Does corporate hedging affect firm valuation? Evidence from the IPO market

• Author: Zheng Qiao,Lei Zhang,Chongwu Xia
• Published date: 01 June 2020
• Date: 01 June 2020
• DOI: http://doi.org/10.1002/fut.22098

J Futures Markets. 2020;40:895–927. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

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895

Received: 23 January 2019

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Accepted: 8 January 2020

DOI: 10.1002/fut.22098

RESEARCH ARTICLE

Does corporate hedging affect firm valuation? Evidence

from the IPO market

Zheng Qiao

1

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Chongwu Xia

2

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Lei Zhang

3

1

Department of Finance, School of

Management, Xiamen University,

Xiamen, Fujian, China

2

International Institute of Finance, School

of Management, University of Science and

Technology of China, Hefei, Anhui, China

3

UQ Business School, University of

Queensland, Brisbane, Queensland,

Australia

Correspondence

Chongwu Xia, International Institute of

Finance, School of Management,

University of Science and Technology of

China, 96 Jinzhai Road, Hefei, 230026

Anhui, China.

Email: cwxia@ustc.edu.cn

Funding information

National Natural Science Foundation of

China, Grant/Award Numbers: 71790601,

71802171

Abstract

Focusing on the IPO market, we examine the influence of corporate hedging on

firm valuation. Consistent with the argumentthathedgingreducesinformation

asymmetry, we find that hedging IPO firms are associated with lower price

revisions and underwriting fees. More important, hedging reduces IPO under-

pricing, especially for informationally opaque firms. This provides strong evidence

that corporate hedging increases firm valuation. We also show that corporate

hedging lowers aftermarket idiosyncratic volatility, enhances aftermarket liquidity,

and improves the long‐term performance of IPO firms. We use both an

instrumental variable approach and a regulation change on derivatives supply to

address endogeneity concerns.

KEYWORDS

corporate hedging, firm valuation, information asymmetry, IPO

JEL CLASSIFICATION

G14; G32; G34

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INTRODUCTION

An important topic under debate in corporate finance is whether corporate hedging affects firm value. In the

frictionless regime of Modigliani and Miller (1958), hedging should not matter. However, this theory is at odds with the

risk management practices that are widely used by corporations.

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Various explanations exist regarding the relationship

between corporate hedging and firm value (Bessembinder, 1991; Campell & Kracaw, 1990; Froot, Scharfstein, & Stein,

1993; Smith & Stulz, 1985; Stulz, 1984). On the empirical side, Allayannis and Weston (2001), Carter, Rogers, and

Simkins (2006), and Perez‐Gonzalez and Yun (2013) document a positive relationship between corporate hedging and

firm value, while Tufano (1996) and Jin and Jorion (2006) find no significant relationship. In this paper, we add to the

debate by studying the performance of hedging issuers versus nonhedging issuers in the IPO market.

To the best of our knowledge, this is the first study that examines the effects of corporate hedging on IPO firms. The IPO

market acts as a unique setting for examining how hedging is associated with firm valuation for three reasons. First, IPO

firms are typically younger, smaller and more opaque and, hence, suffer more from increased levels of information

asymmetry. If corporate hedging does indeed affect firm valuation by lowering information asymmetry, it should be

especially relevant for IPO issuers. Second, the IPO market allows us to examine an array of unique aspects in both the

primary market and the secondary market, such as price revision and underwriting fees during the book‐building process

and aftermarket stock characteristics. Third, the IPO setting provides us with a more direct and market‐based measure of

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For example, in 2017, U.S. nonfinancial firms held $20.8 trillion (in terms of notional value) in interest‐rate‐and foreign exchange‐rate‐related derivatives (Bank for International Settlements, 2017).

firm valuation in addition to the typically used Tobin's Q: IPO underpricing. If corporate hedging improves firm valuation, it

will translate into a lower level of underpricing, that is, a lower cost of raising external capital.

The literature has argued that corporate hedging helps to mitigate the information asymmetry between inside managers

and outside investors. DeMarzo and Duffie (1995) show that corporate hedging allows investors to better learn about the

management ability and project quality from firm performance, hence enabling them to make better investment decisions.

Similarly, Breeden and Viswanathan (2016) argue that managers can use hedging as a strategy for enhancing investors'

learning processes concerning management ability. The reduction in information asymmetry leads to a positive effect of

corporate hedging on firm valuation. Therefore, we hypothesize that corporate hedging reduces the information asymmetry

and value uncertainty faced by the IPO firm and increases its valuation, particularly during the issuing process.

