Derivative Cash Flows and Corporate Investment

Abstract

A crucial argument for motivating hedging is that it supports corporate investment when internal cash flows are volatile and external financing is costly (Froot, Scharfstein and Stein, 1993). Despite its vast influence, the predictions of this theory have not yet been directly tested. I investigate the relationship between derivative cash flows and investment using hand-collected data from the oil and gas industry between 2000 and 2015. The data supports the theory. On average derivative cash flows make up 16% of the financing of capital expenditure, a number that rises to over 40% in crisis periods. Investment-derivative cash flow sensitivities are close to one for high-leverage firms. Derivative cash flows furthermore reduce investment tail risk, i.e. the risk of large shortfalls in capital expenditure relative its predicted value.