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«Do Firms Use Derivatives to Reduce their Dependence on External Capital Markets? TIM R. ADAM Hong Kong University of Science & Technology, Department ...»

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European Finance Review 6: 163–187, 2002.


© 2002 Kluwer Academic Publishers. Printed in the Netherlands.

Do Firms Use Derivatives to Reduce

their Dependence on External Capital Markets?


Hong Kong University of Science & Technology, Department of Finance, Clear Water Bay,

Kowloon, Hong Kong. E-mail: adam@ust.hk.

Abstract. This study investigates if the use of derivatives by corporations is likely to affect their

financing strategies. I find a strong positive relation between the minimum revenue guaranteed by hedging and investment expenditures. This result implies that hedging increases the likelihood that investments can be financed internally. I also find that firms tend to finance their investment ex- penditures externally rather than internally. If external capital is more costly than internal capital it would clearly be in a firm’s interest to reduce its dependence on external capital. Consistent with this result, I find that the median firm that does not hedge finances 100% of its investment expenditures externally, while the median firm that hedges finances only 86% of investments externally.

Key words: Financial risk management, hedging, investments, financing policy, financial constraints, gold mining industry.

JEL classification codes: G32

1. Introduction Froot, Scharfstein and Stein (1993) show that firms may have an incentive to hedge if external capital is costly. In such case, firms use derivatives to increase the correlation between internal funds and their investments in order to reduce their dependence on external capital. The purpose of this study is to test if firms indeed use derivatives for the purpose of reducing their dependence on external capital markets.1 I am grateful to Sudipto Dasgupta, Jin Duan, Joseph Fan, Vidhan Goyal, Peter Tufano, Steven Wei, and an anonymous referee for many valuable suggestions. I would also like to thank George Allayannis, Ken Eades, Wake Epps and Robert King for their helpful comments on earlier versions of this paper. Finally, I thank seminar participants at Northwestern University, the University of Virginia, the 1999 Derivatives Securities conference, and at the 1999 FMA annual meeting for their comments and discussions. Any remaining errors are my own. Funding was provided by the HKUST Research Grants Committee under project no. DAG97/98.BM24.

1 This objective is interesting from a financial market development perspective also. If firms are able to use derivatives to reduce their dependence on external capital markets, then this would indicate that a well-developed derivatives market can overcome some of the constraints imposed by a less-developed capital market.

164 TIM R. ADAM There are several papers that have tested the empirical relevance of Froot, Scharfstein and Stein’s (1993) theory. The earliest papers have focused on a firm’s decision to use derivatives, based on the notion that a firm is more likely to hedge if the cost differential between internal and external capital is large.2 The empirical results show that the likelihood to use derivatives increases among larger firms and among firms with high R&D expenditures. A high R&D budget could indicate that external capital is relatively costly due to information asymmetries and the potential for asset substitution, but firm size should be negatively correlated with the cost differential between internal and external capital. Thus, the empirical results are ambiguous with respect to Froot, Scharfstein and Stein’s (1993) financial constraints hypothesis.

A second line of research analyzes the extent of hedging.3 It is not clear, however, why financial constraints should affect the extent of hedging. In the absence of any costs of hedging, firms should fully hedge, independent of the magnitude of their financial constraints. In the presence of costs associated with hedging, firms should still fully hedge as long as the marginal benefit of hedging outweighs the costs. Thus, for an interior solution of the hedge ratio to exist, the cost of hedging must be a convex function of the extent of hedging. Only in this case would a change in the marginal benefit of hedging, e.g., a change in the magnitude of financial constraints, affect the extent of hedging. This is a strong requirement, and the only example that Froot et al. (1993) advanced is the existence of a natural hedge in which cash inflows and outflows are positively correlated. Since hedging would destroy this natural hedge, the optimal hedge ratio is less than one. In light of this argument, it is perhaps not surprising that the empirical studies explaining the extent of hedging have provided largely inconsistent results with respect to the financial constraints hypothesis. Some authors, e.g., Haushalter (2000), find evidence that financial constraints matter, while others, e.g., Tufano (1996), find the opposite.

Finally, Allayannis and Mozumdar (2000) analyze the effect of hedging on a firm’s investment/cash flow sensitivity. Following Fazzari et al. (1998), they interpret a positive correlation between investment expenditures and internal cash flow as an indication of financial constraints, although Kaplan and Zingales (1997,

2000) criticize this interpretation on both theoretical and empirical grounds. Allayannis and Mozumdar (2000) show that firms that use derivatives display a lower investment/cash flow sensitivity than firms that do not use derivatives. This result is consistent with the hypothesis that hedging reduces financial constraints and thus lends support to Froot, Scharfstein and Stein’s (1993) theory, but it does not address the broader question of whether hedging affects financing strategies.

Although the above mentioned empirical papers have provided many valuable insights about corporate risk management, they suffer from two methodological 2 See Nance et al. (1993), Dolde (1996), Mian (1996), and G´ czy et al. (1997).

e 3 See Tufano (1996), Haushalter (2000), Allayannis and Ofek (2001), and Graham and Rogers (2002).



limitations with respect to testing the financial constraints hypothesis. The first problem lies in identifying financially constrained firms. In the past, researchers have relied on proxy variables such as firm size, debt and liquidity ratios, marketto-book ratios, dividend policies, existence of a public debt rating, investment/cash flow sensitivities, etc. to measure the existence or the magnitude of financial constraints. Whether or not these proxy variables are successful in picking out financially constrained firms is highly controversial.4 Second, researchers who study the effects of risk management typically rely on a control group that represents how derivatives users would have behaved had they not used derivatives. If the decision to hedge were random, this approach would be valid and differences between hedgers and non-hedgers could be attributed to the use of derivatives. However, previous studies have shown that the decision to hedge is not random but rather a deliberate choice. Of course, there are econometric models that can control for the implied selection bias. Since to date we have only a limited understanding of this choice, it is unlikely that we can eliminate the selection bias completely, indicating that alternative test procedures are warranted.

