VALUE AT RISK: USES AND ABUSES

Value at risk (or "VAR") is a method of measuring the financial risk of an asset, portfolio, or exposure over some specified period of time. By facilitating the consistent measurement of risk across different assets and activities, VAR allows companies to monitor, report, and control their risks in a manner that efficiently relates risk control to desired and actual economic exposures. 1998 Morgan Stanley.