We explore the relationship between the type of derivative instrument used and firm value, in a sample of Australian firms. Specifically, we examine the impact of the corporate use of swaps, futures, forwards and options, and the extent of such usage, on firm value. Our findings suggest that a ‘discount’ is most severely imposed on users of swaps.

Hoa Nguyen

Robert Faff

English

Research Papers in Economics

 
 
 
 
 
Faculty of Business and Law 
 
 
 
SCHOOL OF ACCOUNTING, ECONOMICS AND FINANCE 
 
 
School Working Paper - Accounting/Finance Series 2007 
 
SWP 2007/15 
 
 
Does the Type of Derivative Instrument used by Companies 
Impact Firm Value?  
 
 
 
 
 
 
 
Hoa Nguyen and Robert Faff  
 
 
 
 
 
 
 
 
 
 
The working papers are a series of manuscripts in their draft form. Please do not quote 
without obtaining the author’s consent as these works are in their draft form. The views 
expressed in this paper are those of the author and not necessarily endorsed by the School. 
 Does the Type of Derivative Instrument used by Companies Impact 
Firm Value? 
 
 
 
 
Hoa Nguyen* and Robert Faff** 
 
 
 
 
 
* School of Accounting, Economics and Finance 
Faculty of Business and Law 
Deakin University 
225 Burwood Highway 
Burwood VIC 3125 
Australia 
 
** Department of Accounting and Finance 
Faculty of Business and Economics 
PO Box 11E 
Monash University  
Victoria 3800 
Australia 
 
 
 
 
 
 
 
 
 
**  Corresponding author. Tel: +61 3 9905 2387; Fax: +61 3 9905 2339;  
Email: robert.faff@buseco.monash.edu.au Does the Type of Derivative Instrument used by Companies Impact Firm Value? 
 
 
 
Abstract 
 
We explore the relationship between the type of derivative instrument used and firm 
value, in a sample of Australian firms. Specifically, we examine the impact of the 
corporate use of swaps, futures, forwards and options, and the extent of such usage, on 
firm value. Our findings suggest that a ‘discount’ is most severely imposed on users of 
swaps.  
21.   Introduction 
In one of the pioneer papers that address the relationship between corporate risk management 
via the use of financial derivatives and firm value, Allayannis and Weston (2001) report that 
the corporate use of foreign currency derivatives by US (non-financial) firms has a positive 
impact on firm value. They documented a hedging premium of 4.87% of firm value for firms 
with positive foreign sales. More recently, Carter, Rogers and Simkins (2006) support the 
finding of Allayannis and Weston (2001) and report a hedging premium of 14% associated 
with fuel hedging in the airline industry. However, Lookman (2004) and Jin and Jorion (2006) 
examine the risk management practices of U.S. oil and gas producers and fail to find a 
significant relationship between commodity derivatives and firm value. Accordingly, in this 
paper we extend the literature by testing the hypothesis of whether the use of specific 
financial derivative instruments is rewarded by a higher market value. Specifically, we 
examine the impact of the corporate use of swaps, futures, forwards and options, and the 
extent of such usage, on firm value as measured by Tobin’s Q for a sample of Australian 
publicly listed companies over the period of 1999–2000. In direct contrast to the prediction 
that the use of derivatives is associated with a ‘hedging premium’, our findings suggest that if 
anything financial markets that are more prone to information asymmetry impose a ‘discount’ 
on derivative users – notably, the users of swaps.  
 
2.   Research Framework 
2.1  Data 
We use the Connect4 database that contain data of publicly listed Australian firms on the 
ASX to obtain our sample of non-financial firms. Based on the Notes to Financial Statements 
of each individual firm, we classify a company as either a derivative user or non-user. 
Specifically, a company is identified as a derivative user if it reports the use of options, swaps 
and futures/forwards. For every derivative user, the notional value of derivative contracts is 
  1used to proxy how active that user is in that derivative instrument. The sample obtained from 
Connect4 was then compared with the Datastream database to obtain data on the market value 
of equity. Our final sample consists of 428 firm/year observations, of which 217 observations 
relate to 1999 and the remainder to 2000. As revealed in Table 1, our sample is unevenly 
distributed across 23 industries, most heavily represented by the Property Trusts (47 
observations), Miscellaneous Industrials (50 observations) and, as expected from an 
Australian sample, Gold (35 observations) industries.  
2.2  Variables 
We use a simple type of TobinQ calculated as the sum of total liabilities and market value of 
equity divided by total book assets as our dependent variable. Table 1 further reveals that, 
specific to our sample, firms belonging to the Healthcare and Biological Index industry have 
the highest average TobinQ (2.53). At the other end of the spectrum, firms in the Engineering 
sector score the lowest average TobinQ (1.07).  
Our independent variables are measures of whether a firm uses a specific financial 
derivative instrument or not and in the case of a user, the extent to which that instrument is 
used. To proxy for the incidence of derivative usage, we use a dummy variable which equals 
unity if a firm uses a particular form of financial derivative and zero otherwise: (a) FUFO – 
futures and/or forwards; (b) OP - options; (c) SW - swaps. The extent of usage is calculated as 
the total notional value of derivative contracts for the given instrument, scaled by firm size 
where firm size is defined as total book assets: (a) ExtentFUFO – futures and/or forwards; (b) 
ExtentOP - options; (c) ExtentSW - swaps.  
To identify the impact of financial derivatives on firm value, we consider a number of 
factors that have been documented in the literature. These control variables are (a) firm size  
(eg Daines, 2001; Carter, Simkins and Simpson, 2003) – proxied by the log of total assets; (b) 
Leverage (eg Titman and Wessels, 1988; Rees, 1997) – proxied by the ratio of long term debt 
  2to total assets; (c) Liquidity  – proxied  by the ratio of corporate cash and cash equivalents 
holding to total assets; (d) Profitability (eg Rees, 1997 and Hand and Landsman, 2005) – 
proxied by the ratio of net profit after tax and before abnormal items to total assets, ROA; (e) 
Growth (eg Sougiannis, 1994; Green, Stark and Thomas, 1996) – proxied by capital 
expenditure scaled by total assets; (f) Industrial Diversification – proxied by an ‘industry 
segment’ variable, the number of industrial segments in which the firm operates; (g) 
Geographical Diversification (eg Carter, Panzalis and Simkins, 2001) – proxied by the ratio of 
foreign sales to total sales (FSTS); (h) Managerial Ownership – proxied by the percentage of 
shares held by directors and executive officers. 
 
