How Firm Value Is Impacted By Risk Management And How Firms Can Use Derivatives To Increase Firm Value (Essay Sample)

RISK MANAGEMENT AND FIRM VALUE: A CASE FOR LISTED UK COMPANIES
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Contents TOC \o "1-3" \h \z \u Table of Figures PAGEREF _Toc459888444 \h 3Chapter 1 Introduction PAGEREF _Toc459888445 \h 4Background of research PAGEREF _Toc459888446 \h 4Problem Statement PAGEREF _Toc459888447 \h 5Data Collection PAGEREF _Toc459888448 \h 5Model Specifications and Analysis PAGEREF _Toc459888449 \h 5Research Question PAGEREF _Toc459888450 \h 6Significance of Research PAGEREF _Toc459888451 \h 6Chapter 2 Literature Review PAGEREF _Toc459888452 \h 7Risk management and relevance PAGEREF _Toc459888453 \h 7Advantages of hedging PAGEREF _Toc459888454 \h 7Risk and Industry oriented research PAGEREF _Toc459888455 \h 8Multiple risk exposures PAGEREF _Toc459888456 \h 8Multiple Industry based analysis PAGEREF _Toc459888457 \h 9Importance of Research PAGEREF _Toc459888458 \h 10Chapter 3 Methodology PAGEREF _Toc459888459 \h 12Hypothesis PAGEREF _Toc459888460 \h 12Data PAGEREF _Toc459888461 \h 13Methodology PAGEREF _Toc459888462 \h 15Model developed PAGEREF _Toc459888463 \h 17Chapter 4 Results PAGEREF _Toc459888464 \h 18Univariate analysis PAGEREF _Toc459888465 \h 18Multivariate analysis PAGEREF _Toc459888466 \h 19Chapter 5 Conclusion PAGEREF _Toc459888467 \h 22References PAGEREF _Toc459888468 \h 23Appendix PAGEREF _Toc459888469 \h 26
Table of Figures
TOC \h \z \c "Figure" Figure 1 Derivative Usage PAGEREF _Toc459888232 \h 23
Figure 2 Descriptive Statistics of Derivatives PAGEREF _Toc459888233 \h 23
Figure 3 Derivative Usage PAGEREF _Toc459888234 \h 24
Figure 4 Descriptive Statistics of Variables PAGEREF _Toc459888235 \h 24
Figure 5 Pairwise Correlation PAGEREF _Toc459888236 \h 24
Figure 6 Regression Results PAGEREF _Toc459888237 \h 25
Figure 7 Interest Rate Based Analysis PAGEREF _Toc459888238 \h 26
Figure 8 Foreign Exchange Based Analysis PAGEREF _Toc459888239 \h 27
Chapter 1 Introduction
Derivatives are becoming more and more important with time and play an essential role in financial markets currently. The derivatives market has become larger than stock market in terms of the underlying assets which defines them. They are also being used as a tool for risk management due to which hedging is now being carried out with the use of financial derivatives. Risk management and hedging with the use of derivatives have now become a norm. Risk management is carried out in order to make sure that the company is protected from any sort of risk to which it can be exposed to. Modigliani and Miller (1958) have stated in past research that risk management should have no impact on the firm value as there are perfect capital markets that exist and due to that any sort of company strategy will be irrelevant as shareholders can use their own risk management techniques in order to hedge their risk with similar costs. However, once the assumption of perfect markets is relaxed and presence of information asymmetry and costs is taken into consideration, it can be said that hedging is able to add some value to the company’s value. There is a lack of consensual and comprehensive evidence which can be presented to show how firm value is affect by hedging and risk management. In light of that, this research will look at how this relationship exists in the current markets and firms.
