Introduction

M & M – Risk management is irrelevant to the firm, shareholders can themselves eliminate any risk they do not wish to be exposed too (through diversification for example). However, studies have found that by introducing some level of market friction, taxes, managerial risk aversion or information assymetry for example, that there exists benefits to corporate risk management.

Literature on reasons for hedging

Firm value maximising: firms hedge to reduce the costs that are involved with volatile cash flows of operation. Three lines of explanation:

Reduces expected costs of financial distress: Mayers and Smith (1982), Smith and Stultz(1985), Visvanathan (1998), Haushalter (2000)

Tax incentives, reduce tax when firms are exposed to convex tax function or increase a firms debt capacity: Mayers and Smith(1982), Smith and Stultz(1985)

Reduce Underinvestment problem: Froot, Scharfstein and Stein (1993), Geczy, Minton, and Schrand (1997)

Managerial personal utility maximisation: risk averse managers who have their wealth and human capital largly invested in the firm will hedge if they find the cost of personal risk management is greater then the cost of hedging at the firm level: Stultz (1984), Smith and Stultz(1985), Tufano (1996)

OTHER: DeMarzo and Duffie (1995) – private information

Should split up this section to first describe the theoretical reasons then give empirical results.

Theoretical Literature

In a world with perfect capital markets, free of taxes, information asymmetries or transaction costs, Modigliani and Miller show that risk management activities should be irrelevant. Hedging should not create value for a firm as shareholders can themselves undertake whatever risk management activities they desire at the same cost. The question of why firms undertake risk management activities, such as hedging, can be explained through either shareholder value maximisation theories, or managerial utility maximising theories.

Theories of firm value maximisation explain that firm’s hedge in order to reduce any costs associated with volatile cash flows of operating. There exists a strong body of research in support of the firm value maximisation motive for hedging, with differing explanations to where the value added is created. Mayers and Smith (1982) and Smith and Stultz (1985) show that by reducing the probability of bankruptcy and hence the expected costs of financial distress, hedging contributes positively towards value creation for shareholders. The costs associated with volatile cash flows, and financial distress, was expanded in later literature by Froot, Scharfstein and Stein (1993) to include underinvestment costs; the costs of failing to invest in positive net present value projects due to financial constraints. Froot, Scharfstein and Stein (1993) illustrated that hedging can help alleviate the underinvestment problem, and hence increase value for a firm, by generating extra cash flow in times when cash flow is low and reducing the need for firms to raise external capital. Stultz(1996) something related to underinvestment… Hedging can create value by decreasing the expected tax liability of firms that are exposed to convex tax functions; a progressivity of tax payable in which when income is low the effective tax rate is low, but when income is high the tax rate is also high (Graham & Smith, 1995)(Mayers and Smith(1982)) (Smith and Stultz(1985)). Leland (1998) also demonstrated that hedging can inflate the tax advantage of leverage by allowing a firm to increase its debt capacity beyond what would be feasible without cash flow hedges in place.

The counter to shareholder value maximisation explanations of corporate hedging are theories of managerial personal utility maximisation, which state that hedging is motivated by managers seeking to increase their personal utility functions. These theories state that managers who have large proportions of wealth and human capital invested in a firm will establish corporate hedging if they find the cost of personal risk management greater then the cost of hedging at the firm level (Stultz (1984), Smith and Stultz(1985)). Demarzo and Duffie (1995) put forth a further explanation for corporate hedging, stating that hedging may be optimal at the firm level if managers hold superior or private information which would make them more informed of firms hedging needs then private investors

Empirical Literature

Initial empirical research in the area focused on attempting to identify which motive explained why firms undertook risk management activities.

Risk management is more prevalent in large firm