This intuition is consistent with the asymmetric information models of IPO underpricing. First, Beatty and Ritter

(1986) demonstrate that the level of underpricing is positively related to the ex ante uncertainty about the value of IPO

firms, as a higher uncertainty induces a higher proportion of informed investors and aggravates the winner's curse

problem of Rock (1986). Since corporate hedging reduces cash flow uncertainty, it should help in lowering IPO

underpricing. Second, book‐building theory (Benveniste & Spindt, 1989; Benveniste & Wilhelm, 1990; Sherman &

Titman, 2002; Spatt & Srivastava, 1991) argues that IPO underpricing is a mechanism to elicit truth telling from

informed investors. When corporate hedging reduces the information asymmetry between issuers and investors, IPO

firms have lower information demand from informed investors. As a result, we expect corporate hedging to reduce both

price revision in the premarket and IPO underpricing in the aftermarket.

We test these hypotheses using a comprehensive sample of 2500 IPO firms from 1996 to 2014. We collect corporate

hedging information from IPO firms' Form S‐1/S1‐A filings. Our measure of corporate hedging is a set of indicator variables

on whether the firm uses financial derivatives to hedge against interest rate risk or foreign exchange rate risk.We find strong

evidence that corporate hedging reduces information asymmetry and increases the firm valuation of IPO issuers.

First, we document that corporate hedging reduces the price revision of IPO firms. The price revision of hedging issuers

is lower than that of issuers without hedging, suggesting that less information is extracted from book building for hedging

firms. Along this line, the underwriting fee is found to be lower for IPO firms with hedging, which is consistent with the

weakened role of underwriters in book building. Then, we study the effect of corporate hedging on IPO underpricing. We

find that corporate hedging is negatively related to IPO underpricing at the 1% significance level. The differences in IPO

underpricing between firms with and without corporate hedging range from 6.3% to 6.6%, or 28.1–26.8% of the average

underpricing in our sample, which translates into an average valuation increase from $6.2 to $6.5 m.

Consistent with the intuition that corporate hedging reduces the information uncertainty of issuers, we find that IPO

aftermarket volatility is lower for firms with corporate hedging. Finally, consistent with the effect of corporate hedging

on reducing the information asymmetry between informed and uninformed investors, we show that post‐IPO liquidity

and long‐term performance are positively associated with corporate hedging.

The potential issue with the previous analyses is endogeneity. One may argue that firms are self‐selected into making

hedging decisions or that omitted firm characteristics that explain the performance differences between hedging and

nonhedging firms in the IPO market exist. We take a three‐pronged approach to address these concerns. First, we use

the state‐average corporate tax convexity as an instrumental variable for corporate hedging. Campello, Lin, Ma, and

Zhou (2011) show that firms with higher tax convexity have stronger incentives to hedge against the volatility of

earnings to minimize expected tax payments. Specifically, for each IPO firm, we calculate the average tax convexity of

all listed firms in the same state of the same year. We find that the state‐average corporate tax convexity measure, which

is not firm‐specific, is strongly related to the corporate hedging of IPO firms. Our main findings remain robust to the

two‐stage least square regressions (2SLS) instrumental variable (IV) specification.

Second, we identify exogenous variations in corporate hedging decisions. Specifically, we focus on the 2005 Safe

Harbour Reform as a regulation change that significantly affects the availability of derivatives instruments, especially

for distressed firms. The new regulation protects derivative counterparties by allowing for foreclosure on the derivative

collaterals of firms when entering Chapter 11. The reform also expands the list of qualified counterparties and further

includes yet‐to‐be‐developed derivatives. Overall, the 2005 Safe Harbour Reform better protects derivative counter-

parties from firm defaulting, resulting in the higher supply/availability of derivatives contracts for distressed firms.

Consistently, Giambona and Wang (2019) document a sharp increase in both the number of derivatives contracts and

corporate hedging usage for distressed firms after 2005.

We keep the 4‐year sample period around 2005 to examine how this reform affects our findings. The years 2004 and

2005 are taken as the pre‐reform period, and the years 2006 and 2007 are taken as the postreform period. Indeed, we

find that the overall hedging usage, interest hedging usage, and FX hedging usage are all significantly higher for

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distressed IPO firms in the postreform period. Then, we construct an abnormal hedging measure to take advantage of

this exogenous variation, and we re‐examine the relationship between IPO underpricing and abnormal hedging for

distressed IPO firms. The relationship remains significant and negative for overall hedging and interest hedging. The

results suggest that the hedging decision induced by derivatives supply shock (as opposed to firm characteristics)

significantly reduces IPO underpricing. These findings lend support to our main findings, from a specific and unique

angle, and help to alleviate endogeneity concerns.

