Risk Measurement and Hedging: With and Without Derivatives

Financial Management (Financial Management Association), Winter, 2000 by Mitchell A. Petersen, S. Ramu Thiagarajan

S. Ramu Thiagarajan [*]

This paper examines a setting in which the derivatives strategies of two firms are known, but completely different. One firm aggressively hedges its risk using derivatives. The other firm uses a combination of operating and financial decisions, but no derivatives, to manage its risk. The different choice of methods is a result of different abilities to adjust operating costs and different needs for investment capital. Managerial incentives also play a role. Although risk-averse managers have an incentive to reduce risk, how and how much they hedge depends on how they are compensated.

In the corporate finance literature, research on risk management has focused on the question of why firms should hedge a given risk. The literature makes the important point that measuring risk exposures is an essential component of a firm's risk management strategy. Without knowledge of the primitive risk exposures of a firm, it is not possible to test whether firms are altering their exposures in a manner consistent with theory.

However, the measurement of risk exposures for non-financial firms has received limited research attention. At one level, the measurement of risk exposure seems intuitively obvious and deceptively simple. It is the covariance of the firm's unhedged cash flows, investment opportunities, or asset values with the risk factor. In practice, the problem is more difficult, since risk exposure can only be seen through the firm's financial disclosures, which might not fully reflect the true economic exposure (Beaver and Wolfson, 1995). The measurement problem is even more complex for some variables, such as investment opportunities, where the existence of the empirical relation in the data depends on a firm's risk management strategy. Investment opportunities might truly covary with a risk factor, but such a relation will not appear in the data if market frictions prevent the firm from taking advantage of investment opportunities when they arise.

In this paper, we take a new approach to measuring risk exposures and thus to testing the theory of risk management. We estimate and compare the risk exposures of two firms that are at opposite ends of the derivative-use spectrum, but are similar in that they both operate in the gold mining industry. The two firms we select are American Barrick, which aggressively hedges its gold price risk with derivatives, and Homestake Mining, which uses no derivatives. By comparing two firms in the same industry, it is possible for us to measure the different dimensions of the firms' risk exposures and how they are altered by the firms' risk management strategies.

Our objective is to understand the way in which firm specific characteristics determine how firms manage risk. The theoretical literature offers many possible objectives for risk management (e.g., operating cash flow, earnings, taxable income, and equity values). The specific objectives that managers choose depend on the fundamental characteristics of the firm. In this paper, we explore how differences in opportunities available to the firms for managing risk (beyond derivatives) and differences in the managerial and firm incentives lead the firms to target different variables for risk reduction and choose different tools for managing their risk exposure.

The paper is organized as follows. Section I reviews the empirical research on derivative use by non-financial firms and describes our research strategy. In Section II, we examine shareholder-based reasons for managing risks. By estimating the sensitivity of the firm's revenues, cash flow, and investment opportunities, we can begin to explain why American Barrick uses derivatives, and Homestake Mining uses changes in its operating decisions to manage risk. Homestake Mining appears to have lower costs of adjusting production, which provides them with an alternative means of reducing the volatility of its cash flow. Since its investment opportunities are more highly correlated with gold prices, this gives them a natural hedge against gold price risk and thus less reason to hedge. In Section III, we focus on managerial incentives for managing risk. By comparing the different ways in which the two firms compensate their managers, we can explain why one firm seems to target equity values and the other targets earn ings as their objective for risk reduction. Section IV concludes.

I. The Research Question and Empirical Strategy

The reasons why publicly traded firms manage risk can be divided into two broad categories: risk management can create value for shareholders, or it can increase the welfare of managers. Although risk management does not affect the value of the firm in a frictionless world, in the presence of market frictions, changes in risk can increase firm value.

A. Theoretical Motivations For Risk Management

Which variable should be the target of risk management depends on the hypothesized source of the gain. Reducing the volatility of taxable income can lower the present value of taxes when the tax schedule is convex (Graham and Smith, 1999). Assuring cash flow in bad states of the world can help the firm avoid financial distress (Smith and Stulz, 1985; and Froot, Scharfstein, and Stein, 1993). Since this strategy can increase the firm's debt capacity, it can also raise the value of the firm through an increase in tax shield (Graham and Rogers, 2000). If external capital is costly, the firm can assure its access to capital when it has positive net present value projects by reducing the volatility of net cash flow which we define as cash flow from operations minus net investment (Froot, Scharfstein, and Stein, 1993; Lessard, 1990; and Myers and Majluf, 1984).