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
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
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.
Financial distress risk
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:
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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