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Corporate Risk Management: Theory and Practice

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CORPORATE RISK MANAGEMENT:
THEORY AND PRACTICE
Cliff'ord W. Smith, Jr.
is Clarey professor of financt at tl1e
William E. Si'mon Graduate &hool of
Business Administration at the Univmity of Rocl1esttr in Rocl1esttr, New York.
As the sopllistication of risk management instn•-
ments l1as increased, the scope of corporate risk manage-
ment policy has become much broader. These instruments
provide great flexibility in structuring a risk management
strategy for tl1e firm. But to realize their potential
orporate risk management has expanded
C dramatically over the past decade. This
expansion reflects a better understanding of
the benefits of a well-structured risk man-
agement program as well as a material reduction in
the costs of risk management products. Much of
what is written about corporate risk management
focuses primarily on the use of derivatives - for-
wards, futures, swaps, and options - in hedging cor-
porate exposures to interest rates, foreign exchange
rates, and commodity prices. But the array of risk
management instruments is much broader.
In this article I discuss the underlying theory
of the mechanisms through which risk management
increases the value of a 5.rm. I believe this is the criti-
cal initial step in designing an effective risk manage-
ment program. For example, there is little agreement
on how one should measure these corporate expo-
sures - should risk management attempt to reduce
fluctuations .in reported earnings, or focus on cash
flows and firm value? As we will see in this analysis,
requitts a detailed understanding of the instruments and
their uses.
This article reviews the logic of the links betw«n
risk managtmtnt and value aution as wtll as tht accumu-
lating empirical evidence.
understanding why a firm hedges has direct implica-
tions for how one should measure these corporate
exposures as 'W'Cll as what instruments the 5.rm should
use to hedge. Finally, I review the accumulating evi-
dence on the use of risk management instruments.
I. RISK EXPOSURES AND HEDGING
Of the numerous risks to which firms are
exposed, some affect only individual firms, while
othen affect a broad cross-section of firms in the
marketplace. In Exhibit 1, I array these risks along a
risk spectrum. At one end of this spectrum are mar-
ketwide risks; these risks are not loc:alized to a spe-
cific: firm or industry - for example. the impact of
unexpected changes in interest rates. FX rates, or oil
prices. At the other end are firm-specific risks; these
include fires, lawsuits, outcomes of exploration and
development activities for 6rms in natural resoui:ce
industries, and outcomes of research and develop-
ment projects.
THl,JOUl\HALOl'Dlllt.rVATMS 21
EXHIBITt
C.0RPORATE RISJC SPECTRUM
Risk Exoosures Ofr-Balanc:e Sheet
firm- j ' fire
Spec:i6c Lawsuit Insurance
Payoffs to Wanants·
R&D Projects
Commodity Forwards
Prices
Futures
FXRates Swaps
Marketwide Interest Rates Options
'
Risk Management Imtnunenta
A major advantage of arraying the sources of
risk as in Exhibit 1 is that it clearly lets us see that dif-
ferent risks are managed with clifFerent hedging instru-
ments. In the second column, for example, insurance
policies are employed to manage firm-specific risks
like fires. Marketwide risks, such as exposures to
interest rates, can be managed with off-balance sheet
derivative instruments like forwards, futures, swaps,
and options. 1
Over the past decade, many new financially
engineered securities have been introduced to provide
customized solutions to corporate risk management
problems. Since these hybrid securities are built
around bonds or preferred stock. they are on the
firm's balance sheet. In creating these hybrids, finan-
cial engineen operate much like General Motors in
producing automobiles to meet specific customer
demands: GM achieves customization by assembling
various combinations of off-the-shelf components -
frames. trim packages. engines, interior appointments,
and so on. Similarly, financially engineered inscru-
ments are customized securities, but the components
that make up the securities are themselves fairly basic
off-the-shelf loans, forwards, swaps, and options.2
As illustrated in Exhibit l, the firm's choice of
JUsk Manaaement Tools
On-Balance-Sheet
Financial Production
Loss Prevenlion
and Control 1
Convertible Joint Ventures
Bonds
Hybrids TechnoJogy Choice
- Dual Currency
- Oil-Indexed Notes Plant Siting
-Etc.
