Master Thesis

The use of Interest Rate Derivatives and Firm Market Value

An empirical study on European and Russian non-financial firms

Tilburg, October 5, 2014

Mark van Dijck, 937367

Tilburg University, Finance department

Supervisor: Drs. J.H. Gieskens AC CCM QT

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Master Thesis

The use of Interest Rate Derivatives and Firm Market Value

An empirical study on European and Russian non-financial firms

Tilburg, October 5, 2014

Mark van Dijck, 937367

Supervisor: Drs. J.H. Gieskens AC CCM QT

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Preface

In the winter of 2010 I found myself in the heart of a company where the credit crisis took

place at that moment. During a treasury internship for Heijmans NV in Rosmalen, I

experienced why it is sometimes unescapable to use interest rate derivatives. Due to difficult

financial times, banks strengthen their requirements and the treasury department had to use

different mechanism including derivatives to restructure their loans to the appropriate level. It

was a fascinating time. One year later I wrote a bachelor thesis about risk management within

energy trading for consultancy firm Tensor. Interested in treasury and risk management I have

always wanted to finish my finance study period in this field. During the master thesis period

I started to work as junior commodity trader at Kühne & Heitz. I want to thank Kühne & Heitz

for the opportunity to work in the trading environment and to learn what the use of derivatives

is all about.

A word of gratitude to my supervisor Drs. J.H. Gieskens for his quick reply, well experienced

feedback that kept me sharp to different levels of the subject, and his availability even in the

late hours after I finished work.

At last I want to thank my family for the unconditional support they have given me during my

study period: Without your support it was impossible for me to be who I am and where I am at

the moment.

Thank you,

Mark.

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Contents

List of tables and figures ............................................................................................................................. 5

Glossary ............................................................................................................................................................. 6

Abstract .............................................................................................................................................................. 7

1. Introduction ................................................................................................................................................ 8

1.1 Background .......................................................................................................................................... 8

1.2 Research question ............................................................................................................................. 9

1.3 Thesis outline .................................................................................................................................... 11

2. Literature review ..................................................................................................................................... 12

2.1 The universe of risk ........................................................................................................................ 12

2.2 Derivatives .......................................................................................................................................... 14

2.3 Risk management and firm value .............................................................................................. 17

3. Theoretical model ................................................................................................................................... 21

3.1 Definition of measurement .......................................................................................................... 21

3.2 Hypotheses ......................................................................................................................................... 22

3.3 Research model ................................................................................................................................ 23

4. Methodology .............................................................................................................................................. 24

4.1 Sample selection ............................................................................................................................... 24

4.2 Research methods ........................................................................................................................... 26

4.3 Control variables on Firm Value ................................................................................................ 28

5. Empirical results ...................................................................................................................................... 32

5.1 Univariate test ................................................................................................................................... 33

5.2 Multivariate tests ............................................................................................................................. 35

5.3 Robustness tests ............................................................................................................................... 37

6. Conclusions ................................................................................................................................................ 38

7. References .................................................................................................................................................. 40

Appendix A ..................................................................................................................................................... 44

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List of tables and figures

Table Content Page

Table I Notional amount outstanding derivatives Page 14

Table II Notional amount outstanding derivatives Page 14

Table III Descriptive statistics Page 25

Table IV Hedge activity per country Page 32

Table V Hedge activity over time Page 33

Table VI Firm value between derivative users vs non-users Page 34

Table VII Interest rate derivatives use and firm value Page 36

Table VIII Multivariate test: difference before after crisis Page 37

Figure I Research model Page 23

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Glossary

Derivatives: Financial instruments whose value depends on an underlying. E.g. interest rates,

currency or commodity prices.

Euribor interest: Mean variable interest rates between European banks.

Firm market value: Price stock * number of shares outstanding

Forward/Futures: A Forward or future agreement between two parties obligates one party to

buy and one party to sell a particular commodity at the contract price at a certain date in the

future. Futures are listed and forwards are over-the-counter contracts.

Free Cash Flow: EBIT (1-Tax Rate) + Depreciation & Amortization - Change in Net Working

Capital - Capital Expenditure

Hedging: Eliminates all exposure to a particular risk. E.g. price risk.

Het Financieele Dagblad: Dutch financial newspaper.

Interest rate swap: Can be used to swap variable interest rates into fixed interest rates on

loans.

Metallgesellschaft AG: Large German Corporation who faces large financial problems due

to the use of commodity derivatives.

Option: An option gives the holder (the buyer of the option) the right, not the obligations, to

buy or sell an underlying at a certain date at a specific price (exercise prize).

Tobin’s Q: Ratio between the market value of a firm and the replacement cost of their assets

(book value).

Variable interest rates: Interest rates whose value depends on a fixed rate + Euribor.

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Abstract

This study is focused on hedging, and in particular the use of interest rate derivatives to reduce

the risk of interest rate sensitivity, which is a small, but important part of the firm’s risk

management. Firms use interest rate derivatives for example to mitigate the volatility of the

Financial Cash Flow. In order to investigate a potential value enhancing effect of the use of

interest rate derivatives univariate and multivariate regressions are used. This study examines

the use of interest rate derivatives in a sample of 282 largest listed European nonfinancial firms

in the year 2007 and in the year of 2012 and its impact on firm value as measured by Tobin’s

Q. The results show that the use of interest rate derivatives is rewarded by investors with lower

firm valuation. The negative hedging premium is statistically significant and is on average -

13.1 percent of firm value. This could be explained by the short research period. Most interest

rate derivatives are used by firms to create value in the long run and firms suffer value

decreasing effects on their cash flow on the short term due to the premium they have to pay

(insurance). This effect is stronger (more negative) when looking at data before the credit crisis

in 2007, suggesting that in the conception of investors derivatives could affect the European

economy positive during financial turmoil. The results are not significant when firm fixed

effects are added to the sample. This indicates a potential endogeinity problem.

Keywords: Interest rate derivatives, risk management, firm value, hedging.

Data availability: Orbis Database and manually collected mainly from annual reports.

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1. Introduction

1.1 Background

On April 17, 2014 Het Financieele Dagblad headed “Holland Casino loses €16 million on

interest rate derivatives”, since the corporation announced in their last annual report (2013)

that they have been forced to restructure their negative derivative portfolio in order to conform

to the tighter and recently changed rules of their banks. Holland Casino, which faces turbulent

financial times, speculated with their derivative contracts on future investments, but

investments were never made, interest rates went down due to the financial crisis and it looks

like the banks gave them a taste to their own medicine. The difficult subject regarding the use

of derivatives is not a recent phenomenon. Throughout time on the derivative market several

unmistakable events have earned their own place in history. Most of these events were

associated with a dramatic corporate or governmental earthquake and resulted in renewed

concerns about the use of financial instruments every time. In 2001, for example, weak

accounting rules result in the mysterious swap construction between the Greek government and

Goldman Sachs. The expert ‘adviser’ in the use of those complex financial instruments created

a two component swap deal between the Greek government and Goldman Sachs, designed to

restructure the national debt in order to conform to Eurostat rules. The swap, which consists of

a cross-currency- and interest rate swap construction to mitigate exposure to both foreign

currency and interest rates on these loans, resulted in a dramatic long term value destruction of

Greek sovereign Treasury. Leautier (2007) and Froot, Scharfstein and Stein (1994) mentioned

a huge metamorphosis in risk management over the last decades, such as firms manage their

risks more from inside the company, and the increased attention of managing risk management

programs in general. Historical cases such as the stories of Holland Casino, Greece, and

Metallgesellschaft AG (Culp & Miller, 1995) highlighted the weakness and difficulties of risk

management hedging programs. Therefore, the firms’ top management has become

increasingly aware on how their organization can be attacked by risk beyond their control. This

research is focused on hedging, and in particular the use of interest rate derivatives to reduce

the risk of interest rate sensitivity. This particular risk is an important part within the firm’s

risk management programs nowadays.