To avoid these limitations, this study pursues a different method to answer the question, “Do firms use derivatives to reduce their dependence on external capital markets?” Instead of analyzing differences in financing strategies between hedgers and non-hedgers, this study determines if firms hedge their future investment expenditures. More concretely, this study examines if hedging increases the likelihood that future investments can be financed internally.5 In addition, I investigate how firms finance their investment expenditures. If it can be shown that firms hedge their future investment expenditures and that the marginal investment is financed externally, then this would constitute indirect evidence that firms hedge to reduce their dependence on external capital markets. The advantages of this approach are that it is not necessary to distinguish between financially constrained and unconstrained firms and that the group of non-hedgers need not be used as a control group. The disadvantage of this approach is that it provides only indirect evidence.

The sample for the econometric analysis is the North American gold mining industry. This sample choice has several advantages. First, financial constraints appear to be an important concern in the mining industry. Second, the similarity in risk exposures among gold mining firms implies that differences in hedging strategies are not merely reflections of differences in risk exposures but more likely reflections of differences in firm-specific factors such as financial constraints.

Third, the detailed derivatives disclosures and similar accounting treatments of

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derivatives transactions among gold mining firms make the above mentioned test method feasible.6 Consistent with previous studies, I find that larger and more mature firms are more likely to use derivatives than are smaller and less mature firms. The signicance of the risk exposure is a further important determinant of the decision to hedge. Less diversified firms are more likely to hedge, which is consistent with the findings of Allayannis and Ofek (2001). More importantly, I find a strong and robust relation between the minimum revenue guaranteed by hedging and investment expenditures, suggesting that firms hedge their future investment expenditures, as predicted by Froot et al. (1993). In addition, I find that investment expenditures are a major determinant of the amount of capital that firms raise externally. Finally, I find that the median firm that does not hedge finances 100% of its investment expenditures externally, while the median firm that hedges finances only 86% of its investment expenditures externally. These results are consistent with the hypothesis that firms hedge to reduce their dependence on external capital markets.

The results are also consistent with Minton and Schrand (1999) who show that cash flow volatility reduces investment spending. Since accessing external capital markets is costly (see Myers and Majluf (1984)) firms do not raise external funds to make up for all their cash shortfalls but they also cut investments. The appropriate response to this underinvestment problem is not necessarily to reduce volatility per se but to reduce the negative impact of volatility on investment. By hedging investments and hence reducing their dependence on external capital markets, firms seem to be following this rationale.

The remainder of this paper is organized as follows. Section 2 develops testable hypotheses. Section 3 provides some background information about the gold mining industry. Section 4 describes the data and the construction of variables. Section 5 presents the econometric results. Finally, Section 6 concludes the paper.

2. Hypotheses Development Froot, Scharfstein and Stein (1993) showed that firms have an incentive to hedge if external capital is more costly than internal capital. The purpose of hedging in this case is to align cash inflows with cash outflows to avoid the use of external financing. Hedging in this way generates additional cash inflows in those states of the world in which a firm experiences a cash shortfall. For example, if a firm is long in one asset and faces certain expenditures in the future, then the risk management objective can be achieved by purchasing put options (insurance) or by going short in forwards. The firm’s future cash inflow would then become certain up to the hedged amount, ensuring that future expenditures can be financed internally.

Pegasus Gold, a North American gold producer, seems to have adopted such a hedging strategy. In its 1997 annual report, management writes, 6 See Section 3 for more details.



The company entered into forward sales contracts to hedge the price risk associated with its gold sales and to assure itself of a fixed future income stream over the lives of its operating mines.

Froot et al. (1993) theory would predict that this fixed future income stream is positively related to the firm’s expected future investment expenditures. Hedging in this way would imply that future investments can be financed internally independent of future gold prices. To test this proposition, I estimate the following

regression model:

FFIS = α + βI + γ Controls + ε,

where FFIS denotes a firm’s fixed future income stream and I denotes the expected investment expenditures over the next year.7 A firm’s fixed future income stream may not only be a function of its future expected investment expenditures, but also a function of the availability of other internal and external financing sources. For example, if a firm keeps a high cash balance, then it does not need to hedge as much. Therefore, appropriate control variables are added to the above regression.

The next step is to determine how investments are generally financed. If firms hedge their future investment expenditures and such investment expenditures are generally financed externally, then this would represent indirect evidence that firms reduce their dependence on external capital.8 If investment expenditures were generally financed internally, however, then hedging would not change the mix between internal and external financing because hedging cash flows are themselves a form of internal financing.

To test if investment expenditures are an important determinant of the amount

of external financing raised, I estimate the following regression model:

FINCF = α + βI + γ Controls + ε,

where FINCF stands for a firm’s financing net cash flow, i.e., the net amount of external capital raised. The coefficient β measures how much external capital firms raise on average to finance one dollar’s worth of investments. Since the amount of external capital raised should also be a function of the amount of internal funds available as well as the financial condition of a firm, appropriate control variables are added.

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