Venical Integration
real production activities also can be used to manage
its risk exposures. For example, moving production
oveneas can change the firm's foreign exchange expo-
sure dramatically. But producing in a new market with
new suppliers, new workers, and different labor laws is
not a small decision. One materiaJ advantage offered
by financial market risk management products is that
they allow more effective separation of production
and risk management activities. Moreover, financial
contracts are more liquid, so if market conditions and ·
exposures change, this added flexibilir:y allows more
rapid adjustments.
Risk&po1me
It is important to understand the relation
between an underlying risk and firm value in analyz-
ing a firm's hedging incentives. Some relations are
straightforward; an uninsured casualr:y loss, for exam-
ple, directly reduces firm value. Yet. other exposures
can be more subde.
In Exhibit 2. I illustrate the exposure pmfile for
an oil company. Because this firm owns substantial
reserves of oil. higher oil prices raise revenues and
increase firm value. Thus, the exposure profile relating
the unexpected change in firm value to an unexpect-
ed change in oil prices has a positive slope. (For siln-
S.ll!oWIA 1"5
EXIUBIT2 It is important to note that this hedging activi-
Ex.PosURE PROFILE FOR AN OIL CoMJtANY llELA11NC 111E ty. although designed to change our chemical firm's
l1NExPECTED OIANCE IN FIRM VALlJE TO AN exposure to oil prices, generally will not affect the
UNEXPECTED CHA.NcE IN OIL PRICES firm's optimal pricing or production decisions. Basic
economic theory implies that optimal production and
pricing occur where marginal cost equals marginal
AV revenue. The opportunity cost of the oil is its spot
Core Oil
price, and thus the firm's relevant marginal cost is
Business
determined by the current spot price of oil. For that
reason, this hedging activity affects neither the firm's
relevant marginal costs nor marginal revenues.
Therefore, firms' decisions to use 6.n.ancial instruments
AP(oil) to hedge their exposures and their pricing and pro-
duction decisions generally are separable.

D. BENEFITS OP RISK MANAGEMENT

Sine~ risk management reduces the volatility

plicity I illustrate this relation as a straight line.) of firm value, one might presume that all firms
But for a petrochemical firm, the exposure would want to engage in risk management. Yet there
pr:ofile would look quite difrerent. For this firm. high- is wide variation in the use of risk management
er oil prices raise the costs of a major input. Thus the instruments across firms, even among firms that have
exposure profile relating the unexpected change in similar exposures. There are firm characteristics that
firm v.alue to an unexpected change in oil prices has a can provide firms with strong economic incentives to
negative slope. This exposure profile is illustrated in
Exhibit 3.
With the firm's exposure identified, I can now EXHIBrrs
EXPOSURE PROFILE FOR A PETROCHEMICAL CoMPANY
analyze the impact of risk management on &rm nlue.
For example, to hedge its exposure to oil prices, the
chemical company in E:xlubit 3 must employ a hedg- AV
ing instrument that will appreciate in value if oil
prices increase. Because gains on the hedge of&et loss-
es in the firm's core business, risk management
reduces the volatility of firm value.
Hedge
Richard Breeden, former Securities and
Exchange Commission chairman, notes that "deriva- AP {oll)
tives are the moving vans of risk - they shift risk &om
place to place by substituting one type of risk for
another." Yet my analysis above suggests such a charac- Net Exposure
terization of derivatives ignores a critical aspect of these
instruments. The dift"erence in exposures aaoss di&r- Core Business
ent firms offers potent:Wly imponant gains from the use
of derivatives. For example, an oil swap negotiated. with
our oil company as one end-user and the pea:ochemical The core business curve reJaces the unexpected chanp in mm
yalue to an unexpected change in oil prices. The hedge curve
firm as the other allows both firms to hedge. Therefore musantes the payol' to an oil swap that nceives cuh flow-based
derivatives do not just shift risk &om place to place - spot prica. The net exposure curve nflecu the modi6cadon in
they also can reduce the tocal risk in the system. exposure t:0 oil prices 6om the hedge.
hedge their exposures.
