Which Risks Should Firms Hedge and Derivatives Should Be Used? Evidence from the UK

Abstract

This paper uses a dataset that comprises information on 275 nonfinancial firms listed in the FTSE-All share index over the time period between 2005 and 2012, and reveals interesting features of the UK nonfinancial firms regarding the effect of hedging on firm value and performance. We show that interest rate risk hedging is negatively related to firm value and performance and that this adverse relation is caused by the use of very popular and yet inefficient hedging strategies which rely on options and swaps contracts. The high demand for the above inefficient hedging strategies is very intriguing because we concluded that firms did have available a less popular but more efficient hedging strategy that relies on FO contracts. The popularity of the least efficient hedging strategies and unpopularity of the most efficient hedging strategy is rather puzzling because these results hold for every year of our sample time period and there are no differences among the derivates in terms of complexity or innovativeness that could justify such “imperfect” risk management behavior. We also find that the financial crisis of 2008-09 did not change significantly firms’ commitment to hedging, although during the crisis period the hedging of the foreign exchange and interest rate risks affects more positively and more negatively, respectively, firms’ performance.

Keywords: Financial Derivatives, Hedging, Performance, Value, Risk management

JEL Classification: G3, F4, F3