Two essays on corporate hedging: the choice of instruments and methods

Abstract

This dissertation examines corporate use of derivative instruments and multi-period hedging methods. It studies the use of linear (e.g. futures) and nonlinear (e.g. options) derivatives in a sample of 382 U.S. non-financial firms (920 firm-year observations) between 1992 and 1996. It also measures the performance of stacked hedge techniques with applications to three investment assets (heating oil, light crude oil, and unleaded gasoline) and to three commercial commodities (British Pound, Deutsche Mark, and Swiss Franc). In a stacked hedge, corporations hedge the long-term exposures by repeatedly rolling nearby futures contracts until settlement. Analyzing the 382 firms, I find that both value maximization and managerial incentives explain the use of linear and nonlinear derivatives by corporations. In particular, the use of nonlinear instruments is positively related to the firm's investment opportunities, size, free cash flow, and prospect of financial distress and managerial option grants. Firms are more likely to use derivative contracts with linear payoffs when their CEOs receive more compensation from bonus compensation or have been in their positions for longer periods of time. I evaluate how well long-term exposures to asset prices can be neutralized using stacked hedge techniques with applications to investment assets and to commodities. My evidence suggests that stacked hedges perform better with investment assets than with commercial commodities. The stacked hedge produces hedge performance of at least 0.98 for investment assets and hedge performance of less than 0.83 for heating oil. The results are consistent with the hypothesis that a stochastic representation of convenience yields results in pronounced deviations from the spot-futures parity resulting in non-trivial hedge errors.