Company Ownership Stmcture
In examining risk management incentives, I
generally assume that the objective of the firm is to
maximize its current value. This implies that risk
management will be undertaken so Jong as it increases
the present value of the firm's expected cash flows.
In their individual affairs, risk-avcnc people
have incentives to manage risk because doing so low-
ers the expected rate of return they require to engage
in a risky activity. For cxampJc, an insurance company
has a comparative advantage over most individuals in
bearing risks, and therefore is willing to do so at a
lower price than the individual. But for a widely heJd
corporation, this logic fails.
Portfolio theory indicates that because investors
can ine:>.."PcnsiveJy manage non-systematic risk through
diversification, a corporation's required rate of return
does not depend on total risk but only on the system-
atic risk of its cash flows. Thus a hedging instrument
that works primarily on divcrsi6ablc risk docs not
provide a lower discount rate for firms whose owners
hold· well-diversified portfolios.
And even if systematic risk is affected, so long
as the risk is correctly priced, risk management still
will not affect firm value, even though the firm's non-
divcrsifiablc risk changes. For example, within a
CAPM framework, if oil price changes arc correlated
with market returns, hedging this exposure by pur-
chasing oil futures would change the firm's beta. Yet,
so long as the futures contract is priced to reflect its
systematic risk, this purchase would only move the
6rm along the security market line - it would not
change firm value.
Nevertheless, some firms have owners who do
not hold well-diversified portfolios. This is most likely
the case in firms where ownership is concentrated.
Thus in partnerships, proprietorships, and closely held
corporations, risk aversion of the firm's owners can
provide an important risk management incentive (see
Mayers and Smith [1982]).
for risk management to increase the value of a
widely held firm, if it does not reduce the firm's
requited rate of return, then it must increase the 6.rm's
expected net cash flows. To examine how this might
occur, recall the Modigliani-Miller proposition. It states
that the 6.rm's financing decisions - including its risk
management activities - will not a!"ect 6rm value so
Jong as the firm's investment decisions are 6.xed and
assuming there are no taxes or contracting costs.
For my purposes, it is useful to restate this
proposition and change its emphasis. If financial deci-
sions - including risk management decisions -
affect firm value, they must do so through their J
impact on taxes, contracting costs. or investment deci-
sions. I will use this restated form of the M and M
proposition to help identify circumstances in which
firms have economic incentives to hedge.
The Underinvestment Problem
Although well-diversified shareholders and
bondholders may not be concerned about the
prospect of unhcdged losses per se, they will become
concerned if such losses materially raise the probabili-
ty of financial insolvency, mainly because of their
potential to cause significant reductions in companies•
operating values.
There are two things to keep in mind about a
firm's operating cash flows in this context. First,
unhedged losses effectively reduce a company's stock
of capital. Second, because operating cash flows arc
before interest expense, a company•s value can also be
viewed as the sum of the bondholders' and the stock-
holders' claims on the company. This sharing of value
between the two groups can create problems that end
up reducing the value of the firm.
for example, to begin with the extreme case,
companies that wind up in Chapter 11 face consider-
able involvement of the bankruptcy court in their
investment and operating decisions, not to mention
substantial direct costs of administration and reorgani-
zation. But. even short of bankruptcy, financial diffi-
culty can impose large indirect costs. One important
source of such costs is a potential underinvestment
problem (see Myers [1977]). This problem arises fiom
conflicts of interest between stockholders and bond-
holders in companies with significant fixed claims.
If a company's fixed obligations are large
enough. a management acting on behalf of its share-
holders would have an incentive to pass up a positive-
NPV investment. As. M,ers demonstratcS, this would
be a rational decision (not just the result of managerial
shortsightedness) if enough of the value of the new
EXHIBIT.f
EXPOSURE PROPJLE FOR A PETROCHEMICAL CoMPANY
REFLEC11NC 111E FORGONE VALUE AsSOCIATED wmr 111E
lJNDERINVESTMENI' PROBLEM
4V
Net Exposure
Core Business
investment goes to shoring up the creditors' position.
