The Determinants of Firms Hedging Policies

I. Introduction

Nowadays, hedging has a reputation of being an instrument for highly speculating activities. We find many articles in the Medias about the abuse of hedging instruments especially in the context of hedge funds. But basically, hedging can be also used to stabilize companies. E.g. highly volatile cashflows can be stabilized to maintain an easier control of liquidity in firms. Beside this example, hedging provides many more positive ones. In this term paper I explain three (probably the most important issues according to hedging) possibilities how firms can benefit when they decide to hedge.

The basis of this work is a paper written by Smith and Stulz (1985). It is one of the milestones in explaining the benefits which hedging has. It is subdivided into three main areas, taxes, debt and managerial behavior.

Smith and Stulz (1985) show in simple models how the firm after tax value is related to their behavior in these three areas. The first chapter of my term paper discusses how hedging effects tax shields of a firm. This chapter is based on the argument of Smith and Stulz (1985) who highlight that hedging provides a higher after-tax value for companies. However, most of their analysis is done under the assumption that hedging is not costly. They argue that their assumption does not influence the basic setup of their work. Furthermore they argue that costly hedging would not change their results dramatically. Only the explanation will change a little bit. The second part of this paper is built up like the first one. But now I analyze the connection between debts hedging and the after tax value of a firm. The third and last part of my work discusses managerial behavior and its outcomes. In this case I find many statements that different management contracts result in a different acting for the firm. Especially, I will highlight the results for concave and convex payout structures.

As I mentioned, the basis of my work is the Smith and Stulz (1985) paper. Furthermore, I compare their work and results to other papers. Most of the other research papers are influenced by the work of Smith and Stulz (1985). But nevertheless, they discuss the critical outcomes and add a few more facts. At the end of the paper I give a brief summary about the most important results of my work.

II. Taxes

Smith and Stulz (1985) are one of the first researchers who concern taxes in hedging decisions. They form a model to describe whether financial hedging is good or bad for companies at all. In their model they defined certain assumptions. On the one hand they argue that the marginal tax value increases with the pretax return of a firm. The main argument of their work is that the after-tax value and pretax value of a firm is given by a concave function. This model tries to show the common tax systems of most countries. The more a company earns the higher is the amount of tax that it has to pay for. The usage of derivatives has the possibility to decrease liabilities of taxes as it is shown in figure 1.

Figure 1: usage of costless hedging to decrease tax liabilities and furthermore to increase post tax firm value (Smith et. al., 1985, p.393)

Figure 1 is divided into two parts. The upper part shows the relation between pre-tax firm value on the x-axes and corporate tax liability on the y-axes. As it is explained above we can see a linear relation in this graph (without hedging!). The lower part of figure 1 indicates the relation between pre-tax value and post-tax value. Also this relation is linear without the use of derivatives.

By looking at the graph we can see that the post-tax firm value is dependent on the tax rate and the pre-tax value. The expected value for a firm is given by E (V-T). Now the authors show that companies can increase their after-tax value by using derivatives. Additionally, they introduce hedging when a company faces two different states. The states are shown as Vj and Vk in figure 1 where VJ < Vk. Overall, the company creates a portfolio that is hedge to this two possible state outcomes. That means that it does not matter which state occurs because the payment will be the same. Hence, the new expected value of the company which hedges would be E (V-T:H). This is caused by a decrease of total taxes as we can see in the upper part of figure 1.

In a last step of this analysis the authors focus on the fact that in reality, hedging is never costless. The authors argue that a rational company would hedge as far as they would get a benefit out of it. Using the graph, we see that we move to the left side on the concave line until the point E (V-T) on the y axes. This means that firms accept costs until the new expected value equals the expected value without a hedging strategy. However, this model only holds for companies which act in countries that have a linear tax structure. If they do not have it, a further research would be far more complex.

Although, this explanation was one of the big milestones in risk management many researchers struggled with this model. Graham and Rodgers (2002) make an empirical research in this topic. But they do not use the model by Smith and Stulz (1985). This new research is based on a research done by Graham and Smith (1999). The new approach in their work is to explain tax hedging strategies by implementing different simulations. They definitely come to the result that almost every firm faces a convex tax structure. Only one of four firms has a concave structure. Therefore, they argue that the result of Smith and Stulz is right but only consistent for one of four firms.

In the paper of Graham and Rodgers (2002) take these results and discuss hedging strategies with the new model. One main argument of them is that some accounting methods can provide a disincentive to hedge. Especially, the structure of net operating loss carryforwards is mentioned. Due to carryforwards companies have a chance to state present losses in future years. This leads to a decrease in profits and furthermore to a decrease in tax liabilities. When a firm uses this accounting method they do not need hedging anymore to decrease tax liabilities. If they focus also on a hedging strategy the costs out of it would be quite higher than the benefit. So in general Graham and Rodgers (2002) find out that firms tend to use some hedging strategies. But if they have a possibility to make loss carryforwards (like it is possible according to US GAAP) they do not need a good hedging anymore.

Another paper of Gagnon et. al. (2010) investigates reasons why small and medium size firms try to hedge. They highlight three main factors. First, hedging has the advantage that the operating income is stable over time. Especially, shareholder

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