Input Hedging, Output Hedging, and Market Power
| Date | 01 February 2017 |
| Author | David De Angelis,S. Abraham Ravid |
| DOI | http://doi.org/10.1111/jems.12180 |
| Published date | 01 February 2017 |
Input Hedging, Output Hedging, and Market Power
DAVID DEANGELIS
Jones Graduate School of Business
Rice University
Houston, TX 77005
deangelis@rice.edu
S. ABRAHAM RAVID
Sy Syms School of Business
YeshivaUniversity
New York,NY 10033; and Research Fellow
Knut Wicksell Center for Financial Studies
Lund University
ravid@yu.edu
We argue that commodity input hedging is different from commodity output hedging. Output
hedging can be detrimental to “sector play.” Furthermore, firms with market power that hedge
outputs have incentives to over-produce and distort market prices. In rational markets, such
hedging will be expensive and we expect to see a negative relationship between hedging and
market power in “output industries” but not in “input industries.” We test these predictions
on a sample of S&P500 firms from 2001 to 2005. Our results support both hypotheses. Placebo
tests show that the same empirical regularities do not apply to currency hedging. Finally, our
empirical framework, which differentiates between hedging inputs and hedging outputs, can also
help in reconciling conflicting results in prior studies.
1. Introduction
In markets with few frictions, investors should not want firms to hedge risks, which
shareholders can hedge more easily and cheaply by their own portfolio choices and in
various derivative markets.1The literature proposes several motives, related to various
Weare very grateful to Ren´
e Garciafor sharing the hedging database with us. We thank the Editor,Dan Spulber,
and two anonymous referees for their valuable comments. We also thank Tim Adam (discussant), Yakov
Amihud, Michael Faulkender (discussant), Hamed Ghoddusi (discussant), Mark Huson, Kose John, JC Lin,
James Ohlson, Adriano Rampini, David Scharfstein, Betty Simkins, Matt Spiegel, Ryan Williams(discussant),
and David Yermack, as well as seminar and conference participants at American University, Baruch College,
FAU, Haifa University, Hebrew University,Hong Kong Poly, NYU, Rutgers, Stevens Institute of Technology,
University of Alberta, Yeshiva University, the 2010 European Finance Association Annual Meeting, the 2011
European Winter Finance meeting in Austria, the 2011 Oklahoma Risk Management Conference, the 2015
Financial Management Association Annual Meeting, the 2016 Midwest Financial Association Annual Meeting
and the 2016 IRMC conference in Jerusalem for helpful suggestions and discussions. All remaining errors are
our own. Ravid thanks the Sanger Family Foundation in Israel and the Whitcomb Center at Rutgers Business
School for financial support.
1. This can be easily understood by the following extreme example. Suppose that two firms produce
the same product, and their revenue can be either $50 or $150 with equal probabilities. Suppose further
that the revenue streams are perfectly negatively correlated. Each firm can pay an insurance company to
guarantee $100 in all states by paying $50 in the good state to cover the $50 shortfall in the bad state. Suppose
the insurance company charges $3. Then investors are guaranteed $97. However,it should be obvious that just
by buying the two stocks investors can guarantee $100 x 2 in all states on their own, without paying the $3.
Or, of course, they can just buy treasuries. Thus, in a world without significant frictions, as long as investors
can create portfolios relatively cheaply,firms should not hedge.
C2016 Wiley Periodicals, Inc.
Journal of Economics & Management Strategy, Volume26, Number 1, Spring 2017, 123–151
124 Journal of Economics & Management Strategy
market frictions, which can make hedging an optimal policy for an individual business
entity. Other work suggests that agency issues related to managerial risk aversion may
also be at the root of firm hedging policies. However, very little work, if any, focuses on
the distinction between hedging inputs and hedging outputs and the costs thus created.
In general, hedging outputs does not allow investors any “sector play.” In other
words, investors buy gold mining shares for the risk and returns of the gold mining
sector and if gold mining firms hedge their production (assuming that quantity can
be predicted), then investors may end up with an expensive riskless instrument. On
the other hand, because investors may buy gold mining shares for “sector play,” they
do not necessarily wish to take on risks related to say, exogenous electricity or fuel
prices, which may be inputs in that sector. In that sense, hedging inputs is different
from hedging outputs. Our paper argues, however, that in addition to this drawback,
hedging firm output in noncompetitive markets can also create adverse incentives for
over-production and distorted prices, affecting the entire market, which can be viewed
as an implicit cost of hedging. In other words, whereas much of the literature focuses on
the benefit side of hedging, here we focus on the costs (besides transaction costs) that
may be involved. We conclude that adverse incentives resulting from hedging outputs
will be greater for firms with market power (i.e., with a greater ability to influence output
prices), and if the counter-parties realize that and increase the hedging costs accordingly,
such leading firms are less likely to hedge their output. This simple conjecture, that is,
that firms with high market power are less likely to hedge outputs, is also consistent with
recent empirical work by Raman and Fernando (2010). Raman and Fernando present an
event study for the gold mining industry,which includes several large players who often
hedge their outputs. They find that the market “likes” hedging decreases and “dislikes”
hedging increases of gold mining firms, consistent with our conjectures.
We test our idea of a connection between hedging outputs, hedging inputs, and
market structure on a sample of S&P500 firms from 2001 to 2005. Industry classifications
from the input/output tables of the U.S. Bureau of Economic Analysis (BEA) allow us
to proxy for firms that are likely to hedge inputs versus firms that are likely to hedge
outputs. Most of the analysis includes companies that hedge commodity risk, an ideal
candidate for our study,because firms that have large positions in product markets may
be able to influence output prices. Our main hypothesis predicts a negative relation
between a firm’s market power and hedging in an “output industry,”and no significant
relation between market power and hedging in an “input industry.”
Consistent with our conjectures, we observe that in “output industries,” 64%
of the firms with low market power hedge commodity risk, as opposed to only 18%
of the firms with high market power. On the other hand, in “input industries,” this is not
the case. Regression analysis confirms these initial observations. Wefind that firms with
high market power are more likely to hedge commodity risk if they use commodities
as inputs rather than if they produce them as outputs. The economic significance of
our results is strong. For instance, if a firm that is expected to hedge output increases
its market share by 10%, then the odds of it hedging commodity risk decrease by 50%;
whereas in an input industry these odds do not change significantly.
We employ various econometric specifications to test our predictions. We first run
a subsample analysis. We then show that interaction effects,which represent the change
in the predicted probability of hedging commodity price risk for a given change in
both the firm’s market power and type of industry (output vs. input), are significantly
negative, as predicted. These results support our argument: a firm’s ability to influence
output prices creates adverse incentives, which increase hedging costs and thus, ceteris
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