The new equity issue would amount to a major
wealth transfer from stockholders to lenders - and a
shareholder wealth-maximizing management would
thus choose not to invest. Forgoing a positive NPV
project reduces overall firm value (see Mayers and
Smith [1982, 1987], Smith and Stulz (1985], and
Froot, Schar&tein, and Stein [t 993]).
Returning to the petrochemical firm in
Exhibit 3, an unexpected increase in oil prices raises
operating costs and causes a reduction in firm value.
This raises the firm's effective leverage, exacerbating
the underinvestment problem, and raising the likeli-
hood that the firm will forgo a positive-NPV project.
This is illustrated in Exhibit 4; the underinvestment
costs of the forgone projects axe the shaded area.
By purchasing an oil swap, the firm hedges its
oil exposure. Now, the reduction in operating cash
flows fiom an unexpected increase in oil prices is off-
set by inflows fiom the swap. Thus, both the induced
increase in leverage and the exacerbation of the
underinvestment problem is smaller. This is illustrated
in Exhibit 4 by the smaller shaded area associated with
the firm's net exposure. In this case, the real benefit of
hedging is the reduction in the underinvestment costs
(the xeduction in the shaded wedge) - not the flat-
tening of the curve.
Now, an alternative solution to this underin-
vestment problem would be to reduce the amount of
fixed claims in this firm's capital strUcture. Indeed, one
could argue that, as a general rule, corporate d~cisions
to retain large exposures effectively reduce the optimal
amount of debt - convenely, hedging increases cor-
porate debt capacity.
Risk Shiftinc Within the Firm
Up to this point, we have viewed the firm
from the perspective of its investors. Of course, the
corporation is a vast network of contracts among vari-
ous parties with conflicting as well as common inter-
ests. In addition to bondholders and stockholders, a
corporation has other constituencies such as employ-
ees, managers, suppliers, and customers - all have
vested interests in the company's success.
Like the owners of private or closely held com-
panies, the firm's managers, employees, suppliers, and
customers may not be able to divenify their risb; if
not hedged, these risks can affect their future payoffs
under their respective contracts. (In many cases, of
course, these contracts are implied rather than explic-
it.) Because they arc also risk-averse, these groups arc
likely to require extra compensation to bear any risk
not assumed by the owners or transferred through
hedging to a counterparty. .
Employees will demand higher wages (or xeduce
their loyalty or perhaps their work effort) at a company
where the probability of layoff is greater. Managers
with alternative opportunities will demand higher
salaries (or maybe an equity stake in the company) to
run firms where the risb of insolvency and financial
embarrassment arc significant. Suppliers will be more
reluctant to enter into long-term contracts, and trade
creditors will charge more and be less flexible with
companies whose prospects are more uncertain. And
customers concerned about the company's ability to
fu1fUl warranty obligations or service their products in
the future may be reluctant to buy those products.
Becawe of limited liability, the amount of risk
that can be allocated to the stockholders is limited by
the capital stock of the company. Companies in ser-
vice industries, for instance, are often thinly capital-
ized. And, for such companies, where the claims -
and thus the risb - of managers and employees are
likely to be large relative to the claims of investo:s,
thexe may be substantial benefits fiom hedging those
'l'HIJQUkNALOFDEP.l\Anv& 25
 risks through a risk management policy.
Note, however, that there is one important
aspect of achieving these potential risk management
benefits that has received little attention - a firm's
ability to precommit to a hedging strategy. This is less
a problem with some firm-specific risks; supplier,
employment, and customer contracts long have stipu-
lated levels of insurance coverage. But it is rare to see a
supplier contract that specifies that interest rate risk be
managed on an ongoing basis.
Without an ability to precommit to hedge, the
realized gains to a firm in these dimensions will be
lower. It is difficult to rely on implicit reputational
eff'ects to support an ongoing hedging policy because
of basic incentive incompatibility problems. In some
circumstances where these claimholders would value
hedging quite highly, the firm's stockholders face big
incentives to unwind the hedge.
