Does hedging enhance firm value in good and bad times

• Published date: 05 March 2018
• Pages: 132-152
• Date: 05 March 2018
• DOI: https://doi.org/10.1108/IJAIM-03-2017-0041
• Author: Nafis Alam,Amit Gupta
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Does hedging enhance firm value

in good and bad times

Nafis Alam

Henley Business School, University of ReadingMalaysia, Johor Bahru, Malaysia, and

Amit Gupta

GE Power Solutions, Kuala Lumpur, Malaysia

Abstract

Purpose –The purpose of thispaper is to examine if the hedging strategy of the firm adds value to the firm,

and if so, is the source of the benefit consistentwith the hedging theory?

Design/methodology/approach –The paper used data from 129 top non-financial Indian companies

spanninga period of 2008-2015and analyzed using the ordinary least squares regressiontechnique.

Findings –The study finds that firms engagedin hedging compared to non-hedgers have less volatilityin

the firm’s value.The use of hedging during the financial crisis is foundto be value enhancing for the hedgers.

The results also found that some firms do not disclose the notional value of derivatives clearly, which

highlightsthe need of clear regulation for derivativedeclaration in the annual reports.

Research limitations/implications –Research implicationsof this study are to gain an insight into the

hedging effectivenessin the highly volatile Indian marketas compared to developed countries. High volatility

in the exchange rate of Indian rupee further makes it one of the most relevantmarkets to study the effect of

hedgingon the firm’s value.

Practical implications –Mostly hedging is done purely for risk management, and if managers try to

time the market by selective hedging, it can bring a negative impact for the firm. Findings show that

managers should manage their hedging strategy based on changing the economic environment and not

purely on the firms’financialvalue.

Originality/value –To the authors’best knowledge, this is the first study to extract the dollar value of

derivativeusage of sample firms and analyze its effectiveness in enhancing firm value in the presence of other

financial parameters. This will be an advancement of previous studies, which used hedging as a dummy

variable only. Most studies on this topic are carriedout in developed countries; there is a limited research on

developing marketssuch as India, and past studies have been more genericone like determinants of hedging

and overallderivative scenario.

Keywords Financial crisis, Hedging, Firm value, Accounting standard, Financial strategy

Paper type Research paper

Introduction

Risk management plays an important role in corporate financial strategy. Assuming

Modigliani and Miller’s (1958) hypotheses are valid, companies’financial policies do not

have any impact on firm value in a perfect capital market. If financial markets are efficient,

hedging activities by a firm does not add any valuebecause the investor would then be able

to build such a diversified portfolio that wouldallow them to eliminate the risks and would

make the payment of a premium for the firm adopting a hedging policy unnecessary.

However, when some of the assumptions made by Modiglianiand Miller (1958) are relaxed,

it is possible to show that a company’s hedging policy would add value to the firm. Smith

and Stulz (1985) show that tax reasons and the possibility of incurring in costs of financial

distress could lead hedging to add value to the firm.Similarly, Froot et al. (1993) noted that

IJAIM

26,1

132

Received26 March 2017

Revised4 August 2017

Accepted5 September 2017

InternationalJournal of

Accounting& Information

Management

Vol.26 No. 1, 2018

pp. 132-152

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-03-2017-0041

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

financial market imperfectionsand the problem of underinvestment would cause hedging to

have a positive impact on firm value.

Some firms feel that hedging methods are more speculative and hence they refrain from

hedging related activities.There are few firms which believe that shareholders value cannot

be increased by hedging and individual shareholders can do the same by using derivative

instruments or by diversifying (Giddy and Dufey, 1992). The International Fischer Effect

suggests that changes in exchange rates can be balanced out by changes in inflation and

interest rates (Sivakumar and Sarkar, 2008). However, market imperfections and related

costs make currency risk management an important area of worry for firms (Giddy and

Dufey, 1992).

In recent years, the Indian rupee has been very volatile adding financial pressures to

firms with exposure to foreign currency transactions. Given recent crisis and uncertainties

in a market such as the financial crisis of 2008-2009, the European sovereigndebt crisis, the

Yuan depreciation and a recentrate hike from Federation Bank of US, the Indian Rupee has

fluctuated wildly (See panelA and B in Figure 1).

From Figure 1, it can be seen that theIndian rupee fell from a strong position of 40 INR/

US$ in the beginning of 2008 to high of 55 INR/US$ at the peak of crisis in 2008. In the

immediate post crisis period,the Indian rupee fluctuated between 45 INR/US$ to 65 INR/US$

showing a high level of fluctuation. In these circumstances, firms in India like other parts of

the world used hedging tools to protectthemselves from currency volatility.

There are many studies to explain the motivation for hedging. Main motives include

savings of taxes, reduction in financial distress and transaction costs, reduction in under

investment decisions, lower agency cost, improving liquidity and multinational natures of

firms to name few.

The effects of hedgingin developed economies have been mixed. Some researchersfound

that hedging increased the value of the firm (Allayannis and Weston, 2001;Carter et al.,

2006;Nguyen and Faff, 2002;Graham and Rogers, 2000).However a few studies also found

Figure 1.

Indian rupee

exchange rateagainst

US$

35

40

45

50

55

1/1/2007

16/05/2007

19/10/2007

10/3/2008

28/07/2008

17/12/2008

USD vs INR

USD

35

40

45

50

55

60

65

70

U

S

D

USD vs INR

(a)

(b)

Does hedging

enhance firm

value

133