Background of research
In 2009, international swaps and derivatives association reported that around 94% of the companies around the world were using derivatives in order to manage the risk that they are exposed to. This shows that companies are using interest rate derivatives or swaps in order to mitigate most of the operational and market risk that they exposed to. Due to this, this research will examine how hedging is being carried out by firms in UK and how use of hedging is able to have an impact on its firm value. Based on researches of Bartram et al. (2011) and Ahmed et al. (2013) the research will focus on multiple risk exposures which are present in the market like interest rate risk and foreign exchange risk while in terms of the derivatives being used the swaps, options and forward contracts will be taken. The context of contract used in this research will use all derivatives available in the market i.e. swaps, options and forwards which can be used to hedge any sort of risk a company is exposed to. This research will try to go beyond past research by looking to distinguish each of these instruments which has not been carried out in the past.
Problem Statement
The research will look to first identify the derivatives use being carried out and see whether hedge either of the risks is able to add value to the firm. This looks at the application of any derivative being used and sees whether firm value increased due to use of these derivatives. After this, the next step of the research is to apply the same analysis with specific derivatives against the relevant risk in order to see how different derivatives are able to give different results and affect the firm value.
Data Collection
The sample of this research will be two companies listed on the London Stock Exchange namely 3i Infrastructure and Automobile Association. The FTSE is considered to be one of the most developed capital markets of the world and the choice of this sample will see how hedging strategies are being applied by some of the leading companies of Europe. In order to fully capture the market and foreign exchange risk, listed companies are considered only as they will change with the market behavior. Data collection will be done through financial databases and annual reports of the companies which give details of the hedging derivatives being used. The data will be collected for the period from 2005 till 2013 and based on the complete information, the data will be collected to be analyzed. Past researches have used binary variables while this research will use continuous variables in order to capture the intensity of the derivatives being used based on their firm size.
Model Specifications and Analysis
Tobin’s Q will be used in order to approximate for firm size and this will be dependent variable for this research and only hedging based derivatives will used as compared to ones taken for speculation or trading. Tobin’s Q is the book value of assets less the book value of equity plus the market value of equity divided by the book value of total assets. All information pertaining to the company will be collected from their annual reports and filings it has carried out to the London Stock Exchange. The data collected will be analyzed by applying OLS method and two stage least squares instrumental variables as this will allow to mitigate some of the endogeneity which is present in the data. This will make the results more robust, reliable and valid.
Research Question
The research questions which have been developed for this research will look at two fundamental aspects of this research:
Question 1: Does derivative use lead to positive firm value in relation to interest rate risk and foreign exchange currency risk?
This question will look into the fact that whether use of derivatives is able to add value to the firm by hedging the interest rate risk and foreign currency exchange risk that the company is exposed to. Hedging should be able to eliminate the risk for the company but this question will focus on whether hedging is able to add to the firm value or not by limiting the risk available in the market.
Question 2: Does the use of derivative affect the value addition or is it uniform for all types of derivatives?
This question will focus on the fact that whether the value addition being made by the use of derivatives is uniform for all the derivative contracts or whether one derivative has superiority over the other. As derivatives are used for hedging, this question will see if any one of the contracts used is able to add additional value to the firm due to its use.
Significance of Research
This research will look to add to the literature which currently exists as it looks at both types of risk and then matches it up to the derivative contract being used rather using all derivatives as being uniform and same. This research will also add value as it uses a continuous variable for hedging rather than a dummy binary variable as used in older researches. This adds the degree of intensity of hedging being carried out rather than just considering the use of derivatives alone. This adds a validity, relevance and reliability to the research which has not been carried out before. Lastly, the use of FTSE listed companies allows the research to be relevant for London as well as Europe as the index has many European companies listed on it. This adds a European context to the research and considers investor’s behavior of the people investing in it. The time period being used also adds value to the literature that exists in this field as it is able to take the global financial crisis into account and sees how the crisis was able to change the dynamics of the model and research as well.
Chapter 2 Literature Review
Risk management and relevance
Past research has been carried out by Modigliani and Miller (1958) which argues that if markets were perfect and the market had an absence of market imperfections, risk management will have no additive advantage for the company and the outcome will remain the same. This gives support to the notion that companies should not carry out any form of hedging strategy as it will not add any form of extra addition to the firm’s value. As shareholders are part of the market and they are exposed to the risk that the company itself is exposed to, they will carry out the hedging strategies themselves in order to mitigate the risk while being able to bear a fraction of the cos...