Consideration of comparative advantage in
risk-bearing also has implications for the design of
compensation contracts. Effective compensation plans
achieve an appropriate balance between two potential-
ly conflicting goals - strengthening employees' per-
formance incentives and insulating them from risks
beyond their control. Incentive considerations dictate
that firms link compensation to performance measures
such as share price changes or earnings. Yet a potential
problem with such performance proxies is that they
contain significant variation that is unrelated to
employees' actions. Because financial price risks are a
potential source of such noise, companies also may
achieve economies in risk-bearing by more eff'ectively
excluding them from performance measures that serve
as the basis for employee evaluations and bonuses.
Perhaps an example would. make this point
more clearly. In 1988, the iiben division of DuPont
announced .. one of the most ambitious pay-incentive
programs in America:• The plan covered nearly all of
the division's 20,000 employees with a bonus tied to
the division's profits. Yet in 1990, the plan was can-
celled. Profits were off' 26%, in part because of the
increases in oil prices (and hence the division's costs)
due to the Gulf War.
By keying compensation to performance mea-
sures that were largely uncontrollable for the vast
majority of the division's employees, the plan created
significant worker discontent while providing limited
offsetting benefits from increases in producti"Vity. If
managers had instead hedged the division's expo~ure to
oil price changes, the target against which the employ-
ees were being assessed would have been more direcdy
linked to employee actions, and the bonus would have
been a more constructive motivating force.
'Dlxes
So long as the effective tax function is linear
(the 6.rm faces a constant eff'ective marginal tax rate),
hedging will not affect the firm's expected tax liability.
But if the 6.rm faces some form of tax progrcssivity -
the firm's effective tax function is convex - then
hedging taxable income by reducing the volatility of
pre-tax income reduces the firm's expected tax liabili-
ty. (This result follows Crom Jensen's inequality, and
hence this implication is quite general - see Smith
and Stub: (1985].)
The logic of the impact of risk management on
taxes is quite simple. If the effective tax function is
convex, in yean when taxable income is low, the
effective tax rate will be low; but in years when tax-
able income is high, the tax rate will be high. If tax-
able income is hedged. the tax increase in bad yean
would be less than the tax reduction in good years so
that the firm's expected tax liability falls.
Convexity of the 6.rm's eff'ective tax function
arises 6:om three general sources: statutory progressivi-
ty, limitations on the use of tax preference items, and
the alternative minimum tax. Although it is the most
straightforward. the importance of statutory progressiv-
ity is generally small because its range is quite limited.
Tax preference items like tax-loss carryfor-
wards, foreign. tax credits, and investment tax credits
typically have limitations on their use. Thus if taxable
income falls below some level, the value of the tax
preference item is reduced either by loss of the tax
shield or postponement of its use (see DeAngelo and
Masulis (1980]). Finally, the alternative minimum tax
linb tax liabilities to the difference between reponed
and taxable income.
Tax considerations thus suggest that the eco-
nomic incentives to hedge should be greater for firms,
1) the higher the probability that the firm's pre-tax
income is in the progressive region of the tax schedule
(for example, smaller firms or stan-up firms), 2) the
more tax preference items the 6.rm has, and 3). the
 greater the potential tax liability under the alternative
minimum tax.
Hedging Motives and Methods
Understanding the motives for risk manage-
ment is a eritical step in designing an effeet:ive hedg-
ing program for a firm. If the primary motive for a
particular firm to hedge is wees, then this firm should
focus on hedging its taxable income. If hedging is
prompted by risk-sharing coneerns, then a firm like
DuPont (where the fiben division bonus w:as keyed to
accounting returns) should focus on hedging account-
ing earnings. If the cost of financial distress and the
underinvestment problem is the primary factor that
motivates hedging, the firm should hedge firm value.
It is important to note that, in general, hedging
value and hedging earnings are not the same thing.
FASB rules have evolved to a point where it is typical-
ly difficult to obtain hedge accounting treatment for
an off-balance sheet hedge. Most firms that use stan-
dard derivatives thus are required to mark the hedge
to market in each aecounting period. Yet accounting
rules also generally prohibit the firm &om marking its
core assets or liabilities (whieh give rise to the expo-
sure) to market. This means that a firm can engage in
risk management activities that, while redueing the
volatility of firm value, increase the volatility of
reported earnings.