3. Findings 
We aim to ascertain if the use of one type of derivative instrument is more value inhibiting 
than another. To achieve this objective, we classify our sample into futures and forwards users 
(FUFO), option users (OP) and swap users (SW). These analyses are motivated by the belief 
that derivatives with symmetrical payoffs are potentially more value hurting than derivatives 
with asymmetrical payoffs, assuming constant costs of hedging.   
Panel A of Table 2 reports the results of regressions that differentiate the use of 
financial derivatives along these dimensions.
1 The major result observed is that the market 
apparently imposes a hedging discount on swap users. Moreover, the magnitude of the 
hedging discount is striking. Specifically, the incidence of swap usage is associated with a 
reduction in firm value of around 0.36. Given that the average TobinQ of the sample is 1.51, 
the hedging discount associated with the use of swaps represents a 24% reduction in firm 
value. Additionally, the more extensively firms make use of swap instruments, the lower the 
                                                 
1 The results for the control variables are suppressed to conserve space. 
  3firm value. Although futures/forwards also provide symmetrical payoffs, the use of these 
instruments does not appear to induce a ‘hedging discount’.  
In Panels B and C of Table 2, we go one step further by considering the two 
dimensional interaction between the type of derivative instruments and the underlying 
exposure. As such, we develop nine new independent variables and examine the impact of 
each of these variables on firm value.
2 The results that we obtain are largely consistent with 
those reported in Panel A. The choice of the type of derivative instrument does impact firm 
value – swap contracts tend to impair firm value. 
While derivative usage in general can potentially be a source of information 
asymmetry that explains a hedging discount, market participants may discount the use of 
swaps more heavily due to the possibly higher default risk associating with swap contracts. 
Despite the fact that default risk is inherent for all derivative contracts, in the case of 
exchange traded futures and options, the risk is mitigated through daily marking to market 
processes by an organized exchanged.  In contrast, the swap market, like all other over the 
counter derivative markets, does not have such a systematic approach to control default risk 
but primarily rely on credit enhancement devices to control for default risk. Our results, 
therefore, suggest that market participants may price default risks associating with swap 
contracts into the valuation of a firm.  
 
5. Conclusion 
We extend the literature by testing the hypothesis of whether the use of specific financial 
derivative instruments is rewarded by a higher market value. Specifically, we examine the 
impact of the corporate use of swaps, futures, forwards and options, and the extent of such 
usage, on firm value for a sample of Australian publicly listed companies. In direct contrast to 
                                                 
2 They are: FUFO_FCD, FUFO_IRD, FUFO_COM, OP_FCD, OP_IRD, OP_COM, SW_FCD, SW_IRD and 
SW_COM. 
  4the prediction that the use of derivatives is associated with a ‘hedging premium’, our findings 
suggest that a ‘discount’ is imposed on derivative users. This discount is most strongly related 
to the use of swaps, while there is little evidence indicating that the use of options is harmful 
to value.  
  5REFERENCES 
 
