the beautiful girl

Journal of Banking & Finance 35 (2011) 1491–1506

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Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf

Corporate derivatives use and the cost of equity
Gerald D. Gay a,⇑, Chen-Miao Lin b, Stephen D. Smith a,1 a b

Georgia State University, United States
Clayton State University, United States

a r t i c l e

i n f o

a b s t r a c t

Article history:
Received 21 February 2009
Accepted 31 October 2010
Available online 3 November 2010

We investigate the relation between derivatives use and corporations’ cost of equity capital. Using a large sample of non-financial firms, we compute and analyze (i) the relative cost of equity of firms that use derivatives and those that do not; and (ii) the change in cost of equity experienced by firms initiating derivatives programs. We find that the cost of equity of derivatives users is lower than non-users by
24–78 basis points. Our results are robust to specifications that account for potential endogeneity related to a firm’s derivatives use and capital structure decisions. We further find that the reduction in the cost of equity is attributable to both lower market beta and SMB beta, suggesting that firms use derivatives to reduce their financial distress risk and that this distress risk has a systematic component that is priced in the market. Finally, the observed reductions in the cost of equity tend to be largest for smaller firms and for firms utilizing currency and interest rate derivatives.
Ó 2010 Elsevier B.V. All rights reserved.

JEL classification:
G12
G13
G32
Keywords:
Derivatives
Risk management
Asset pricing
Financial distress risk

1. Introduction
We investigate a potential consequence of financial risk management as it relates to a firm’s cost of equity. Specifically, we examine whether derivatives users have a lower cost of equity and, if so, what are the economic factors driving such reductions.
For a large

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