As access to hedge accounting treatment for
off-balance sheet derivatives has been restricted, there
has been a dramatic inerease in the use of structured
notes and other hybrid securities. This has occurred in
part because accounting rules generally do not require
that a risk management contract bundled with a loan
or preferred stoek issue be marked to market.
Finally, note that with three independent
instruments, three different targets can be achieved.
Therefore, in principle, with .the appropriate choice of
hedging instruments, a firm could simultaneously
manage the impaet on its value, reported earnings,
and taxable income.
m. THE COSTS OP RISK. MANAGEMENT
..
It is important to identify the aspects of the risk
management tn.nsaetions that iepresent real costs. The
relevant eost of hedging is basically the sum of any
out-of-pocket fees plus the implicit cost of the bid-ask
spread plus the opportunity eost of management's
time in the administration of the program.3 For stan-
dard swaps, these eosts lu.ve fallen dramatically over
the past decade.
In the early 1980s, the bid-ask spread for swaps
at times exeeeded 100 basis points. In 1995, it can be
as low as 2 basis points for a standard interest rate
swap. This profound reduetion in hedging costs,
reflecting the material increase in the liquidity of these
markets, makes the net benefits from accessing the
market greater, and explains part of the observed
growth in these markets. Moreover, standardization
and increased familiarity with these instruments and
their uses have lowered the administrative costs.
In addition to this variation in eost over time,
there is also important variation in costs across hedg-
ing instruments at a given date. In general, the eosts of
hedging will be lower: the greater the volume of
transactions in a given market, the lower the volatility
of the underlying asset priee, and the less private
information is relevant for prieing the underlying
asset. Therefore, hedging costs are generally lower for
derivatives on inten:st rates and major currencies but
higher for more eustomized hedging instruments.
IY. EVIDENCE ON CORPORATE HEDGING
Recent press coverage of Procter &: Gamble,
Orange County, California, and Barings Bank indi-
cates dearly that derivative instruments can be used
either to speculate on financial priee movements or to
hedge. Thus, a basic question to be addressed is: Do
firms use derivatives to hedge or to speeulate?
Although the evidenee is still preliminary, the answer
appears to be, for the most part, to hedge.
Perhaps the most eomprehensive survey to date
of the corporate use of derivatives was conducted by
Dolde (1993]. The overwhelming majority of the 244
Fortune 500 companies that responded to Dolde's
questionnaire report that their policy is t.o use deriva-
tives primarily to hedge their exposures. At the same
time, however, only about 20% of the responding
firms report that they attempt to hedge their expo-
sures eompletely. Moreover, smaller firms - those
likely to have lower credit ratings and hence greater
default risk - report hedging larger percentages of
THI J()U'P.NAL OP DllU\'A"llVES 27
 their exposures than big companies.
About 90% of the firms in Dolde\ survey also
said they sometimes have a view on the market direc-
tion of interest rates or exchange rates. And although
roughly one in six of even these companies hedges its
exposures completely, the rest claim to modify their
positions to accommodate their view.
For example, if they expect rates to move in a
way that would increase firm value, they might hedge
only 30% of their exposure; but if they expect rates to
move in a way that would reduce firm value, they
might hedge 100% of their exposure. Only two firms
said that they would use hedge ratios outside the 0%-
1OOoAi range. In effect, this means that less than 1% of
the firms said they would use derivatives to speculate
and enlarge an existing exposure.
Of course, there arc potential problems with
surveys. For example, some companies might be
reluctant to admit in a survey that they use derivatives
to speculate. Yet other evidence on hedging also bean
out this corporate propensity to hedge. For example, a
mounting number of studies find that firms with taX
or operating characteristics that theory suggests should
make hedging more valuable appear to use m~ne
derivatives. If derivatives were used primarily to spec-
ulate, no such associations should be expected.
Before I turn to examine those empirical
results, however, I must note one caveat about the
data examined by these studies. There are important
limitations in our current ability to judge whether one
firm hedges more than another. These limitations are
of two basic varieties.
