Advances in Financial Risk Management

Corporates, Intermediaries and Portfolios

Jonathan A. Batten, Peter MacKay, P. Mackay, N. Wagner

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137025098
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

The latest research on measuring, managing and pricing financial risk. Three broad perspectives are considered: financial risk in non-financial corporations; in financial intermediaries such as banks; and finally within the context of a portfolio of securities of different credit quality and marketability.

Part I

Corporate

1

Strategic Risk Management and Product Market Competition

Tim R. Adam and Amrita Nain

1.1 Introduction

How does competition affect corporate risk management strategies? The theoretical literature has derived conflicting predictions. Allayannis and Ihrig (2001) predict that firms operating in more competitive industries are more likely to hedge, while Mello and Ruckes (2008) predict that firms hedge less if competition is more intense. Adam, Dasgupta, and Titman (2007) show that competition can have a positive or negative impact on the number of firms that hedge in equilibrium. While the theoretical literature has produced conflicting answers, anecdotal evidence suggests that the competitive environment does affect firms’ hedging strategies. For example, Brown (2001) reports that competitive pricing concerns in the product market, rather than the traditional models of hedging, determine how a major durable goods producer in the US hedges its FX exposures.

A related question is whether corporate hedging strategies are interdependent across firms; in other words, is the incentive of a firm to hedge affected by the hedging decisions of its competitors? Most theories of corporate risk management model firms in isolation, and therefore do not consider the possible interaction of hedging strategies between firms.¹ In contrast, Froot, Scharfstein and Stein (1993) argue that the nature of competition can affect a firm’s optimal risk management strategy and may lead to hedging decisions that are different from the firm’s rivals. Adam, Dasgupta, and Titman (2007) formally study the hedging decisions of firms in an industry equilibrium, and show that the incentive to hedge declines as more firms hedge.

The objective of this chapter is twofold. First, we empirically examine how competition affects corporate derivatives strategies, and second, we test whether firms’ derivatives strategies are interdependent, as prior research has suggested. Examining such interdependence is also interesting from a modeling perspective, as it would indicate whether we need equilibrium models to better understand corporate risk management. We investigate these questions using hand-collected data on foreign currency derivatives usage in 1999 for a large sample of US firms.

We find that in more competitive industries, fewer firms hedge. While this finding does not prove causality, it is consistent with the notion that firms strategically decide not to hedge if they face more intense competition, as in Adam, Dasgupta and Titman (2007). The finding that in more competitive industries fewer firms hedge is due to smaller firms, which are less likely to use derivatives in more competitive industries. In contrast, larger firms are more likely to use derivatives in more competitive industries. These results imply that it is the smaller firms that behave in the strategic sense of Adam, Dasgupta and Titman (2007) by opting to not hedge when competition is high. Larger firms behave in the manner predicted by Allayannis and Ihrig (2001), that is, hedge when competition is high, profit margins are tight and shocks can’t be passed through to prices. These results are robust to controlling for other determinants of derivatives usage, such as size of exposure, growth options, and financial policies, and support the prediction that competition has a negative impact on hedging of foreign exchange risk.

Next, we examine whether derivatives strategies are interdependent across firms. Derivatives strategies will be interdependent if a firm’s exposure to exchange rate risk is affected by the hedging decisions of its competitors. Therefore, we examine firms’ (ex-post) net FX exposures.² We find that firms’ net FX exposures depend not only on a firm’s own hedging decision, but also on the hedging decisions of its competitors. Consistent with Guay (1999) and Allayannis, Ihrig and Weston (2001), derivatives users have lower net FX exposures than derivatives non-users.³ More importantly, however, as more firms in an industry use derivatives, the exposure of derivatives non-users increases, while the exposure of derivatives users declines. In other words, firms’ net exposures are lowest if their hedging decisions conform to the hedging decisions of the majority, and are highest if they deviate from the hedging decisions of the majority. This result is robust to alternative estimation methods and alternative definitions of hedging in an industry.

In Adam, Dasgupta and Titman (2007) and Mello and Ruckes (2008), the interdependence between firms’ hedging choices relies on the existence of imperfect competition. Therefore, we further support our empirical evidence by examining FX exposures in sub-samples of more competitive and less competitive industries. We find that, as expected, the relation between an individual firm’s FX exposure and the derivatives choices of its competitors is stronger in less competitive industries.

Our results are significant for two reasons. First they show that the nature of competition can affect corporate derivatives strategies, and thus support theoretical predictions by Adam, Dasgupta and Titman (2007) and Mello and Ruckes (2008). Second, the results highlight that derivatives strategies are likely to be interdependent, which implies a need for equilibrium models to better understand corporate risk management behaviors.

