Vol. 46, No. 4, Aug. 2011, pp. 967–999
COPYRIGHT 2011, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195
The Effects of Derivatives on Firm Risk
Sohnke M. Bartram, Gregory W. Brown, and Jennifer Conrad ∗ ¨
Using a large sample of nonﬁnancial ﬁrms from 47 countries, we examine the effect of derivative use on ﬁrm risk and value. We control for endogeneity by matching users and nonusers on the basis of their propensity to use derivatives. We also use a new technique to estimate the effect of omitted variable bias on our inferences. We ﬁnd strong evidence that the use of ﬁnancial derivatives reduces both total risk and systematic risk. The effect of derivative use on ﬁrm value is positive but more sensitive to endogeneity and omitted variable concerns. However, using derivatives is associated with signiﬁcantly higher value, abnormal returns, and larger proﬁts during the economic downturn in 2001–2002, suggesting that ﬁrms are hedging downside risk.
Derivatives are ﬁnancial weapons of mass destruction.
—Warren E. Buffett, 2003 Berkshire Hathaway Annual Report
The ﬁnancial crisis of 2008–2009 has brought new scrutiny to the use of ﬁnancial derivatives. Recent proposals in major countries, including the United States, call for greater regulation of over-the-counter (OTC) derivatives, including conditions for marking positions to market prices, trade registration, trade clearing, exchange trading, and higher capital and margin requirements. ∗ Bartram, email@example.com, Lancaster University, Management School, Lancaster LA1 4YX, United Kingdom, and State Street Global Advisors; Brown, firstname.lastname@example.org, Conrad, j email@example.com, Kenan-Flagler Business School, University of North Carolina at Chapel Hill, CB 3490, Chapel Hill, NC 27599. We thank Hendrik Bessembinder (the editor), Evgenia Golubeva, Reint Gropp, Peter Pope, Peter Tufano (the referee), Gautam Vora, Tracy Yue Wang, Chu Zhang, and seminar participants at the 2009 Meetings of the Western Finance Association, 18th Annual Conference on Financial Economics and Accounting, 2006 Financial Intermediation Research Society Conference, 2007 Meetings of the Financial Management Association, DePaul University, Exeter University, Florida State University, Georgia State University, G¨ ttingen University, Hamburg Unio versity, Manchester University, M¨ nster University, Regensburg University, State Street Global Adu visors, University of North Carolina at Chapel Hill, and York University for helpful comments and suggestions. Financial support by the Leverhulme Trust is gratefully acknowledged. Bartram gratefully acknowledges the warm hospitality of the Kenan-Flagler Business School of the University of North Carolina, and the Red McCombs School of Business, University of Texas at Austin, during visits to these institutions.
Journal of Financial and Quantitative Analysis
The derivative securities that have caused the most harm during this economic downturn have been those held by ﬁnancial ﬁrms. In contrast, there have been relatively few instances of problems with derivatives at nonﬁnancial ﬁrms in the current downturn.1 As a consequence, in response to the proposed new regulations of derivatives, many nonﬁnancial ﬁrms in the U.S. (including energy producers, airlines, and industrial equipment manufacturers) have started lobbying Congress, arguing that the proposed rule changes may “drive U.S. companies to seek ﬁnancing overseas, . . . [impair ﬁrms’ ability to] manage ﬂuctuations in materials prices, commodities, fuel, interest rates, and foreign currency,” and, in general, materially harm the 90% of Fortune 500 companies that use ﬁnancial derivatives to manage risk.2
In fact, although data on derivatives usage have become available in the last 2 decades, detailed empirical evidence on...