Firms have to deal with unpredictable fluctuating variable interest rates especially during a

credit crunch when facing more financial requirements of their banks. In order to accommodate

firms that suffer from high interest bearing debt, interest rate derivatives are created to change

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or fix the price of debt to the appropriate firm level. Covitz & Sharpe (2005) found empirical

evidence on the theory that firms who are more exposed to interest rate fluctuations tend to use

derivatives that offset these exposures. Thereby they found no support on eventually

speculative activity through interest rate derivatives. The firms in this study are required to

comply with mandatory rules and regulations by the International Accounting Standards Board.

Therefore the annual reports generally mentioned that the company does not use interest rate

derivatives (any derivatives) for speculating purposes. Which is puzzling.

As argued by Leautier (2007), the goal of managing risk should be focused on value creation

and can be managed through three channels: Provide financial flexibility e.g. protection against

financial distress, Enhance capital allocation and performance management e.g. risk based

project valuation, and Operational and strategic flexibility e.g. protection against operational

failures. Studies of hedging found value creating evidence on this subject which is in contrast

to the Modigliani and Miller (1963) approach. They argue that financial markets are efficient

and financial risk management is irrelevant to firms. Theories imply that well used hedging

mechanisms in an inefficient market should increase the firm's market value (e.g. Allayannis

& Weston, 2001). These theories suggest that finance does matter and hedging could result for

example in tax benefits, lower probability of financial distress and a lower probability that they

have to forgo on interesting investment opportunities (Froot et al, 1994, Stulz & Smith 1985,

Stulz 1996, Minton & Schrand 1999). A more detailed theoretical explanation on this subject

can be found in chapter 2.

1.2 Research question

Various issues make this an instructive thesis. First, obviously, because of the repeated

scandals there is still indistinctness about the emergence and value-enhancing effect of hedging

programs within organizations. Second, the higher awareness and continues growth of risk

management within firms is similar to the results of several academic papers and there are

contradictions between several studies on this subject. For example Tufano (1999) did not find

support of the value-enhancement hypotheses in his sample in the US, which is in contrast to

Allayannis and Weston (2001) who found an approximately 5% increase in firm value by

derivative users. Finally, lots of studies are focused on one or two countries in Europe instead

of Europe as one area. De Ceuster, Durinck, Laveren and Lodewyckx (2002) presented results

for the Belgium market. De Jong, Macrae and Nijman (2000) made a similar study for Dutch

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companies. Bodnar and Gerbrandt (1998) investigated German companies. Grant and Marshall

(1997), Mallin, Ow-Yong and Reynolds (2001) and El-Masry (2006) presented results from

the United Kingdom.

Fifteen years ago, the results were mixed when highlighting the general use of derivatives

within European firms or worldwide. At the time, researchers find that German firms are more

likely to use derivatives than Dutch firms, with 78% of German firms using derivatives (Bodnar

and Gebhardt, 1998) compared to 60% of Dutch firms (de Jong, Macrae and Nijman, 2000).

The result in a US study of Bodnar and Gebhardt (1998) show that 58% of the non-financial

firms’ uses interest rate, currency rate or commodity price derivatives. According to a more

recent survey, now 94% of Fortune 500 firms a specific sort of derivative to help manage their

risk (The International Swaps and Derivatives Association (ISDA), 2007). Nowadays, it is

more general to use derivatives and therefore no less interesting to test the hedging theories.

Why ‘everyone’ uses those instruments? Do they really create value? As the theory suggest,

most large corporations increasingly turn to hedging programs to reduce their Free Cash Flow

volatility. But what are the underlying motives to use interest rate derivatives and do firms

really create value by financial risk management in this way? The goal of this study is to

provide better insight in the relationship between financial risk management, the use of interest

rate derivatives and firm value by large listed firms in Europe. Therefore this study tries to

answer the main question:

Do the largest listed non- financial European firms who use interest rate derivative

experience higher firm market value than non-users?

This study will take upon the subject of the use of interest rate derivatives and its effect on firm

market value, with a focus on large listed non- financial European firms who uses interest rate

derivatives.

Firm’s risk management should be part of the overall strategy of the firm (Leautier, 2007). The

use of interest rate derivatives is a part of the firms risk management framework to hedge a

specific financial risk on loan rates and often managed by the treasury department (e.g. Annual

report Adidas 2012). For firms, the use of interest rate derivatives is likely to be rewarded by

shareholders with higher valuation in the market, as it should result in lower financial risk and

therefore less Free Cash Flow fluctuations. Adidas (Annual report 2012) mentioned their Free

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Cash Flow management as follows: “Our Group also puts a high priority on the optimization

of non-operating components such as financial result and taxes, as these items strongly impact

the group’s cash outflows and therefore the Group’s Free Cash Flow. Financial expenses are

managed centrally by our Group Treasury department.”

By looking at a new and extensive dataset in Europe (including Russia) this study defines a

clear geographical area that is not often tested as one region on this specific subject and has

two main objectives. First, this study investigates a potential hedging premium between

derivate users and nonusers. Second, due to the financial meltdown the debate about the use of

derivatives has been further intensified. Are derivative users blamed for their behavior?

Therefore it is interesting to look at a possible hedging premium before and after the European

credit crisis in 2008. This could examine potential differences in time with regard to the use of

derivatives. This study investigates these issues, which could be a contribution to the existing

literature.

1.3 Thesis outline

After the introduction, chapter 2 starts with a literature review. There are theories that explain

firm value, the use of interest rate derivatives and their relationship. This study will briefly

introduce relevant theories with respect to this subject. The theoretical model of this research

is described in chapter 3. Chapter 4 describes the methodology and with the empirical method

of doing research, the results will be analyzed in chapter 5. The conclusion of this study can be

found in chapter 6.

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2. Literature review

Interest of this study is primarily the value enhancing effect of risk management and firm value.

Therefore section 2.1 will be based on the concept of risk and risk management in general.

Different risk measures, hedging and interest rate derivatives in particular will be described in

section 2.2. Building on this, section 2.3 will describe in which way financial risk management

can create value to firms.

2.1 The universe of risk

This paragraph starts by introducing risk. What is risk? Leautier (2007) defines risk as “the

variability in the value of a firm or project”. This definition is further explained as the

acknowledgement that the future – hence the profitability – of an action or project, is variable.

Risk does not have to be negative per se. For example, the risk that oil price goes up is positive

for oil companies, however negative for airline companies. Therefore risk managers need to be

aware of the up- or downside potential. Leautier (2007) defines a clear core message of risks

and risk management in his book: “Managing risks means maximizing value from the volatility

inherent in a firms’ business environment” and risk management is the glue that hold the two

sides of the balance sheet together: “a firm’s risk management strategy is determined by the

overall corporate strategy”. In an effort to understand his message, the meaning and goal of

risk management programs, a lot of academic research can be accessed. The most prevailing

approach by theory of risk management is variance mitigation or risk measurement and control.

For example, most risk management companies quote on their websites the risk mitigation

effect of their services instead of the value creating effect. However more recent theory shows

that risk management can create value through different channels, at least for those who know

how to harness it. Section 2.3 will further describe a potential value creation through risk

management.

All firms, either small or large, have developed approaches to manage risks to their future cash

flows for years. The exposure to a certain category of risk differs per company. Every risk

management paper or textbook uses their own typology. Leautier (2007) mentioned four broad

categories; price, counterparty, operations and business risk. Jarrow and Chatterjea (2013)

added legal risk to their list. These categories are further explained in short below.

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Counterparty risk; the risk a counterparty cannot meet their obligation to the company.

Examples are receivables risk and supplier default risk.

Operational risk: the exposure to negative cash flow shocks due to failure in the firms’ daily

operations and processes.

Business risks: the risk is often beyond the firms control and can be divided in short- and long

term exposure. Short term business risk is often created by the competitive environment in the

industry and long term risk is more strategic risk; examples including regulatory- or

technological changes.

Market/Price risk: the variability of the firms’ cash flow due to external movements in interest

rates, exchange rates or commodity prices.

Legal risk: the risk of legal contractual errors.