First, over the past decade there has been wide
variation in the disclosure of corporate hedging activi-
ties. Prior to the adoption of SFAS 105, firms' disclo-
sure was generally required only if a hedging activity
was material. Yet, some firms voluntarily disclosed
more than was required This means that firms with
essentially equivalent hedging policies might appear
different because of difl'erent disclosure policies. The
adoption ofSFAS 105 should reduce this problem.
The second problem is more fundamental. Even
with complete access to hedging data, if two firms
employ different risk management instruments, judging
which firm hedges more can be dif:licult. For example,
assume firm A has $10 million (notional principal) of
three-year interest rate swaps, firm B has S20 million of
three-year swaps, and firm Chas $10 million of seven-
year swaps. Firm A dearly hedges less than either B or
C. but comparing B with C is more difficult. For the
next three years, B hedges more than C. but for the
following four yean firm C hedges more.
And if we turn to options, the problems get
dramatically more difficult - attempting to compare
firms with different size contracts and different exer-
cise prices is quite difficult. In principle, one could
estimate the contracts' deltas, but deltas depend on the
prices at which they are evaluated. These data limita-
tions mitigate the value of all the empirical work in
this area.
Investment Policy
Nance, Smith, and Smithson [1993] and Mian
[1994] examine whether firms with more growth
opportunities in their investment opportunity sets are
more likely to hedge. (The former examine hedging
activity by .169 Fortune 500 fimu; Mian analyzes data
from 3,022 COMPUSTAT firms.) Nance, Smith, and
Smithson find that firms with more growth options
hedge more, while Mian finds inconsistent evidence
across different measures.
Pinancinc Policy
Block and Gallagher [1986) and Nance, Smith,
and Smithson examine the association between hedg-
ing and leverage. (Block and Gallagher focus on the
use of interest rate futures by 193 Fortune 500 firms.)
Neither study finds a significant association between
hedging and leverage. 4
Booth, Smith, and Stolz [1984], Wall and
Pringle [1989], and Mayen and Smith [1990] examine
the impact of the probability of financial distress on the
incentive to hedge. (Booth, Smith, and Stolz examine
the use of interest rate futures by 238 financial institu-
tions; Wall and Pringle examine hedging by 250 swap
users from the NAARS data base; and Mayers and
Smith examine reinsurance purchases for a sample of
1;276 property-casualty insurance companies.)
Wall and Pringle find that firms with lower
credit ratings use more swaps, 5 Mayers and Smith
report that insuren with lower Best's ratings reinsure
more, and Booth, Smith, and Stolz report that S&Ls
hedge more than banks. These results suggest that
with a higher probability of financial distress, 6nns
 have stronger incentives to hedge.
Firm Size
Booth, Smith, and Stolz; Block and
Gallagher; Nance, Smith, and Smithson; and Mian
all report that large firms are more likely to hedge
with derivative securities than are small firms. This is
consistent with the proposition that there are signifi-
cant transaction costs as weU as information and scale
economics. Derivatives frequently arc viewed as
sophisticated products, and large firms are more like-
ly to hire managers with the requisite expertise to
manage a hedging program.
The analysis in Mayers and Smith, however,
indicates that small insurers reinsure more. This result
is consistent with size-related tax and financial distress
incentives. Moreover. the inform:ttion cost issues that
attend derivatives instruments for industrial or finan-
cial firms arc likely to be less important for insurance
companies' purchase of reinsurance.
Hedging and Taxes
Mian and Nance, Smith, and Smithson test the
proposition that statutory progressivity of the tax
function provides an incentive for firms to hedge.
Both find that the greater the likelihood that a firm's
pre-tax income falls in the progressive region of the
tax schedule, the more likely the firm is to hedge.
The effective tax schedule can be convex
because of limitations on the use of ax credits. Mian
finds more hedging by 6.rms with more foreign ax
credits, and Nance, Smith, and Smithson document
more hedging by firms with more investment tax
credits. They report inconsistent evidence on the
impact of tax-loss carryforwards.
