Abstract
The adaptation of free market policies in the world economy has increased the employment of risk management practices in corporation’s financial decisions in order to reduce the variability in firm’s future cash flows, due to the highly volatile exchange rates and interest rates. It is generally argued that, extensive usage of derivative instruments can minimize the firm’s cash flow unpredictability by reducing financial distress costs, underinvestment problem, tax convexity and managerial ownership. Current paper attempts to identify the factors affecting the corporation’s extent of both foreign currency and interest rate derivative instruments by Tobit model using the sample data of 105 non-financial firms listed on Karachi Stock Exchange. Aligned with the Pakistan derivative market, firm’s extent of derivative usage is found to be positively related with lower financial distress costs, higher debt, underinvestment problem and fewer managerial holdings. Key words:
Highlights
In a competitive financial environment, along with free market policies, usage of derivatives for the risk management purpose increases over time in order to reduce the impact of volatile exchange and interest rates on firm’s future cash flows
Asian crises in 1998 and US financial crunch in 2007 provided the incentives to many corporations, especially Asian countries, for using derivatives instruments to hedge their respective risk exposure as their highly volatile home currency and interest rates make their cash flows more vulnerable to financial risks
Current study attempts to fill this gap by exploring the factors affecting the firm’s extent of hedging usage by using 105 non-financial firms of Pakistan listed on Karachi Stock Exchange for the period of 2004-2008
Summary
In a competitive financial environment, along with free market policies, usage of derivatives for the risk management purpose increases over time in order to reduce the impact of volatile exchange and interest rates on firm’s future cash flows. Foreign exchange derivative instruments are more widely used that is, about 88% of total surveyed sample firms whereas 83% firms are using interest rate derivatives This growing usage of derivatives for hedging purpose inclined financial theorist to determine the factors affecting firm’s extent of derivative usage. Existing hedging theories segregate determinants of hedging usage in two mainstreams: first one is shareholder’s wealth maximization hypothesis that hedging instruments are employed by corporations to minimize cash flow variability by reducing financial distress cost, underinvestment problem, agency cost of debt and tax convexity (Smith and Stulz 1985; Froot et al, 1993) while managerial risk aversion hypothesis states that, in order to protect their equity value, managers use hedging instruments in their own best interests. Study examines whether the determinants of corporations decision to use derivative instruments to hedge risk are like determinants of extent of such derivative usage or whether the factors affecting the corporation’s extent of derivative usage accords with the risk management theory
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