Allayannis, G. and Weston, J. 2001, ‘The use of foreign currency derivatives and firm market 
value’, Review of Financial Studies, 14, 243-276. 
Carter, D. A., Pantzalis, C. and Simkins, B. J. 2001, 'Firm-wide risk management of foreign 
exchange exposure by US multinational corporations', Working paper, Oklahoma 
State University. 
Carter, D. A., Simkins, B. and Simpson, G. 2003, ‘Corporate governance, board diversity and 
firm value’, Financial Review, 38, 33-53. 
Carter, D.A, Rogers, D. and Simkins, B. 2006, ‘Does fuel hedging make economic sense? The 
case of the U.S. airline industry’, Financial Management, forthcoming. 
Daines, R. 2001, ‘Does Delaware law improve firm value?’, Journal of Financial Economics, 
62, 525-558. 
Green, J. Stark, A. and Thomas, H. 1996, ‘UK Evidence on the market valuation of research 
and development expenditure’, Journal of Business Finance and Accounting, 23, 2, 
191-216 
Hand, J. and Landsman, W. 2005, ‘The pricing of dividends in equity valuation’, Journal of 
Business Finance and Accounting, 32, 435-469. 
Jin, Y and Jorion, P. 2006, ‘Firm value and hedging: evidence from U.S. Oil and Gas 
producers’, Journal of Finance, 61, 893-919. 
Lookman, A. 2004, ‘Does hedging increase firm value? Evidence from oil and gas producing 
firms’, working paper, University of South Florida. 
Rees, W. 1997, ‘The impact of dividends, debt and investment on valuation models’, Journal 
of Business Finance and Accounting, 24, 1111-1140 
Sougiannis, T. 1994, ‘The accounting based valuation of corporate R&D’, Accounting 
Review, 69, 1, 44-68 
Titman, S. and Wessels, R. 1998, 'The determinants of capital structure', Journal of Finance, 
43, 1-19. 
 
 
 
 
 
 
 
  6  
Table 1 
Industry Classification 
 
Industry 
Number of 
Observations  Mean Tobin Q  Median Tobin Q 
Gold 35  1.2735  1.1486 
Other Metals  19  1.2545  1.1951 
Diversified Resources  5  1.4293  1.3126 
Energy 27  1.5888  1.1601 
Infrastructure and Utilities  17  1.4193  1.1711 
Developers and Contractors  15  1.4502  1.1703 
Building Materials  15  1.1353  1.0460 
Alcohol and Tobacco  9  2.4296  2.2706 
Food and Household Goods  12  1.1872  1.1408 
Chemicals   5  1.1854  1.1861 
Engineering 7  1.0735  1.0124 
Paper and Packaging  8  1.3625  1.2409 
Retail   29  1.8085  1.5238 
Transport 8  1.8204  1.3727 
Media 24  1.6271  1.3907 
Banks 0  NA  NA 
Insurance 4  1.7081  1.0875 
Telecommunications 21  2.3358  1.9528 
Investment and Financial Services  29  1.3570  1.0506 
Property Trusts  47  1.1102  1.0108 
Healthcare and Biological   17  2.5302  2.0802 
Miscellaneous Industrials  42  1.5346  1.2855 
Diversified Industrials  22  1.2630  1.1783 
Tourism and Leisure  11  1.5570  1.2355 
      
Total 428  1.5133  1.1904 
 
  7 
Table 2 
Type of Derivative Instrument Used and Firm Value 
 
Panel A:  Futures/Forwards; Options; Swaps  
     Predicted Sign  Tobin Q  t-stat  R-squared 
FUFO   +  -0.1012  -1.2035  0.4048 
OP   +  -0.0299  -0.4333  0.4019 
SW   +  -0.3633
a -4.3576 0.4343 
ExtentFUFO   + -0.0012  -0.7645  0.4020 
ExtentOP   +  0.0004  0.2004  0.4017 
ExtentSW     +  -0.0086
b -2.4556 0.4088 
Panel B: An Interactive Model of Derivative Usage  
    Tobin  Q  t-stat  R-squared 
FUFO_FCD   + -0.0360  0.0795  0.4021 
FUFO_IRD   +  -0.2179  -0.9838  0.4023 
FUFO_COM   + -0.0718  -0.9763  0.4026 
OP_FCD   +  -0.0257  -0.2934  0.4018 
OP_IRD   +  0.1962  1.3189  0.4039 
OP_COM   +  0.0449  0.5613  0.4020 
SW_FCD   +  -0.0360  -0.2761  0.4018 
SW_IRD   +  -0.3117
a -3.8557 0.4272 
SW_COM     +  -0.1860  -1.4760  0.4044 
Panel C: An Interactive Model of the Extent of Derivative Use  
     Tobin  Q  t-stat  R-squared 
FUFO_FCD   + -0.0003  -0.2417  0.4017 
FUFO_IRD   +  -0.0794  -1.8452  0.4025 
FUFO_COM   + -0.0004  -1.4453  0.4028 
OP_FCD   +  -0.0002  -0.2470  0.4017 
OP_IRD   +  0.0034  0.4363  0.4019 
OP_COM   +  -0.3866  -0.3009  0.4018 
SW_FCD   +  -0.0050
c -1.7058 0.4029 
SW_IRD   +  -0.0070
a -3.2036 0.4104 
SW_COM     +  -0.0031
b -2.4987 0.4040 
a significant at 1% level 
b significant at 5% level 
c significant at 10% level 
 
 
 
  8

Does the Type of Derivative Instrument Used by Companies Impact Firm Value?

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