Essays on corporate hedging, ownership structure and financial conservatism policies

Babajide, Bola Oluwayemisi

Abstract

Corporate hedging strategies are those risk management mechanisms used by firms to reduce their exposure to the risk of price movement in the financial markets. In Modigliani and Miller’s theorem, corporate hedging and corporate financing are irrelevant in a perfect capital market, as firms may not derive any benefit from them. In the presence of market imperfections, however, these two corporate policies become important and matter to the shareholder value maximisation objective because of the presence of taxes, financial distress costs, agency costs, and transaction costs. Thus, unless a firm has hedging strategies in place to reduce the impact of capital market imperfections, it may not be able to invest in valuable projects or meet financial obligations, which may lead to lowered firm performance. This may be so because without hedging, firms may, at some point in time, encounter variability in the cash flows generated by assets in place. In view of this logical implication, finance literature implicitly suggests that corporate hedging matters.

This thesis investigates whether corporate hedging matters by investigating the determinants of hedging policy. It also examines the influence that ownership structure has on the relationship between hedging and corporate performance. The thesis goes further to examine why firms choose to adopt a conservative financial structure at the possible expense of shareholders. Thus, the thesis comprises three different empirical chapters.

In Chapter 2 of the thesis, we examine the rationales for corporate hedging. The main objective of the chapter is to empirically investigate whether the incentives for corporate hedging under different macro-economic conditions – pre-financial crisis, during a financial and after a financial crisis, differ. In general, hedging theories suggest that the characteristics of an imperfect capital market such as the expected cost of financial distress, underinvestment problems, tax liability, agency problems and information asymmetry create incentives for firms to hedge in order to stabilise their cash-flow (Froot et al. 1993; Smith and Stulz 1985). To achieve the above-stated objective, the chapter examines two broad research questions. The first research question is: what are the incentives for hedging, in general? Second, we investigate if there are differences between the factors that make firms hedge in tranquil macroeconomic conditions and during a financial crisis. The first research question provides us with the opportunity to compare our findings with those of previous studies and the second question provides the main contributions of the study. The chapter considers that macroeconomic conditions are not always similar, as there may be three distinct macroeconomic periods: pre-financial crisis, during financial crisis and post crisis periods. Therefore we cannot treat the factors that induce corporate hedging during the three sub-periods as though they were homogenous.

Using logistic models to analyse a sample of UK non-financial firms that are quoted on the London Stock Exchange FTSE ALL SHARE we present several important findings. First, we show that derivatives are commonly and increasingly used by non-financial firms, as we find that about 55 per cent of our sample hedged with derivatives in 2005 and this increased to almost 64 per cent in 2008. Second, the analysis indicates that leverage, capital expenditure, size and exposure to foreign exchange risk are firm-level factors that significantly induce corporate hedging decisions. Third, we find that the factors that induce corporate hedging activities in normal macroeconomic conditions are different from the ones that induce hedging decisions during a financial crisis. Specifically, the analysis shows that tax liability is significantly important to hedging decisions during a financial crisis period but not during tranquil macroeconomic conditions. In addition, our analysis reveals that factors such as dividend pay-outs, capital expenditure and the shareholdings of institutional investors, particularly investors with fewer business ties, significantly create incentives for firms to engage in hedging activities in the pre-financial crisis period; however, the influence of the factors on the decision to hedge is insignificant during the crisis.

In Chapter 3, we investigate the implications of corporate derivatives usage by focusing on the interaction effects of derivatives usage and ownership structure on firm performance. Theories indicate that corporate hedging is a value-maximising strategy in the presence of the probability of financial distress, underinvestment problems, tax liability, agency problems and information asymmetry, as it would stabilise firms’ cash-flow to ensure they are able to cover operations and financial obligations (Froot et al. 1993; Smith and Stulz 1985). Using unbalanced panel data of U.K non-financial firms, over 2005-2011, we address the research question, how does the relationship between hedging and firm performance change relative to ownership structure? We argue that if ownership structure can be used by firms to reduce agency problems, then the value-maximisation effects of hedging on performance would not be strong in firms with a high ownership structure (managerial or institutional ownerships).

The empirical analysis in the chapter reveals important findings. First, we find that there is a negative association between hedging and performance as measured by Tobin’s Q. Second, we find that the effect of hedging on the performance of firms with high board of directors (institutional) ownership is different from those with low board of directors (institutional) ownership. Specifically, we find that the effect of hedging on the performance of firms with high board (institutional) ownership is weaker than in firms with lower board (institutional) ownership. The analysis suggests that there is no performance benefit associated with the use of hedging. Last but not least, we observe that institutional investors that have fewer business relations with a firm (i.e., grey investors) actively monitor and influence firms’ decisions to make decisions that induce good performance, as we find a positive association between the holdings of grey investors and firm performance.

Chapter 4 of the thesis investigates the factors that make firms follow a conservative financial policy despite the potential benefits of debt financing. More specifically, the chapter investigates whether corporate hedging plays a significant role in influencing financial conservatism policies. We emphasise that the optimal leverage level of each firm must be considered when identifying whether a firm is financially conservative or not. Thus, we estimate a leverage model that takes into account financial constraint, investment opportunities, asymmetric information and profitability, and thus identifies four different types of conservative firms, namely the low-leverage firms, nearly low-leverage firms, nearly zero-leverage firms and zero-leverage firms.

Using a sample of UK non-financial firms over 2000-2013 in logistic regression analysis, our analyses reveal very important findings. First, in separate logistic regressions for the four different leverage conservative policies (low-, nearly low-, nearly zero- and zero-leverage policies), we find that the factors that make firms adopt the four policies are not similar. For example, underinvestment problems as measured by growth opportunities contribute to the conservative decisions of nearly low-, nearly zero- and zero-leverage firms but not to those of low leverage firms. Also, we find evidence that the percentage of firms that follow financial conservatism policies declines during the financial crisis, suggesting that leverage conservatism is pro-cyclical. Finally, we find that hedging with derivatives plays a significant role in leverage conservatism decisions, particularly low-leverage and nearly low-leverage policies. The findings of this chapter add to the growing body of literature that investigates leverage conservatism. Also, the chapter contributes to knowledge in the field of corporate finance on the importance of risk management.

Overall, the analysis of this thesis provides new insight into our understanding of the importance of capital market imperfection in determining corporate policies including, corporate hedging, leverage and corporate performance. More specifically, the study reveals that firms that are susceptible to financial distress, tax liability, underinvestment problems and agency problems are more likely to engage in hedging activities during a financial crisis. In addition, the study reveals that the role of corporate hedging in performance may be insignificant in those firms that have in place mechanisms that may work in similar ways to corporate hedging. This is because as far as ownership structure reduces the impact of capital market imperfection on performance by mitigating agency problems, hedging may not be necessary. Similarly, since hedging may be costly, the impact of hedging on performance may be negative, as the market may perceive the activity unfavourably. Further, in the light of capital market imperfection, the findings of this study provide plausible evidence that hedging matters in deciding whether firms would be conservatively levered or not, as hedging firms would not find it difficult to issue debt.

Citation

Babajide, B. O. (2016). Essays on corporate hedging, ownership structure and financial conservatism policies. (Thesis). University of Hull. Retrieved from https://hull-repository.worktribe.com/output/4222220

• Thesis Type: Thesis
• Deposit Date: Feb 28, 2020
• Publicly Available Date: Feb 23, 2023
• Keywords: Business
• Public URL: https://hull-repository.worktribe.com/output/4222220
• Additional Information: Business School, The University of Hull
• Award Date: Jan 1, 2016