Risk management and derivatives use in Australian firms.

• Author: Batten, Jonathan A.
• Position: Report

ABSTRACT

Country-specific information on risk management is increasingly important, not only for investors and decision makers in international markets but also, for those in national and regional markets. This study reports the results of a cross-sectional survey of risk management practice and derivatives use by a sample of Australian firms. Overall, the results suggest that firm-specific factors appear to have some influence on risk management practice with the industry of the respondent being the most important, while the degree of international exposure has the least. Larger and more internationally exposed firms are likely to have more frequent reporting of derivatives use, and are more likely to use swaps and options to manage risks than other types of firms. Issues and implications for international firms are discussed.

Keywords: Risk Management, Derivatives, Australia, Firm-specific Factors, Hedging

INTRODUCTION

Management of financial risks--the management of foreign exchange risk, interest rate risk and other financial market risks--is a crucial task for the modern corporation. Increased volatility in financial markets, the development of new instruments and techniques for risk management, and the large losses by some firms arising from their use of financial derivatives, have increased the attention given to the firm's risk management activities by investors, analysts, and supervisory authorities. With the exuberant expansion in financial markets with a high level of globalization, country-specific information on risk management has become increasingly important, not only for investors and regulators in international markets but also, for those in national and regional markets.

The decision by the corporation to actually undertake a transaction in the financial markets to hedge risk, is a complex decision-making process that may involve undertaking offsetting transactions in cash, over-the-counter (OTC) or exchange-traded markets. F o r example, the early empirical literature on foreign exchange risk management by international firms (Belk and Glaum 1990; Collier, Davis, Coates and Longden 1990; Batten, Mellor and Wan 1993; Ho 1993; Malindretos et al. 1993) suggest extensive use of cash based or "on-balance sheet" products (spot and forward sales or purchases of currency), and occasionally derivative or "off-balance sheet" products (options, futures and swaps); or combinations of cash and derivative instruments, for hedging risk. However, in recent years there has been an explosion in the use of derivatives -in particular options and swaps--for risk management and speculation purposes by the non-financial firm and only recently has the scale and scope of these transactions been documented or investigated.

The objective of this study is to provide further insight into this area by investigating risk management practice and the use of key derivative products for risk management purposes by non-financial firms in Australia. Specific attention is given to swap and option based transactions. Australia is a leading open and export orientated economy with a highly developed financial market. Use of derivative products in Australia by non-financial firms is enormous, with approximately US$6.0 billion in daily turnover; a figure greater than other leading export orientated economies such as Canada with US$4.1 billion and Germany with US$5.4 billion. Not surprisingly the larger economies of Japan and the United States (US) account for larger amounts (US$40.7 billion together) while the presence of the international financial centre of London ensures that the United Kingdom has the largest of any country with US$47.2 billion in daily turnover (BIS, 2005 Table E27.

Also, while previous empirical studies have tended to focus on cash based aspects of foreign exchange risk management using spot or forward contracts -for example, in the Australian context, Batten, Mellor and Wan, (1993)--or single aspects of financial risk management, such as either foreign exchange or interest rate risk management, the approach of this study is to investigate risk management using derivatives in its broader aspects by considering interest rate in addition to foreign exchange (FX) risk management practice. Better understanding these practices is critical given the fact that public attention has also focused towards the ease with which some firms can manage earnings using derivative products.

International empirical evidence on the risk management practices of non-financial firms suggests there is cross-sectional variation in the way in which firms conduct their risk management activities (e.g. Bartram, Brown and Fehle, 2006). Cross-sectional variation will influence firm risk management and hedging behaviour due to differences in leverage, organisational and industry structure, agency costs and the effects of information and transaction scale economies. To further investigate this issue, statistical analysis is undertaken on a cross-sectional and random sample of leading Australian firms with the objective of linking certain characteristics of firms to different risk management and derivatives practice. Research on derivative usage in Australia by these firms adds to a growing literature on corporate derivative practice and use outside of the US. It is important to recognise that foreign exchange management may be relatively less important for US firms since US international trade as a percentage of GDP is relatively small and most trade when it does occur is priced in US dollars, thereby eliminating any need to hedge underlying foreign exchange (transaction) exposure. On the other hand, risk management in other countries--where financial markets are less stable and/or international trade plays a high role in total GDP--is more critical.

Importantly this study also extends other recent Australian studies and so makes a vital contribution by focusing on the specific relationship between a set of firm variables and a group of unique managerial practices. The focus of the recent Australian study by Nguyen and Faff (2002) was to determine the factors that are important in the decision making process of derivatives usage and in deciding the extent to which derivatives should be used. While their overall results indicate that Australian companies use derivatives with a view to enhancing the firm's value, rather than to maximize managerial wealth, it is also important to determine the scope of risk management practice and policy across a variety of firm criteria. Benson and Oliver (2004) while considering industry effects, focus on managerial attitudes to risk rather than specifically addressing risk management practice and find that managers are focused on the broad reduction of risk and volatility of cash flows and earnings in using derivatives.

The study is structured as follows: Section 2 provides a perspective on the current literature on the theory and practice of corporate risk management and hedging behaviour. Section 3 establishes three propositions on how key firm variables are expected to affect management practice; Section 4 describes the research methodology and section 5 provides the test results in the context of the propositions. The final Section provides for some concluding remarks.

A BRIEF REVIEW OF RISK MANAGEMENT THEORY AND PRACTICE

Theories explaining risk management behaviour initially noted the efficiency of financial markets when in equilibrium with the view that firms could not add value by simply engaging in financial contracts (Modigliani and Miller, 1958). Later, Myers (1984) in support of positive theory argued the validity of this interpretation, inviting different views on capital structure theory due to effects of market imperfections that were neglected in neoclassical capital market theory. Examples of such imperfections include the costs of financial distress, the problems of synchronizing investments and financing activities coupled with the costs of external funding, agency conflicts between managers and shareholders, and the convexity of the tax function.

The general theoretical framework to explain the diversity of corporate hedging practice proposed by Smith and Stulz (1985) and later Froot, Scharfsteinn and Stein (1993), assumes a number of different states of the world (s) with [V.sub.i] defined as the pre-tax value of the firm in the ith state of the world. States of the world are numbered so that [V.sub.i]

Consequently various studies attempt to test theories on the determinants of corporate hedging (for example, Nance et al. 1993; Mian 1996; Fok et al. 1997; Goldberg et al. 1998; Howton and Perfect 1998; Jalilvand 1999), with the key finding that larger firms are more likely to engage in risk management activities than smaller firms. Froot et al. (1993) look at underinvestment as a possible motive for hedging, while Brown (2001) supports the view that agency problems between managers and shareholders as well as factors which are not described by the existing risk management theory (e.g. earnings management and speculation) may encourage risk management usage. Given the enormous growth in derivatives use and trading activities by both the financial and non-financial sectors in the last few years there is now extensive proof of the benefits from derivatives usage in the form of higher firm value (Bartram, Brown and Fehle, 2006). This result is also consistent with the findings of Graham and Rogers (2002) and Allayannis and Weston (2001). A recent survey by Graham and Rogers (2002) also provides useful information on CEO risk-taking incentives and corporate derivatives usage. The result of this study is consistent with the notion that derivatives are used for hedging earnings volatility. Hedging reduces noise related to exogenous factors and inturn decreases the level of asymmetric information regarding a firm's earnings (Gay and Nam, 1999).

Motivated by the existence of...