However, some important risk factors are not mentioned in the two books of Leautier (2007)

and Jarrow and Chatterjea (2013). Miller (1992) mentioned the importance of Environmental

risk in addition to the described risk factors above. His paper divided environmental risk in

political risk, macroeconomic risk and natural uncertainties. Political risk are the risk

associated with democratic changes in government, war, other political turmoil, fiscal changes

and unknown future trade restrictions. Inflation is categorized as Macroeconomic risk and

Natural uncertainties, also named disaster risk or “the hand of god” are the risks associated

with earthquakes, hurricanes, variations in rainfall or other natural disasters.

Firms most well known risk management activities are diversification, insurance and hedging

(Merton 1993). Diversification is described as the percentage of firms operates in industries

other than their main industry. Therefore firms can manage their risk exposure when a specific

industry faces difficult times. Insurance strategies protect firms only against falling prices

while retaining upside potential. This is the case when a firm buys a put option. Then the firm

has the right to sell a specific product for the option price in a specific future time area, but not

the obligation. Therefore the firm lost any downside potential, because of the option, but could

still benefit from the upside potential. The option premium may be viewed as the price

(premium) everyone pays when purchasing insurance. As described by Tufano (1999) this is

a non-linear strategy which differs from linear hedging strategies. The main difference is the

fact that hedging eliminates all exposure to price volatility. The best examples are forward

agreements, which are private agreements between two parties. Price is fixed, and the

settlement occurs at the end of the contract period. Therefore no up-or downside potential is

possible (when ignoring the possible default risk of the counterparty).

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Managing market or price risk (interest rates) and the potential value creation is the main

subject of this paper. To hedge interest rate exposure, firms mainly use derivatives. In order

to understand interest rate derivatives, an explanation about hedging and derivatives in general

will be described below.

2.2 Derivatives

“Hedging involves taking a financial position to eliminate parties’ exposure to a particular

risk” (Stulz, 1996). Or “protect one’s investment or an investor against loss by making

balancing or compensating contracts or transactions” (Jarrow & Chatterjae, 2013). Therefore

a perfect hedge should reduce all firms’ exposure to rate or price fluctuations. There is larger

need for hedging price fluctuations in interest rates, exchange rates or commodity prices

because those risks occur out of firms control. Firms often use derivatives to protect

themselves against those risks. A derivative is a financial contract that derives its value from

an underlying asset price such as interest rates, exchange rates or commodity prices. Most

derivative contracts are traded over-the-counter (e.g. forwards, swaps) or through an exchange

(futures). Over the counter agreements are transactions between two parties without the use of

an exchange. Derivatives have been used for decades and retain excessive worldwide growth

due to different factors such as standardization, population growth, political changes,

economy’s internationalization and the expansion in the IT industry (Jarrow & Chatterjae,

2013). Table I show that in December 2012, the notional amount of outstanding derivatives

agreements was $632.6 trillion according to the International Swap and Derivatives

Association (2012).

Table I: Notional amount outstanding derivatives as mentioned by Jarrow & Chatterjae, 2013 & ISDA Market survey 2012.

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2.2.1 Interest rate derivatives

As the introduction already reveals, academics and managers are sometimes surprised by the

world of interest rate derivatives. As it sounds a fair instrument, recent examples of Holland

Casino and Greece are very clear examples of the recent problems within the market. However,

interest rates derivatives play an important role in the overall derivative market and the total

volume increases from 50 trillion in 1996 to 554 trillion dollar in the first half of 2011 as

pictured in table II. This is approximately 75% of total derivatives usage in the world.

Table II: notional amount outstanding interest rate, exchange rate and commodity price derivatives (ISDA Market survey 2012).

It started in the late 1970s, when oil price fluctuations and other supply-side disturbances hiked

up inflation, resulting in highly volatile interest rates. Firms started looking for tools that could

manage their interest rate risk. In short, interest rate derivatives are financial instruments whose

value depends on their underlying interest rate. Well known derivative instruments are swaps,

options and futures who are explained briefly below.

A Swap agreement between two parties (mostly between firms and banks) is used to switch

variable firm loans into fixed loans. Two parties obligate to exchange their interest loan rates.

As shown in table II the interest rate swaps are the most used interest rate derivatives in the

world. Therefore a detailed example of an interest rate swap between two parties is conducted

in appendix A.

Table II Global Derivative Market

Amounts outstanding, in billions of US dollars

Variable 2009 2010 2011 (H1)

Total 604000 601000 708000

Interest rate derivatives 450000 465000 554000

FRAs 52000 52000 56000

Swaps 349000 348000 442000

Options 49000 48000 56000

Exchange rate derivatives 49000 58000 65000

Commodity price derivatives 2900 2922 3200

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An option gives the holder (the buyer of the option) the right, not the obligations, to buy or sell

an underlying at a certain date at a specific price (exercise prize). The option seller has the

potential obligation to sell or buy a specific underlying product at a certain date at a specific

time in the future. Therefore it is much riskier to sell an option, because of the contractual

obligations.

A forward or future agreement between two parties obligates one party to buy and one party

to sell a particular commodity at the contract price at a certain date in the future. Futures are

listed and forwards are over-the-counter contracts. For example an airplane uses gasoline to

power its airplanes may find it necessary to buy a forward contract on gasoline. If gasoline

prices go up in the future, then the forward contract takes away more financial losses. The

seller of a forward or future contract sets its selling price fixed. For example a goldmine sells

gold forward and reduces potential losses when gold prices go down.

In recent years several approaches about derivatives are made. Some theorists and managers

are positive about the use of derivatives in the field of risk management and argue that the use

of derivatives give firms lots of possible strategies to maintain to create value. On the other

hand users are critical about the financial instrument. In line with the last statement, it is almost

impossible to ignore the well-known quote of the economic icon Warren Buffet while writing

a master thesis about the value of derivatives. He called derivatives “weapons of financial

mass destruction” and called the creators of those financial instruments “geeks bearing

formulas.” This is an apt metaphor of the line from Virgil’s Aeneid, written by Virgil between

29 and 19 B.C: “Beware of Greeks bearing gifts”(such as the Trojan horse). Derivatives

(makers) are not trustworthy either. Therefore a more detailed theoretical framework about

potential value creating risk management activities will be established in section 2.3.

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2.3 Risk management and firm value

The academic consensus on how risk management actually creates value starts with

Modigliani-Miller irrelevance propositions in 1958. It is interesting to know more about this

irrelevant risk management perfect world as described by Nobel Prize winner Modigliani and

Miller. Therefore a short explanation on the Modigliani and Miller theory will be discussed.

In a perfect capital market, capital structure and risk management decisions are irrelevant for

firms, as shareholders can replicate on their own any choice made by the firm. For example by

holding well diversified portfolios. Modigliani and Miller argue that, with zero cost of financial

distress, contracting costs or taxes, shareholders are not better off if a firm manage its financing

policy, because they can manage their risk at zero costs. In a growing field of corporate risk

management several questions were raised whether markets were as efficient as formerly

assumed. In fact, the market contains several frictions and nowadays many academics and

practitioners believe in the value creating benefits of risk management.

The increase of risk management programs is an interesting future. As argued by Leautier

(2007), the goal of managing risk should be focused on value creation through volatility

reduction and not, as often experienced, minimizing risks by managing volatility. This can be

managed through three channels, which are, as argued by Leautier (2007) “largely untapped”.

Provide financial flexibility, Enhance capital allocation and performance management and

strategic flexibility. Financial flexibility ensures a firm to make value-enhancing investments

even when facing adverse cash flow shocks. Throughout time on corporate finance one of the

most important task a manager faces is to attain and preserve financial flexibility to their firm.