Our results also contribute to several other strands of the literature. Most of the empirical literature on corporate risk management has examined how firm-specific factors, such as firm size, tax considerations, financial constraints, growth options, and managerial incentives affect firms’ hedging strategies. We add to this literature by focusing on the relations between industry characteristics and hedging strategies.⁴ In a related study, Allayannis and Weston (1999) find that firms that operate in lower mark-up (more competitive) industries are more likely to use FX derivatives, which seems to contradict our industry-level result. We show, however, that the relation between a firm’s decision to hedge and measures of industry competitiveness is a function of firm size. Smaller firms are less likely to hedge if competition is more intense, while for larger firms it is the opposite. Thus, it is especially smaller firms that strategically choose not to hedge in the presence of competition as suggested by Adam, Dasgupta and Titman (2007).

Several researchers have observed the impact of competition on firms’ risk exposures, and by deduction risk management strategies. Lewent and Kearney (1990) write on p. 19 ‘. . . the impact of exchange rate volatility on a company depends mainly on the companies’ business structure, its industry profile, and the nature of its competitive environment.’ Indeed, He and Ng (1998) and Williamson (2001) find that the degree of competition affects exposures: more competition implies larger exposures. We add to this literature by showing that aggregate derivatives decisions in an industry appear to affect the exposures of derivatives users and non-users differently.

Although our chapter is the first to show that adopting hedging strategies similar to the rest of the industry lowers a firm’s exposure, the prediction that firms find safety in conforming to the majority’s decision is not new. De Meza (1986) demonstrates that as the number of firms adopting a given production technology increases, output prices correlate more closely with production costs, providing firms with a better hedge against changes in the cost of production. Maksimovic and Zechner (1991) use the same theoretical argument to show that agency problems associated with debt need to be studied in a multi-firm framework because the risk of a project’s cash flows is endogenously determined by the investment decisions of all firms in an industry.

The remaining chapter is structured as follows. Section 1.2 reviews the existing theories and derives testable predictions. The data sample and variables used in the econometric analysis are described in Section 1.3. Section 1.4 contains the econometric analysis, which focuses on the impact of competition on aggregate hedging strategies in an industry. Section 1.5 contains the econometric analysis, which examines whether derivatives strategies are interdependent across firms, and Section 1.6 concludes.

1.2 Theory and testable predictions

The theoretical literature demonstrates that the impact of competition on firms’ hedging strategies is ambiguous. Allayannis and Ihrig (2001) show that exchange rate exposures rise as industry mark-ups, a proxy for the degree of competition, fall. This is because in less competitive industries, firms have a greater ability to adjust prices in response to cost shocks. In more competitive industries, output prices are set near marginal costs, so that the impact of cost shocks on a firm’s profitability is larger. An implication is that firms that operate in more competitive industries face higher exposures and therefore are more likely to hedge.

In contrast, Adam, Dasgupta and Titman (2007) show that competition can have a positive or negative impact on firms’ incentives to hedge, depending on whether hedging or not hedging is optimal in the absence of any competitive interaction between firms. In their model, volatility in input prices inflicts costs, due to a convex cost function, but also provides benefits, due to the presence of real options.⁵ In the absence of any competitive interaction, firms will either hedge or remain unhedged, depending on whether the cost effect or the real option effect dominates. For example, if the market is sufficiently large then the cost effect dominates so that all firms hedge, while if the market is small the real option effect dominates so that all firms remain unhedged. In the presence of competitive interaction, however, firms also benefit from generating cash flows in states in which other firms are cash constrained, as in Shleifer and Vishny (1992). Since the value of hedging declines as more firms hedge, in equilibrium, some firms hedge, while others do not, even though all firms are ex-ante identical. The resulting heterogeneity in hedging strategies is determined by the degree of competition, and the slopes of the demand and marginal cost curves. An increase in competition, an increase in the slope of the demand curve, and a decrease in the slope of the marginal cost curve all cause more heterogeneity in firms’ hedging decisions.

Mello and Ruckes (2008) also study firms’ hedging decisions in an imperfectly competitive market, and predict that competition reduces the extent of hedging. Although hedging can reduce a firm’s financial constraints, remaining unhedged carries the potential benefit of a large cash inflow relative to the firm’s hedged peers. In such a case, the firm may gain a significant financial advantage, that is, lower marginal costs and hence increase market share, over its competitors that hedge. Due to this competitive factor, firms will not fully hedge their exposures. Controlled risk-taking may make it possible to gain a financia...

Table of contents

• Cover
• Title
• Part I Corporate
• Part II Intermediaries
• Part III Portfolios
• Index