Capital Market Frictions, Leasing and Hedging

Vasantha Rao Chigurupati

doi:10.22158/ijafs.v3n2p45

Abstract

This paper examines the hitherto unexplored effect of lease intensity on hedging. Using a sample of 218 small and large non-financial firms drawn from 2006 to 2010, we find that firms leasing more of their Property, Plant and Equipment (PPE) use less financial derivatives, consistent with the theoretical predictions of Rampini and Viswanathan (2010). Further, using broad market microstructure based measures of information asymmetry, we offer empirical evidence consistent with theory that firms with higher information asymmetry hedge more. These results are robust to several alternative measurements of key variables, different regression specifications, estimation techniques and corrections for endogeneity.

Highlights

The main theory of integrated corporate risk management, financing and investments formalized by Froot, Scharfstein and Stein (FSS hereafter, 1993) is based on the effective risk aversion of firms subject to financial constraints
Using a sample of 218 small and large non-financial firms drawn from 2006 to 2010, we find that firms leasing more of their Property, Plant and Equipment (PPE) use less financial derivatives, consistent with the theoretical predictions of Rampini and Viswanathan (2010)
Theoretical models of risk management predict that firms subject to financial constraints have greater incentives to hedge their risk exposures to ensure that they have sufficient internal funds to exploit investment opportunities

Summary

Introduction

The main theory of integrated corporate risk management, financing and investments formalized by Froot, Scharfstein and Stein (FSS hereafter, 1993) is based on the effective risk aversion of firms subject to financial constraints. In Model (1), the coefficient on OLR (-0.0083) is negative and significant, consistent with our second hypothesis that firms that use more leased capital hedge less as the need for financing the investments and conserving the debt capacity dominate the hedging concerns This evidence supports the arguments by Rampini and Viswanathan (2010) that there is a fundamental trade-off between firms’ financing and risk management policies and financing needs can override hedging concerns for financially constrained firms. The sign on the predicted OLR is negative (-0.0228) as expected and highly significant confirming our second hypothesis that the firm-level hedge ratio varies inversely with the intensity of leasing Based on this estimate, a one standard deviation increase in the predicted value of the operating lease ratio decreases the notional hedge ratio by 0.46%. This further mitigates potential concerns whether our instruments are weakly correlated with the endogenous regressor

Simultaneous Equation Modeling of Hedging and Leasing

Findings

Conclusions