The term financial flexibility is used to interpret a firm’s ability to finance its operations or

investments even facing negative cash flow volatility. In difficult times less healthy firms

cannot rely on their balance sheet and may have to forgo on value-creating opportunities (on a

stand-alone basis), because they do not have the financial resources to pursue them (the

underinvestment problem). Other examples are selling value-creating divisions to refinance the

company or, when things go really bad, a value-creating firm may have to file for bankruptcy

due to financial constraints. However, if markets are efficient, also less healthy firms or less

financial flexible firms should take those opportunities because investors will always fund

value enhancing investments. The second channel means that by incorporating risk within

project valuations, firms can select and structure better investments. And finally, risk

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management enables firms to strategic and operational flexibility, which is focused on for

example risk-based pricing and the timing of capacity addition.

In search for a theoretical explanation economists started to deviate from the efficient market

hypothesis, starting with papers from Smith & Stulz (1985), Bessembinder (1991), and Froot

et al. (1993). In order to understand how risk management creates value to firms, it is necessary

to understand the incentives to hedge. The incentives to make use of derivatives can largely be

divided into five different categories (Graham & Rogers, 2002). These categories are the

reduction of financial distress costs, tax incentives, the reduction of the underinvestment

problem, the management’s risk aversion and other incentives as the existence of informational

asymmetries between managers and shareholders. Now these arguments are further explained

in short:

2.3.1 Financial distress costs

Financial risk management can be used to reduce the chance of costly financial distress and

therefore create firm value. In the extreme case, a highly debt firm which faces a low

operational cash flow, could file for bankruptcy when high financial costs such as high variable

interest rates aren’t hedged (Stulz, 1996). Thereby, a risk management program reduces

possible deadweight costs. Deadweight costs are the cost associated with inefficiency in the

market. For example governmental actions, such as taxes or supply controls.

2.3.2 Tax

Managing risks to mitigate the volatility in net income result in tax benefits (Stulz, 1996).

Smith and Stulz (1985) and Batram (2000) found evidence on tax value creation by firms, when

managing taxes to the optimal firm level by the use of leverage positions. Another tax benefit

found by firms is focused on tax beneficial geographical areas. Firms use tax islands to pay

less taxes and create value for shareholders.

2.3.3 The underinvestment problem

The mainly studied theories of Froot, Scharfstein, and Stein (1993), Stulz (1996) and Lessard

(1990) suggest that risk management programs helps the investment policy of the firm through

less Cash Flow variation and less costly external financing. Several researchers found evidence

regarding this subject. Minton and Schrand (1999) argue that higher cash flow volatility results

in less investment in capital expenditures, R&D, and advertising. This is interesting in the

choice of hedging the firms’ Free Cash Flow volatility in order to create value. For example,

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hedging may help creating additional financial flexibility when the firm needs it. It mitigates

volatility and increases investment on average. But also Myers (1977) and Smith and Watts

(1992) already wrote about this subject. Their result assists the main goal of risk management

as described by Froot et al. (1994): “Reducing the cash flow volatility by hedging results in

more financial flexibility and firms do not have to forgo on interesting investment

opportunities”.

2.3.4 Risk aversion management

Less diversified managers prefer to minimize their risk. This is easier and less costly

throughout the firms risk management program than to manage it on their own account. And

therefore the risk aversion of managers could direct their firms to engage in hedging activities.

Also Tufano (1996) studied the influence on managerial behavior on hedging activities in the

goldmine industry. He found support to the earlier theories because firms whose managers hold

more options manage less gold price risk than firm’ managers with stock.

2.3.5 Other incentives

Other incentives are for example asymmetries between managers and shareholders because of

industrial diversification (Graham & Rogers, 2002).

Contradictory findings have been documented in studies based on the use of interest rate,

currency rate or commodity price derivatives and firm value. On the one hand the use of

derivatives is rewarded by investors with higher firm valuation. Graham & Rogers (2002)

presented that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1

percent of firm value. But also argue that the largest firms rather use their debt structure than

derivatives to decrease their interest exposure. A widely appreciated paper of Allayannis and

Weston (2001) found that the use of currency derivatives increases the value of a firm. They

studied a large sample of 720 large US nonfinancial firms between 1995 and 1999 and find a

positive 5% hedging premium between users and non-users. Allayannis and Miller. (2012)

found strong evidence that the use of currency derivatives for firms with strong internal firm-

level or external country-level governance is associated with a significant value premium.

Finally Carter et al (2004) finds that firms in the airline industry that use commodity derivatives

to hedge fuel prices volatility have a higher market valuation relative to the book value of their

assets than firms that do not hedge.

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On the other hand, Tufano (1999) and Jin & Jorion (2006) found less powerful results. They

did not accept the hypothesis about shareholders’ value creating through hedging in the

American gold mining industry. Leautier (2007) mentioned three possible explanations about

the theories against value creating. First, derivatives are often used (currency) within highly

diversified firms. Second, the market risk is small compared to the overall risk of the firm and

hedging programs are extremely costly.

Now that a clear theoretical view has been established, the theoretical model will be formulated

in the next chapter.

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3. Theoretical model

A theoretical model is established in this chapter. First the definition of measurement is

described in section 3.1. The main components of this study to test the hypotheses will be

described. Secondly, in section 3.2 the main hypotheses will be explained and the research

model of this study is figured in section 3.3.

3.1 Definition of measurement

3.1.1 Dependent variable

The empirical part of this research paper investigates the impact of risk management programs

on firm value, and the potential impact on economic changes over time in firms’ hedging policy

by the largest European non-financial listed companies. Tobin’s Q, is used as proxy for firm

value and the dependent variable of this study. This variable is defined by Allayannis and

Weston (2001) as the ratio of the book value of assets minus the book value of equity plus the

market value of equity divided by the book value of assets. There are other measures to build

Tobin’s Q, however Allayannis & Weston (2001) use three different measures and conclude

that a different construction does not change the outcomes of their study significantly. This

study uses the Tobin’s Q as below:

Tobin’s Q = (Total Assets – Shareholders’ Equity + MV equity)/Total Assets.

The natural log is used because of the difference between the mean (1.74) and median (1.40).

3.1.2 Independent variable

To test the value creation of risk management, interest rate derivatives are used as proxy. A

dummy variable is created which indicates a firm uses interest rate derivatives or not in that

specific year. Complaints about this binary variable is the fact that small users are also

measured as derivative users which are according to Guay & Kothari (2003) more similar to

non-users. As they suggest, potential results should be less significant if this is actually the

case. Information about the use of derivatives and the existence of a hedging program is

manually search on the fillings and collected from the annual reports of the firm. The key words

for searching were: hedge, hedging, derivative, forward, future, swap, options, exchange rate

risk, interest rate risk, price risk, fair value hedge, commodity price and financial instruments.

22

Of course, there are theories that pointed comments on this proxy for risk management as it

measures only a portion of the total risk of the firm. However, other risk types are very difficult

to value and most studies focuses on hedging programs as proxy for risk management.

3.2 Hypotheses

Do the largest listed European firms who use interest rate derivative experience higher firm

market value than non-users? To guide us through the problem indication and research question

of this study a main hypothesis is constructed:

Hypothesis 1: Firms that use interest rate derivatives are rewarded by investors with higher

valuation.

If derivatives are fully or partly responsible for the crisis, investors should value firms different

before and after the crisis when one examines the use of derivatives. Some theorists (Jarrow &

Chatterjea, 2013) argue that “derivatives are a god senses”. Highlighted the growing derivative

market and argue that “they must be serving a useful role in the economy”. This study uses year

dummies to control for time in the regressions and test whether there is a difference between

2007 and 2012. Therefore the second hypothesis is conducted:

Hypothesis 2: After the credit crisis firms who use derivatives are valued less than before crisis,

because derivatives are blamed by investors to financial risks and losses.

23

3.3 Research model

The research model of this study in figure:

Figure I: research model

Research model

Before crisis

(2007)

Interest rate derivative usage Firm value (Tobin's Q)

After crisis

(2012)

Controls

Growth

Financial Health

Profitabilty

Size

Other derivative usage

Acces to financial markets

Legal origin

Industrial diversification

Geographic Segment

Year fixed effects

Country fixed effects

Firm fixed effects

24

4. Methodology

This chapter is divided into three sections. Section 4.1 starts with the sample used in this

study. In section 4.2 the different research methods will be described. Finally, in section

4.3 the control variables used in the regressions with expected signs will be explained.

