Risk Management and Firm Value: Evidence from Weather Derivatives
Stanford University; National Bureau of Economic Research (NBER)
Michigan State University - Department of Finance
AFA 2010 Atlanta Meetings Paper
This paper examines the impact of financial innovation on firm value, investment, and financing decisions. More specifically, we examine the effect of the introduction of weather derivatives on electric and gas utilities, arguably some of the most weather-exposed businesses in the economy. Weather derivatives were introduced in 1997 to help firms manage their weather-related risk exposure. We derive instruments for weather derivative use based on historical (pre-1997) weather exposure. Intuitively, firms whose cash flows have historically fluctuated with changing weather conditions are, relative to other firms, more likely to use weather derivatives once they become available, irrespective of their investment opportunities. Using data from U.S. energy firms, we find that weather derivatives lead to higher market valuations, investments, and leverage. Overall, our results demonstrate that financial innovation can significantly affect firm outcomes and that risk management meaningfully affects valuation, investments, and financing decisions.
Number of Pages in PDF File: 49
Keywords: risk management, hedging, derivatives, firm value, capital structure, debt policy, weather risk
JEL Classification: G30, G32working papers series
Date posted: March 11, 2009 ; Last revised: October 12, 2010
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