Determinants of Hedging and their Impact on Firm Value and Risk: After Controlling for Endogeneity Using a Two-stage Analysis

Abstract

Purpose – In this study, we investigate determinants of hedging with derivatives and its effect on firm value and firm risk for Korean firms.

Design/methodology – To avoid the endogeneity problem pointed out in previous studies, we use a two-stage analysis by using gains and losses from derivatives as instrument variable for hedging with derivatives.

Findings – Our analysis on the determinants of hedging shows that firms that are more leveraged and less profitable, and with more growth opportunities are likely to hedge through derivatives. Additionally, large firms, firms less diversified into industry, and firms more diversified geographically are likely to use derivatives. Our two-stage analysis shows that indicators of hedging with derivatives have an insignificant effect on firm value, and the indicator of futures/forwards use and of swaps use have significant negative effect on firm value. Whereas, the extent of hedging with derivatives has positive effect on firm value for all types of foreign currency derivatives, which suggests that moderately low hedgers use derivatives inefficiently, but extensive hedgers use derivatives properly. With regard to firm risk, hedging with derivatives increases market-based risk, but decreases accounting-based risk. Thus, we conclude that Korean firms use derivatives to manage operational volatility rather than to manage market risk, and accounting-based risk reduction through hedging is not directly translated into higher firm value.

Originality/value – This is not the first study to investigate hedging behavior of Korean firms, but the sample period that that this study analyzed is the longest and various method are used to control the endogeneity problem. We investigate not only total foreign currency derivatives but also by types of derivatives, including futures/forwards, options, and swaps.

Keywords: Corporate Finance, Derivatives, Hedging, Risk Management, Two-stage Analysis Model

JEL Classification: C36, G14, G32