The Strategic Motives for Corporate Risk Management

Abstract

This paper demonstrates that a firm's need to hedge depends on the extent of hedging in its industry. When many firms in an industry experience common cost shocks, prices co-vary with costs providing firms with a 'natural hedge'. However, when hedging is widespread, prices do not offset cost shocks and profits of unhedged firms fluctuate more with cost shocks. This suggests that if firms engage in derivatives hedging to reduce volatility of profits, the incentive to hedge is higher when the extent of hedging in the industry is high. These hypotheses are tested using data on foreign currency derivatives usage. Empirical tests provide strong support for the predictions. First, prices are less responsive to foreign exchange related cost shocks in industries where currency hedging is widespread. Second, an unhedged firm's foreign exchange exposure and, therefore, its perceived need to hedge increases with the extent of hedging in the industry. Consistent with these findings, a firm is more likely to engage in foreign currency risk-management if many competitors are doing so. These strategic incentives for hedging are robust and appear to be more important for currency hedging decisions than some of the firm-specific factors highlighted by existing theory. Finally, results indicate that the market penalizes an unhedged firm with lower value if many competitors of the firm are hedged.