Third, if information asymmetry reduction is the underlying channel through which corporate hedging improves IPO

valuation, opaque firms should be affected by a larger extent than transparent ones. We, therefore, expect to observe cross ‐

sectional differences in the magnitudes of the impact of hedging on firm valuation between opaque and transparent firms.

To investigate this conjecture, we categorize our sample by both firm age and high‐tech industry indicator to re‐examine our

baseline results. Although the coefficients of overall hedging measure and interest hedging measure are significant and

negative in both young and mature firm subsamples, the magnitude of the hedging coefficients are always larger in the

subsample of young firms than in that of mature firms. Similarly, we find that our main findings are mostly concentrated

among high‐tech firms. Overall, the cross‐sectional test results lend additional support to our hypothesis that corporate

hedging increases IPO firm valuation by a larger extent in more opaque firms, that is, firms with higher information

asymmetry, than in less opaque firms.

Finally, given ourargument that corporate hedgingreduces the information asymmetry and value uncertainty faced by

an IPO firm, we directly relate corporate hedging decisions to proxies of information asymmetry measures. We adopt two

measures of information asymmetryfor IPOs firm in both the premarket and aftermarket: Form‐S1 filing uncertainty and

the breadth of investor ownership. The premarket measure, Form‐S1 uncertainty, is defined as the Loughran–McDonald

proportion of uncertainty words for IPO firms' Form S1 filings. A higher proportion of uncertainty words implies higher

information asymmetry between corporate insiders and outside investors. The aftermarket measure, breadth of

ownership, is calculated as the number of actively managed mutual funds holding the stock, divided by the total number

of domestic equityfunds in the same time period. We find that there exists a significant andnegative relationship between

corporate hedging and qualitative uncertainty in S1 filings. We find consistent results that the relationship between

corporate hedging and the breadth of mutual fund ownership is significant and positive. Overall, we find supportive

evidence that corporate hedging is associated with reduced information asymmetry.

Our study contributes to different strands of the literature. The first related literature is on the relationship between

corporate hedging and firm valuation. There are several theories explaining why corporate hedging should affect firm

valuation. Smith and Stulz (1985) argue that hedging can reduce the probability of bankruptcy and hence increase firm

value. Froot et al. (1993) propose that for firms with financial constraints, hedging can reduce the underinvestment

problem that arises from the variation in cash flow and costly external financing. More related to our study is the

asymmetric information model of DeMarzo and Duffie (1995). They argue that with corporate hedging, investors can

better learn about the management ability and project quality from firm performance, hence enabling them to make

better investment decisions. Thus, corporate hedging leads to higher firm valuation.

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The empirical findings, however, are mixed in the extant literature. Allayannis and Weston (2001) find that the use of

foreign currency derivatives causes a 4.87% increase in firm value for large nonfinancial firms. Carter et al. (2006) document

a similar result by examining the U.S. airline industry. Perez‐Gonzalez and Yun (2013) use a natural experiment of weather

derivative introduction and find a positive relationship between hedging and firm value. Gilje and Taillard (2017) document

a similar finding, employing a shock in basis risk in the oil and gas industry. Other studies document the underlying

channels through which corporate hedging affects firm value. For example, Graham and Rogers (2002) show that hedging

increases a firm's debt capacity. Campello et al. (2011) document that hedging firms are associated with lower interest

spreads and smaller likelihoods of capital expenditure restrictions. However, within several specific industries, such as gold

mining and oil and gas production, researchers fail to find any significant relationship between hedging and firm value (Jin

& Jorion, 2006; Tufano, 1996). We add to the debate by showing that the use of financial derivatives increases the valuation

of a firm's IPO, which is a cleaner setting in which to examine the corporate valuation effect.

Another strand of related research is on IPOs. Most related to our study are two asymmetric informational models of

IPO underpricing. First, the winner's curse model by Rock (1986) argues that the information heterogeneity among

investors leads to IPO underpricing, as uninformed investors require additional compensation. Based on Rock's (1986)

model, Beatty and Ritter (1986) show that the level of IPO underpricing should be positively related to the ex ante

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Empirically, Manconi, Massa, and Zhang (2018) and DaDalt, Gay, and Nam (2002) find direct evidence that hedging reduces the value uncertainty and information asymmetry of firms.

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