the beautiful girl

Topics: Risk, Risk management, Weighted average cost of capital Pages: 119 (13572 words) Published: October 11, 2013
Journal of Banking & Finance 35 (2011) 1491–1506

Contents lists available at ScienceDirect

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 sample of non-financial firms taken from two periods (1992–1996 and 2002–2004), we estimate their cost of equity using procedures suggested by the three-factor model of Fama and French (1993). Using both univariate and pooled regression methods, we find firms that use derivatives have a lower cost of equity than non-users by, on average, 24–78 basis points. Our results hold whether a firm’s derivatives activity is measured either as a usage variable or by the extent of its notional holdings. Our findings are also robust to specifications in which we estimate the relation between firms’ cost of equity, derivatives use, and leverage using a simultaneous equation framework to account for endogeneity concerns related to a firm’s derivatives use and capital structure decisions.

We also conduct an alternative test wherein we identify those firms that were non-users of derivatives and subsequently initiated

⇑ Corresponding author. Tel.: +1 404 413 7321; fax: +1 404 413 7312. E-mail addresses:
(C.-M. Lin).
1
Deceased.

ggay@gsu.edu

(G.D.

Gay),

chen-miaolin@clayton.edu

0378-4266/$ - see front matter Ó 2010 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2010.10.033

derivatives programs. Extending the analysis of Guay (1999) who examines the effect on firm’s risk exposures following the initiation of derivatives usage, we find a significant decline in the cost of equity of 93 basis points in the first year of adoption for new users during 1992–1996. For the period 2002–2004, we find a negative but insignificant decline of 55 basis points. We investigate the source for the reduction in the cost of equity as it relates to the various Fama–French risk factors. We find evidence that attributes the reduction in the cost of equity to lower systematic (market) risk and, importantly, a lower SMB (small minus big size) beta. Specifically, while users have on average a 4.9% lower market beta than do non-users, they also have a

40.5% lower SMB beta. When considered in conjunction with...

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