Note, however, that these variables may proxy
for things other than a firm's tax status. For example,
the presence of tax-loss carryforwards also might
proxy for financial disuess; similarly, ITCs may proxy
for aspects of a firm's investment oppormnities; finally,
foreign tax credits potentially proxy for a foreign cur-
rency exposure. (Both Mian and Houston and
Mueller [1988) find that B.rm.s with foreign operations
.. are more likely to hedge.)
To the extent that these variables proxy for
firm characteristics other than the progrcssivity of the
firm's effective tax schedule, we have a potentially
important identification problem. More powerful tests
of these tax hypotheses will require proxies that bcucr
isolate the firm's we status.
Ownership Structure
There bas been little analysis of the use of for-
wards, futures, swaps, or options by closely held firms
largely because of data limitations. Within their sample
of property-casualty insurance companies, however,
Mayers and Smith arc able to examine closely held
firms. In their analysis of hedging through reinsunncc
contracts. they find that closely hc]d insurance firms
buy more reinsurance. This is consistent with the
proposition that 6.rms with owners whose portfolios are
more ill-divcrsi6.cd have stronger incentives to hedge.
V. CONCLUSIONS
Derivative instruments represent a material
addition to the corporate financial officer's tool kit.
These instruments provide incredib]c flexibility in
structuring a customized risk management strategy
for the firm.
To realize their potentia] requires a detailed
understanding of the instruments and their uses. Used
appropriately, they reduce risk and increase firm value.
But used inappropriately, they can cause even a cen-
turies-old institution like Barings Bank to collapse.
ENDNOTES
The author thanks the Bradley Policy Research
Center at the Simon School for financial support, and Mike
Barclay, David Mayen. Charles Smithson, Rene Stulz. Lee
Wakeman. and Sykes W"Uford for help in shaping his ideas
about these issues.
1
Although forward. futures, and simple swap con-
tracts dif.Fer in administration of the contract, liquidity. and
settlement team, all three of these imttumcnts have similar
exposure profiles. Buying a forward, futures or swap con-
tract means that the value of the c:onmc:t appreciates with
unexpected increases in the underlying asset price, and falls
with unexpected reductions. Writing a forward, futures, or
swap contract produces the opposite exposure; the value of ·
the position falls with unexpected increases in the underly-
ing asset price (see Smith. Smithson, and Wdford (1989]).
An option gives its owner the right. but not the
obligation to tramac:t (see Black and Scholes (19731). A call
THEJOUIUW. Of DEl\.IVA'i'lVIS 29
 is an option to buy; a put is an option to sell. Note that
buying a call plus writing a put with the same terms creates
payoffi that are equivalent to those of buying a forwud;
this equivalence is called put-call parley.
2for example, in 1973 PEMEX, the m.te-owned
Mexican oil producer, issued bonds that included a (orward
contract on oil. In 1980, Sunshine Mining issued bonds
incorporating an option on silver. And in t 988 Mapua
Copper issued a bond giving investon a strip of copper
options, one at every coupon payment (see Smith and
Smithson [1990]).
31n this regard, confusion is perhaps greatest in the
case of options. The option premium is not the cost of
hedging. This is perhaps easiest to see by considerir.g the
cue of an idealized "perfect market" (no transaction costs
or taxes). In this cue, the costs 0£ hedging are zero by con-
struction, although the option price is positive.
4
Because leverage and hedging are both endoge-
nous policy choices, this result potentially reflec:&s two otr-
setting effects. IC. given the firm's investment opponunities,
higher leverage raises the probability of financial distress, it
raises the demand for hedging. But firms with high leverage
tend to be firms with fewer growth options (see Smith and
Wam [1992)). If fewer gro\vth options reduce the demand
for hedging, then we might observe little correlation
between leverage and hedging.
5Note that this result is observed despite the &ct
that one would expect that the use of derivatives to hedge
corporate exposures should reduce risk and thereby increase
the firm's credit rating. Without explicitly examining the
firms' core business exposures and the speciiic derivatives
positions that the firms adopt, however, you cannot reject
the hypothesis that as a firm's financial condition deterio-
rates, it is more likely to use these markets to speculate.
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