Performance measurement and derivatives usage.

AuthorSupanvanij, Janikan
  1. INTRODUCTION

    According to the shareholder maximization hypothesis, hedging can increase the firm value and help shareholders diversify their holdings. It allows firms to lower expected financial distress costs and reduce the underinvestment problem. Using derivatives tools to lower earnings volatility can help firms better plan their future investment. Allayannis and Weston (2001) find that the firm value of foreign currency hedgers increases significantly. Foreign exchange and interest rate exposures of multinational firms are hard to identify by investors. They are different from commodity risk exposure that is easy for individual investors to identify and hedge on their own on organized exchanges. Thus, hedging currency and interest rate risk by firms should add some value. On the other hand, Guay and Kothari (2003) argue that the increase in market value is possibly driven by other value-enhancing hedging activities like operational hedges, and the derivatives' potential gains are so small that they may not have significant effect.

    It is unclear whether risk management adds value to firms in general. Prior studies focus on particular industry or short time period due to data limitation, and some researchers have linked hedging behavior or firm performance to management incentives. Guay (1999) finds the correlation between a firm's performance and executive compensation. Joyce (2001) examines the relationship in banking industry. Baum, Sarver and Strickland (2004) update the study of Sheikholeslami (2001) by analyzing the relationship between performance and executive compensation, but their sample period is limited to one year. Haushalter (2000) examines the derivatives usage in gas and oil industry over 3 year period.

    This paper examines the relationship between the 2 popular performance measures (Economic Value-Added and Market Value-Added) and foreign currency/interest rate derivatives usage across industries during 1994-2000. Economic Value Added (EVA) and Market Value Added (MVA) are popular measures of economic profit. EVA focuses on profit and cost; MVA focuses on market value and book value of equity. Some researchers may argue that EVA is a better measure (Sheikholeslami, 2001; Dodd and Johns, 1999; Stern, Stewart and Chew, 1995). It can be derived from a specific time period and is suitable to measure short-term performance; while MVA is suitable to measure long-term performance that include a firm's market value. Thus, management's hedging decision may have difference effect on those measures. Since hedging behavior may tie to firm characteristics, this study also controls firm characteristics that may influence the firm performance

    The paper is organized as follow: Section 2 describes the sample data and model specification. Section 3 presents the empirical results and Section 4 concludes.

  2. DATA AND MODEL SPECIFICATION

    The initial sample consists of S&P500 firms with completed information. Financial firms and utility firms are excluded from the sample. Merged firms during the sample period are also dropped from the sample.

    The final sample consists of 231 industrial firms and the sample period is 1994- 2000. Total of 1,617 observations are included in the regressions.

    The derivatives data are collected from the Annual Reports (Form...

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