Corporate Derivatives Use and the Cost of Equity

40 Pages Posted: 10 Nov 2010 Last revised: 14 Nov 2010

See all articles by Chen-Miao Lin

Chen-Miao Lin

Clayton State University

Gerald D. Gay

Georgia State University - Department of Finance

Stephen D. Smith

(Deceased)

Date Written: June 22, 2010

Abstract

We investigate the relation between derivatives use and corporations’ cost of equity capital. Using a large sample of non-financial firms, we compute and analyze (i) the relative cost of equity of firms that use derivatives and those that do not; and (ii) the change in cost of equity experienced by firms initiating derivatives programs. We find that the cost of equity of derivatives users is lower than non-users by 24-78 basis points. Our results are robust to specifications that account for potential endogeneity related to a firm’s derivatives use and capital structure decisions. We further find that the reduction in the cost of equity is attributable to both lower market beta and SMB beta, suggesting that firms use derivatives to reduce their financial distress risk and that this distress risk has a systematic component that is priced in the market. Finally, the observed reductions in the cost of equity tend to be largest for smaller firms and for firms utilizing currency and interest rate derivatives.

Keywords: Derivatives, Risk Management, Asset Pricing, Financial Distress Risk

JEL Classification: G12, G13, G32

Suggested Citation

Lin, Chen-Miao and Gay, Gerald D. and Smith, Stephen Dewitt, Corporate Derivatives Use and the Cost of Equity (June 22, 2010). Available at SSRN: https://ssrn.com/abstract=1689251 or http://dx.doi.org/10.2139/ssrn.1689251

Chen-Miao Lin

Clayton State University ( email )

Morrow, GA 30260
United States

Gerald D. Gay (Contact Author)

Georgia State University - Department of Finance ( email )

Robinson College of Business
Atlanta, GA 30303-3083
United States
404-413-7321 (Phone)
404-413-7312 (Fax)

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