4.1 Sample selection

This study’s sample consist of the firms listed on European largest exchanges from the

Netherlands, France, the UK, Germany, Spain, Belgium, Austria, Switzerland and Russia,

because they are required to comply with mandatory rules and regulations by the International

Accounting Standards Board in disclosing information on the derivative instruments and

hedging activities (e.g. IAS 39). This rule stands from 2005, which is perfect for this study.

The period includes year 2007 (before credit crisis) and year 2012 (‘after’ credit crisis) and

most of the data, mainly the items in financial statements, are collected from the Orbis

Database 1 . Excluded are financials because they are also market makers in interest rate

derivatives. Allayannis et al. (2001) also excluded financials because they are also market

makers in currency derivatives. The usage of derivatives is manually search on the fillings. For

example Volkswagen is defined as ‘Derivative User’ in both years: “Volkswagen Group

companies use derivatives to hedge balance sheet items and future cash flows (hedged items).

Derivatives, such as interest rate swaps, forward transactions and options, are used as the

primary hedging instruments.’’ Annual report 2012 – Volkswagen

Table III, panel A, displays descriptive statistics of the variables used in this study. In the table

caption all main variables are explained.

1 If a firm has missing data for one of the two years, only the respective firm year is excluded from the sample.

25

Table III: Descriptive statistics:

This table documents summary statistics for my sample of all non-financial largest listed European firms with no missing

values on size or market value of equity and for the subsamples of year data before (2007) and after the European credit crisis

(2012). The interest rate derivative dummy equals 1 if the firm reports the use of interest rate derivatives in any form in the

Table summary statistics

Variable No of Obs. Mean Std. Dev. Min. Max.

Panel A: All firms

Sample description

Total Assets (Mil) 520 35100 59400 71,223 409000

Total Sales (Mil) 519 24100 45900 28,04 467000

MV (Mil) 520 24033 37718 58,43 333014

Derivatives use 520 0,74 0,44 0 1

Tobin's Q (Median) 520 1,74 (1.40) 1,06 0,47 10,61

Controls

Market to Book value 520 3,55 11,29 -5,61 246,18

Debt ratio 520 0,19 0,14 0 0,92

Return on Assets 520 0,08 0,29 -0,27 0,62

Other derivatives 520 0,78 0,42 0 1

Dividend dummy 520 0,79 0,4 0 1

Legal origin 520 0,27 0,44 0 1

Diversification dummy 520 0,51 0,4 0 1

Geographic dummy 520 0,53 0,5 0 1

Variable No of Obs. Mean Std. Dev. Min. Max.

Panel B: Firms before crisis (Year data 2007)

Sample description

Total Assets (Mil) 238 32900 54600 71,22 347000

Total Sales (Mil) 237 22700 43100 28,04 356000

MV (Mil) 238 27733 43852 58,43 333014

Derivatives use 238 0,75 0,43 0 1

Tobin's Q 238 1,91 1,14 0,81 10,61

Controls

Market to Book value 238 4,71 16,33 0,33 246,18

Debt ratio 238 0,18 0,15 0 0,75

Return on Assets 238 0,11 0,44 -0,27 0,62

Other derivatives 238 0,79 0,41 0 1

Dividend dummy 238 0,82 0,39 0 1

Legal origin 238 0,27 0,45 0 1

Diversification dummy 238 0,54 0,5 0 1

Geographic dummy 238 0,56 0,5 0 1

Panel C: Firms after crisis (2012)

Sample description

Total Assets (Mil) 282 37000 632000 121,7 409000

Total Sales (Mil) 281 25300 497000 68,5 467000

MV (Mil) 282 20911 31374 200,74 209685,9

Derivatives use 282 0,74 0,44 0 1

Tobin's Q 282 1,59 0,97 0,47 8,53

Controls

Market to Book value 282 2,57 2,88 -5,61 23,47

Debt ratio 282 0,19 0,14 0 0,92

Return on Assets 282 0,05 0,06 -0,26 0,36

Other derivatives dummy 282 0,77 0,42 0 1

Dividend dummy 282 0,77 0,42 0 1

Legal origin 282 0,26 0,44 0 1

Diversification dummy 282 0,49 0,5 0 1

Geographic dummy 282 0,5 0,5 0 1

26

yearly annual report. Tobin’s Q is the ratio of total assets minus the book value of equity plus the market value of equity to

the book value of assets. This study uses the method of Allayanis & Weston (2001) to construct the Tobin’s Q as proxy for

firm value. Profitability is provided by the return on assets, which is measured by net income divided by total assets. Growth

opportunities are proxied by the market to book ratio. MtB is the ratio of market value of equity to book value of equity. The

debt ratio is the ratio between long term debt and total asset. The dividend dummy is set equal to 1 if the firm paid dividends

that year and 0 otherwise. Legal origin is determined through the difference between common-law and civil-law countries.

This study follows the theory of La Porta et al. (2007) to create a dummy variable on legal origin. The dummy variable takes

the value 1 if the firm is originated in a common-law country and zero otherwise. The diversification dummy is set equal to 1

if the firm is active in a difference industry compared to their primary business segment. Multi-nationality is captured through

the geographical dummy, which values one if the firm is active in another country than her home country.

4.2 Research methods

In order to find an answer to the hypotheses, this research will make use of the ordinary least

square (OLS) method. This method helps to estimate the coefficient of the linear relationship

between the dependent and independent variables.

4.2.1 Univariate test

First, this study uses an univariate to compare firm values, as measured by Tobin’s Q, for users

and non-users (of interest rate derivatives) in order to test the main hypothesis.

4.2.2 Multivariate test

Second, a multivariate test is conducted to exclude the effect of all other determinants that

could have an impact on firm value (Tobin’s Q). Therefore this study controls for growth

opportunities, capital structure, profitability, size, industrial and geographical

diversification, time, country and firm fixed effects. An ordinary least square regression

model with control variables will be used for this research. The formula is as follows:

Firm Market Value (Tobin′s Q) = 𝛼 + 𝛽1 𝛿1 + ∑ 𝛽𝑘 ∗ 𝐶𝑜𝑛𝑡𝑟𝑜𝑙 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠𝑘 + 𝑢

𝛿1 {1 𝑖𝑓𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑑𝑒𝑟𝑖𝑣𝑎𝑡𝑖𝑣𝑒𝑠 𝑎𝑟𝑒 𝑢𝑠𝑒𝑑 0 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒

When βeta1 is zero, the usage of derivatives does not have an impact on firms’ market value.

27

4.2.3 Robustness

First, to test the robustness of this study an alternative measure, the market to book value, will

be used for the dependent variable. This is computed as the ratio of Market capitalization to

Book value of equity. Second, the natural logarithm of Tobin’s q will be used to erase potential

outliers on the dependent variable. They are figured in parentheses in the tables. And finally to

test the robustness of the study’s sample Russia will be moved from the sample due to the large

difference between Russia firms and the other firms within the dataset.

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4.3 Control variables on Firm Value

Since within this study a new area to test the value enhancing effect of the use of derivatives

on firm value is created, the focus of this study is mainly on the use of interest rate derivatives

and firm value. Because not only interest rate derivatives influences firm value, this study need

to control for several factors that also could influence firm value. Therefore several control

variables (sub-hypotheses with regard to firm value effects) will be tested. Explanations about

the control variables used in the multivariate test will be described below. Also the theoretical

explanations are given. The study uses the main variables from the Allayannis and Weston’s

paper of 2001, because they are highly rewarded in the academic world. Some extra variables

as legal protection and extra interest in time effects during the recent credit crisis will be added.

Find below an overview of all variables used in this study multivariate regression:

Tobin’s Q = 𝛼 + 𝛽1 𝐼𝑅𝐷 + β2GROWTH + β3LEVERAGE + β5PROFITABILITY + β6SIZE +

β7OTHERDER + β8DIVIDEND + β9LAW + β10DIVERSIF + β11GEO + β12COUNTRY k+ β13FFE +

u.

Where:

Tobin’s Q = Total book value of Assets – Book value of Equity +

Market value of Equity)/Total book value of Assets.

IRD = 1 if interest rate derivatives are used, 0 otherwise

GROWTH = Market capitalization / Book value of equity

LEVERAGE = Long term Debt / Total book value of Assets

PROFITAB. = Net income / Total book value of Assets

SIZE = LN Total book value of Assets

OTHER DER = 1 if firm uses currency and/or commodity derivatives

DIVIDEND = 1 if firm paid dividend

LAW = 1 if firm is based in common law country

DIVERSIF = 1 if firm operates in ‘secondary’ segment

GEO = 1 if firm operates in non-based country/countries

COUNTRY k = 1 if firm is based in same country k

FFE = Firm fixed effects

The underlying relevance and sub hypotheses of the control variables of this study are briefly

described below.

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Growth: Market to book ratio

Another important measure for firm value is the firm’s potential to growth. Future investment

opportunities influence firm value according to Myers (1977) and Smith and Watts (1992).

Froot et al. (1993) highlighted the importance of such control. They extended the theory, which

argue that hedgers face larger investment opportunities than firms whose do not use derivatives

and growth firms should be rewarded by investors with higher valuation. Gezcy et al. (1997)

found also empirical evidence on this factor arguing that hedgers have more future investment

opportunities.

Hypotheses 3a: Firm value is positively correlated to market to book ratio (growth)

Capital structure: Leverage

This study is interested in the capital structure and their influence on firm value. Leverage is

defined as the long term debt divided by book value of equity as used by Allayannis & Weston

(2001). Some value-enhancing theories about leverage suggest that leverage increase firm

value because of the tax advantages of debt.

Hypotheses 3b: Firm value is positively correlated to the leverage ratio.

Profitability: Return on assets

Return on assets is used as proxy for the profitability of the firm. More profitable firms should

be valued more by investors, because they are more attractive in the market. The more

profitable, the ‘hotter’ the firm. If derivative users are more profitable, they will be valued at

a premium.

Hypotheses 3c: A more profitable firm should be rewarded by investors with higher valuation.

Size: LN Total Assets

There is ambiguous evidence. Peltzman (1977), for example suggest size result in higher firm

value because of higher efficiency. However, Lang and Stulz (1994) reported a negative sign,

because large firms are more diversified, and diversifications lead to lower Q values. An

explanation could be that more agency problems arise when a firm is more diversified and are

therefore lower valued by shareholders.

Hypotheses 3d: Size is ambiguous.

30

Other derivatives usage: uses also currency and/or commodity derivatives

The use of other derivatives should results in more firm value because managers with more

experience on how to manage their price risk should be rewarded by investors with higher

valuation. More hedge activity leads to lower transaction costs, and more experienced risk

management by managers on this factor.

Hypotheses 3e: Experienced hedgers are rewarded by investors with higher valuation because

they value well known risk management.

Access to financial markets: Dividend dummy

The dividend dummy is used to test if the firm is credit constraint or not. When firms pay

dividends it is less likely to be credit constraint. Investors value the firm less, because they are

more exposed to negative NPV project (e.g. more cash availability results in more projects and

higher chance of negative outcomes) (Servaes, 1996).

Hypotheses 3f: Dividend dummy is negatively correlated to firm value

Legal protection: Common law dummy

According to La Porta et al. (2007), investors have the best legal protection in firms that operate

in common-law countries. Firms operating in French civil law countries the worst and

German-Scandinavian civil law countries are somewhere in the middle. Investors are more

likely to invest in common-law countries such as England because they have more investor

protection and therefore value firms more. This study uses a dummy variable which equals 1

if the firm is based in a common law country.

Hypotheses 3g: Firms that operate in common-law countries have higher firm values

Industrial diversification: Industrial diversification dummy

Industrial diversification is widely discussed in academic papers. There is ambiguous evidence

on the value increase potential of diversification. Positive studies suggest for example

diversification result in less cash flow shock when facing difficult times within the primary

industry. Negative studies argue diversification leads to problems between managers and

shareholders because of for example the differences in knowledge about industries (Graham &

Rogers, 2002). This study uses a variable that values 1 if the firm operates in a ‘secondary’

segment based on the Orbis Database. As presented in table III, approximately 51% of this

31

study is diversified across different industries. This is in line with for example the study of

Allayannis & Weston (2001) who presented 63% diversification within their sample.

Hypotheses 3h: Firm value and industrial diversification are ambiguous

Geographical diversification: Geographical diversification dummy

Negative studies argue that geographical diversification leads to problems between managers

and shareholders because of for example the differences in knowledge about countries (Morck

and Yeung, 1991). Positive studies found value enhancing results due to the use of intangible

assets abroad, the increase in size, become more established, which lowers the chances of

competitors (Dunning 1973).

Hypotheses 3i: Firm value and geographical diversification are ambiguous

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5. Empirical results

After a clear theoretical explanation, a sample description, and hypotheses development, this

chapter describes the results of several research techniques that are used to test the previously

formulated hypotheses. Since this study is interested in a potential hedging premium by interest

rate derivatives users in Europe it interesting to show the difference between countries. The

total ‘firm’ number is the total year data observations within this study. The last column of

table IV presents an 82% derivative usage within the sample. Russian firms use least

derivatives (32%) and almost every firm use derivatives in Austria (96%).

Table IV Hedge activity per country

The sample contains of 282 largest listed European firms. Information about the use of derivatives and the existence of a hedging program is

manually search on the fillings and collected from the annual reports of the firm. Interest rate derivative users are tabulated as IRD user and

Derivative users hedge their risk with interest rate, currency or commodity derivatives. Firms are classified per country.

Table V presents summary statistics on firms’ hedging behavior over time. There is no large

difference in data of firms that use interest rate derivatives between 2007 and 2012.

Table Hedge activity per country

Country Firms IRD user Derivative user

Austria 28 24 86% 27 96%

Belgium 28 23 82% 23 82%

France 66 56 85% 57 86%

Germany 99 70 71% 86 87%

Netherlands 38 33 87% 34 89%

Spain 42 28 67% 35 83%

Switzerland 30 23 77% 25 83%

United Kingdom 139 114 82% 125 90%

Russia 50 16 32% 19 38%

Total 520 387 74% 431 82%

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Table V Hedge activity over time

This table presents a summary of firms’ use of derivatives over time. A firm is a derivative user if they reported a certain

hedging program in their yearly annual report. The information is manually search on the fillings and collected mainly from

annual reports per firm. The table provides an inside in the usage of derivatives through time.

5.1 Univariate test

In order to test the main hypothesis of this study if the use of interest rate derivatives results in

higher firm value the univariate test compares Tobin’s Q’s hedgers versus non-hedgers. The

behavior of investors during economic crises regards derivatives is also likely to influence the

value of firms that use derivatives. When financial turmoil occurs, several economists blame

derivatives for their complexity and less transparency of the financial world. Therefore, this

study tests the data separately before and after the credit crisis. Derivate use (derivatives in

general) could either be blamed (negative sentiment, scandals, news etc.) or positively

rewarded by investors (derivatives help to restructure financial frictions within firms and

economy) during difficult financial times. Table VI present the mean statistics of Tobin’s Q

for all firms and separately between the years 2007 and 2012. Row 1, column5 displays the

difference of Tobins’Q between firms that use derivatives and nonusers. The results suggest a

0, 49 higher mean Tobin’s Q for firms that do not use derivatives (mean value 2, 1 versus 1,

61 of users). This result is not consistent with the hypothesis of this study. The table presents

both before and after the European credit crisis a significant hedging premium for non-users.

The difference between users and nonusers decrease after crisis. This result could suggest that

non-users suffer more from credit crisis and are more devaluated by investors based on Tobin’s

Q than firms who use interest rate derivative. This rejects the hypothesis that derivatives

(derivative users) are blamed by investors more.

Table Hedge activity over time

2007 Percent of sample 2012 Percent of sample

Interest rate derivative users 179 75% 208 74%

Currency derivative users 187 79% 213 76%

Commodity derivative users 60 25% 79 28%

Any derivative users 200 84% 232 82%

34

Table VI: firm value between derivative users vs non-users

This table presents a univariate test of Tobins’Q between derivative users compared to non-derivative users with year data

before (2007) and after the European credit crisis (2012). The sample contains of 282 largest listed European firms with no

missing values on size or market value of equity for 2006 and 2012. A firm is a user of interest rate derivatives if they report

a certain hedging program in their yearly annual report.

Table Difference Tobin's Q: Hedgers vs Non-Hedgers

Users Non-Users Difference t-statistic

Differrences in means

All years Mean 1,61 2,1 -0,49 4,68

Std. Dev. 0,75 1,63

N 387 133

Before crisis Mean 1,72 2,47 -0,75 4,54

.(2007) Std. Dev. 0,75 1,78

N 179 59

After crisis Mean 1,51 1,8 -0,29 2,24

.(2012) Std. Dev. 0,73 1,44

N 208 74

35

5.2 Multivariate tests

Several factors could influence firm value. As the univariate test in the previous section do not

control for other factors that could influence firm value. To further investigate a real

relationship between the use of derivatives and firm value this study need to control for the

factors as described in section three. Therefore this study uses a multivariate analysis to run

pooled and fixed effect regression (see table VII). The hedging premium is negative and

significant for the total sample of this study. Therefore it can be concluded that interest rate

derivatives usage decreases firm value. Contrary to this result, e.g. Graham & Rogers (2002)

(interest), Allayannis & Weston (2001) (currency) do find a significant hedging premium.

Table VIII shows the results before and after the crisis. Results are less negative in 2012 which

could indicate that investors value derivative users higher during financial turmoil. Indicating

that derivatives could help to restructure the financial markets. When controlling for fixed

effects, the coefficient of a potential hedging premium based on the interest rate derivative

dummy is not significant (not tabulated in Table VIIII). A potential endogeneity problem arises

and the result indicates that undefined firm fixed factor(s) such as managerial influence should

also influence the valuation of firms.

As previously explained, the control variables of section 4.3 are used. The coefficient value

indicates that interest rate derivative users have a lower firm value as measured by Tobin’s Q

than nonusers by 13.1 percent.

Several control variables are statistically significant and have reasonable signs: Growth, as

measured by the market to book ratio has a positive sign, which is consistent with the theory

that investors value growth firms more. This study find a negative sign on firm size. Larger

firms could be less efficient and lower valued by investors. Leverage is also negative and

significantly correlated to firm value, which could suggest that leverage is negatively seen by

investors through for example higher possibility of financial distress. Tax benefits of debt are

not found through the used ratio. Profitability has the expected positive sign though not

significant in panel A. Common law dummy controls for the difference in legal origin.

Investors are more protected in common law countries (La Porta et al. 2007). In this study, the

expected positive sign is found for firms that are originated in common law countries. The use

of other derivatives is positively correlated to firm value, which could be explained by the

assumption that shareholders value firms more if managers are experienced risk managers. The

firm is, therefore, less exposed to risks and rewarded with higher valuation.

36

Regressions show similar results (not tabulated) when controlling only for the Russian area,

this country has a notable lower amount of derivative users compared to the mean value of the

sample and therefore could bias the tests. Multivariate regressions based on the use of any

derivatives give similar results and are not tabulated.

Table VII Interest rate derivatives use and firm value

Table VII displays the hedging premium for ols and fixed-effects regressions of the use of interest rate derivatives between

interst rate derivative users and nonusers. The sample contains of 282 largest listed European firms with no missing values on

size or market value of equity for 2006 and 2012. Panel B and C are regressions based on data only for one specific year in

2007 and 2012. A firm is a user of interest rate derivatives if they report a certain hedging program in their yearly annual

report. ). The interest rate derivative dummy equals 1 if the firm reports the use of interest rate derivatives in any form in the

yearly annual report. Tobin’s Q is the ratio of total assets minus the book value of equity plus the market value of equity to

the book value of assets. Profitability is proxied by the return on assets.. Growth opportunities are proxied by the market to

book ratio. The debt ratio is the ratio between long term debt and total asset. The dividend dummy is set equal to 1 if the firm

paid dividends that year and 0 otherwise. The dummy of legal origin takes the value 1 if the firm is originated in a common-

law country and zero otherwise. The diversification dummy is set equal to 1 if the firm is active in a difference industry

compared to their primary business segment. Multi-nationality is captured through the geographical dummy, which values one

if the firm is active in another country than its home country. Fixed effects regression is captured by year, country and firm

fixed dummies. The significance of the coefficients is displayed; ***, **, and *, for significance at the 1%, 5% and 10% level,

respectively.

Table multivariate results on IRD use and firm value

Y= Tobin's Q (LN TobinsQ) OLS t-statistic Fe t-statistic

Panel A: all firms

Observations 520 520

R-sq 0,27 (-0,29) 0,16

IRD use dummy .-0,342*** (-0,131***) -2,71 .-0,198 -0,86

Growth (MtB ratio) .0,024*** (0,100***) 6,63 .0,010*** 2,73

Leverage (Debt ratio) .-1,353*** (-0,518***) -4,38 .-1,078** -2,04

Profitabilty (ROA) .0,104 (-0,039) 0,76 .-0,118 -0,87

Size (Ln total assets) .-0,4*** (-0,213***) -6,29 .-1,276*** -4,67

Other derivative use dummy 0,218 (-0,893) 1,70 .-0,394 -1,58

Dividend dummy 0,189 -1,665 1,80 0,094 0,70

Legal origin (Common law dummy) .0,282*** (3,244***) 2,97

Diversification dummy -0,022 (-1,383) -0,26

Geographic Segment 0,139 (-1,665) 1,61 0,132 0,21

Year fixed effects No No Yes

Country fixed effects No No Yes

Firm fixed effects No No Yes 0,21

37

Table VIII Multivariate test: difference before after crisis

Table VIII displays the hedging premium for ols regressions of the use of interest rate derivatives between interst rate derivative

users and nonusers. The sample contains of 282 largest listed European firms with no missing values on size or market value

of equity for 2006 and 2012. Panel B and C are regressions based on data only for one specific year in 2007 and 2012. A firm

is a user of interest rate derivatives if they report a certain hedging program in their yearly annual report. The interest rate

derivative dummy equals 1 if the firm reports the use of interest rate derivatives in any form in the yearly annual report. Tobin’s

Q is the ratio of total assets minus the book value of equity plus the market value of equity to the book value of assets.

Profitability is proxied by the return on assets. Growth opportunities are proxied by the market to book ratio. The debt ratio is

the ratio between long term debt and total asset. The dividend dummy is set equal to 1 if the firm paid dividends that year and

0 otherwise. The dummy of legal origin takes the value 1 if the firm is originated in a common-law country and zero otherwise.

The diversification dummy is set equal to 1 if the firm is active in a difference industry compared to their primary business

segment. Multi-nationality is captured through the geographical dummy, which values one if the firm is active in another

country than its home country. The significance of the coefficients is displayed; ***, **, and *, for significance at the 1%, 5%

and 10% level, respectively.

5.3 Robustness tests

The first robustness test was conducted on another variable which measures firm value. The

Market to Book value is used as dependent variable. The test shows a statistically insignificant

and negative sign for the interest rate derivative dummy. The model has a lower prediction

power because of the lower R-squared (0.04 versus 0.26 by Tobin’s Q). The insignificant

results argue, again, the model need to be enhanced by more (firm specific) factors to test if

the use of interest derivative really creates (negative) firm value. Due to potential outliers the

second robustness test was conducted on a natural logarithm of Tobin’s Q. Results are less

negative and mainly used in this study report. The outcomes are presented in parentheses within

the tables. The last robustness test was conducted on the whole dataset. Russia data was erased

from the sample to see what the outcomes where without this outlier (see Table IV to see the

large difference between Russian firms and other firms within the sample). There was no large

difference is significance and variable signs.

Table multivariate results on IRD use and firm value before and after crisis

Y= Tobin's Q (LN TobinsQ) OLS t-statistic OLS t-statistic

Panel B: before crisis; 2007 C: after crisis; 2012

Observations 238 Observations 282

R-sq 0,27 R-sq 0,63

IRD use dummy .-0,499*** (-0,236***) -2,41 .-0,231** (-0,054) -2,08

Growth (Market to Book ratio) .0,018*** 4,49 .0,171*** 11,83

Leverage (Debt ratio) .-1,782*** -3,56 .-0,351 -1,26

Profitabilty (ROA) -0,074 -0,49 .4,481*** 6,67

Size (Ln total assets) .-0,370*** -3,54 .-0,191*** -3,26

Other derivative use dummy 0,231 1,11 .0,220* 1,93

Dividend dummy -0,109 -0,61 0,164 1,75

Legal origin (Common law dummy) 0,101 0,66 0,081 0,92

Diversification dummy -0,155 -1,13 0,102 1,30

Geographic Segment 0,176 1,28 .0,159* 2,03

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6. Conclusions

This study uses a sample of the largest non-financial firms from the Netherlands, France, the

UK, Germany, Spain, Belgium, Austria, Switzerland and Russia from year 2007 and year 2012.

The study finds that interest rate derivative users are rewarded by investors with lower

valuation.

The problem of this study is to understand a potential value enhancement effect of the use of

interest rate derivatives. Incentives to hedge are for example against financial distress or to

create tax advantages. However, the basic principle is that firms use interest rate derivatives to

minimize their interest rate risk in order to protect their financial flexibility and Free Cash Flow

(Froot et al., 2003). Throughout time on the derivative market, however, several striking events

have earned their own place in history and continuing the debate about the value-enhancing

effect of the use of derivatives. This study uses Tobin’s Q as a proxy for firm value and control

for several factors that could also influence firm value. The variables and tests are broadly

based on the methodology of Allayannis & Weston (2001), who studied a significant hedging

premium by foreign currency derivative users compared to nonusers. This study finds a

negative relation between firm value and the use of interest rate derivatives about 13.1 percent.

However, after controlling for firm fixed effects, there is no significant hedging premium. This

indicates a potential endogeneity problem within this sample. Lack of data regarding

managerial behavior and characteristics are omitted variables who could explain this problem.

The negative premium could be explained by the fact that the study uses a very short time

period. The use of interest rate derivatives is expensive and the premium (insurance) firms have

to pay result in a lower Free Cash Flow and a lower firm value. Interest derivatives are often

used to protect firms against volatility in the financial cash flow over several years. Studies

which found positive hedging premiums were mostly based on longer time periods.

The difference between users and nonusers decrease after the credit crisis. This result could

suggest that non-users suffer more from credit crisis and are more devaluated by investors

based on Tobin’s Q than firms who use interest rate derivatives. This rejects the hypothesis

that derivatives (derivative users) are blamed by investors more during a credit crunch. The

overall negative sign, however, could be explained by a negative sentiment before the years

covered in this study. Investors have already captured unfavorable events and are therefore not

39

shocked by eventually financial turmoil. At least, they do not specifically blame derivatives or

derivative users for it.

This study found some significant evidence against the hypothesis that hedging is valuable.

However after controlling for several factors which also could influence firm value, the results

are mixed though less significant. According to the theory, management behavior and the

relationship between management and shareholders determines also the risk management

strategy of firms. This studies dataset does not capture managerial and ownership influence

and therefore, future work could take into account the relation between ownership-managerial

behavior on the use of interest rate derivatives and their influence on firm value. Covitz &

Sharp (2005) argue that large firms rather use debt structure instead of financial instruments to

limit their interest rate exposure. Smaller firms, however, uses derivatives in particular to

protect themselves against interest rate risk. This could suggest that large firms value derivative

use less. This study only uses the largest listed firms in Europe and therefore the results could

be less positive than if this study had used a sample with, on average smaller firms. At last, this

study does not capture a potential reverse causality problem. Firms with higher Q’s could have

more incentives to hedge. Gezcy, Minton and Schrand (1997) found empirical evidence on the

fact that derivative users have higher growth opportunities. Higher growth opportunities could

be an incentive for investors to value a firm more. This indicates a potential reverse causality

problem. Due to the low difference between the use of derivatives in 2007 and 2012 a time

series regression to test reverse causality is not conducted. Future research could take those

biases into account.

40

7. References

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market value. Oxford Journals, Review of Financial Studies, Volume 14, Pages 243-

276.

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corporate governance, and firm value around the world. Journal of International

Economics, 87(1), 65-79.

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creation." Financial Markets, Institutions & Instruments 9.5 (2000): 279-324.

- Bessembinder, H. (1991). Forward contracts and firm value: Investment incentive and

contracting effects. Journal of Financial and quantitative Analysis, 26(04), 519-532.

- Bodnar, Gordon M., and Günther Gebhardt. "Derivatives Usage in Risk Management

by US and German Non‐Financial Firms: A Comparative Survey." Journal of

International Financial Management & Accounting 10.3 (1999): 153-187.

- De Ceuster, Marc JK, et al. "A survey into the use of derivatives by large non‐financial

firms operating in Belgium." European Financial Management 6.3 (2000): 301-318.

- Culp, C. and M. Miller, (1995), Metallgesellschaft and the Economics of Synthetic

Storage. Journal of Applied Corporate Finance.

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Economic Papers, New Series, Vol. 25, No. 3 (Nov., 1973), pp. 289-336

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Journal of applied corporate finance.

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- Froot, Kenneth A., David S. Scharfstein, and Jeremy C. Stein. "Risk managements

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(1993): 1629-1658.

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Nederlandse niet-financiële bedrijven." FEW Research memorandum 786 (2000): 1-

27.

- Mallin, Chris, Kean Ow-Yong, and Martin Reynolds. "Derivatives usage in UK non-

financial listed companies." The European Journal of Finance 7.1 (2001): 63-91.

42

- Merton, R.C., 1993, "Operations and Regulation in Financial Intermediation, A

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International Economics, 33(1), 41-56.

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pp. 311-331

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- Smith Jr, C. W., & Watts, R. L. (1992). The investment opportunity set and corporate

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Books:

- Covitz, D. M., & Sharpe, S. (2005). Do nonfinancial firms use interest rate derivatives

to hedge?. Divisions of Research and Statistics and Monetary Affairs, Federal Reserve

Board.

- Léautier, T. O. (2007). Corporate Risk Management for Value Creation: A Guide to

Real-life Applications. Risk Books.

- Robert A. Jarrow & Arkadev Chatterjea (2013) An Introduction to Derivative

Securities, Financial Markets, and Risk Management

- Verbeek, M. (2008). A guide to modern econometrics. John Wiley & Sons.

Other readings

- The International Swaps and Derivatives Association (ISDA), 2007,2012.

- Het Financieele Dagblad

- The Wallstreet Journal

- Economist.com

- Accountancy news

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Appendix A

Interest rate swap example

Suppose that the firm borrowed € 2.000.000, - for three years by the bank at a floating rate of

Euribor tariff (let’s say 4%) + 1.5%. The firm is exposed to risk due to possible price increases

in the market interest rate (Euribor) when the firm has to pay more interest. Of course a price

decline would result less payment. The firm can enter into an interest rate swap with the bank

to switch their variable interest payment into a fixed interest payment. The firm would agree

to make payments to a counterparty, in this case a bank but other firms are also optional, equal

to a fixed interest rate applied to € 2.000.000, - In exchange, the bank would pay the firm a

floating rate applied to € 2.000.000, With this interest rate swap, you would use the floating-

rate payments received from the bank to make the variable payments. The only payments the

firm would make out of their cash balance would be the fixed interest payments to the bank, as

if the firm had a fixed-rate loan. Therefore, an increase of market interest rates would no longer

affect the firms’ loan payments.

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