why do firms use derivatives? : theory and empirical evidence the first seoul international...
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Why Do Firms Use Derivatives? : Why Do Firms Use Derivatives? :
Theory and Empirical EvidenceTheory and Empirical Evidence
The First Seoul International Derivative Securities The First Seoul International Derivative Securities ConferenceConference
Sam-Young Chung
Long Island University, NYCISDM-University of Massachusetts
SSARIS Advisors LLC
August 27-28, 2003
Risk Management vs. Hedging
What is Risk Management ?
“Any set of actions taken by individuals or corporations in an effort to alter the risk arising from their primary line of business.”
What is Hedging ?
“ Any risk management activity (Use of derivatives) that reduces a firm’s return volatility.”
Why do firms manage risks?
Staring from the violation of MM-prop…
Why Do Firms Manage Risks Through Derivatives?
Lowering expected taxes:Nance, Smith, and Smithson (1993)Smith and Stulz (1985)
Lowering financial distress costs:Wall and Pringle (1989); Dolde (1996)Sinckey and Carter (1994); Gunther and Siem (1995)
Lowering costly external finance:Gay and Nam (1997); Geczy, Minton, and Schrand (1997)
Managerial risk aversion:Stulz (1984); Smith and Stulz (1985); Tufano (1996)
Informational asymmetry b/w managers and shareholders:DeMarzo and Duffie (1991); Breeden and Viswanathan (1998)
Increasing concern guiding regulatory agencies in their Increasing concern guiding regulatory agencies in their considerations of derivatives regulation.considerations of derivatives regulation.
FASB’s new requirements (FASB #105,107,119) of financial FASB’s new requirements (FASB #105,107,119) of financial statement and footnote disclosure about use of derivatives.statement and footnote disclosure about use of derivatives.
Derivatives users concern that the “excessive” regulation will Derivatives users concern that the “excessive” regulation will reduce the usefulness of derivatives.reduce the usefulness of derivatives.““FASB’ proposal to expand required derivatives disclosure is FASB’ proposal to expand required derivatives disclosure is counterproductive, WSJ”counterproductive, WSJ”
The absence of systematic empirical evidence about the effects The absence of systematic empirical evidence about the effects of derivatives use on firms’ stock return or cash-flow volatility.of derivatives use on firms’ stock return or cash-flow volatility.
A large sample, systematic evidence is important in ascertaining A large sample, systematic evidence is important in ascertaining the debate.the debate.
Concerns About The Use of Derivatives
Empirical EvidenceEmpirical Evidence
Smith and Stulz (1985)Smith and Stulz (1985) DeMarzo and Duffie (1992)DeMarzo and Duffie (1992) Froot, Scharfstein and Stein (1993)Froot, Scharfstein and Stein (1993) Tufano (1996, 97)Tufano (1996, 97)
Firms can achieve such risk reduction (lowering its return Firms can achieve such risk reduction (lowering its return volatility), through the use of derivatives, volatility), through the use of derivatives,
moreover, moreover, if firms have (1)poorly diversified business, (2)risk averse if firms have (1)poorly diversified business, (2)risk averse
owners, (3)progressive taxes, (4)large costs of financial owners, (3)progressive taxes, (4)large costs of financial distress, or (5)funding needs for future investment projects,distress, or (5)funding needs for future investment projects,
they have more incentives of the use of derivatives to reduce they have more incentives of the use of derivatives to reduce their return uncertainty. their return uncertainty.
Alternative View and Empirical EvidencesAlternative View and Empirical Evidences
Stulz (1996): Firms primarily use derivatives to reduce the risk associated Stulz (1996): Firms primarily use derivatives to reduce the risk associated with short-term contracts. Since the cash flows associated with these with short-term contracts. Since the cash flows associated with these contracts represent a small fraction of firm value, risk reduction for these contracts represent a small fraction of firm value, risk reduction for these contracts is unlikely to have material (statistical) effects on overall firm contracts is unlikely to have material (statistical) effects on overall firm volatility.volatility.
Brown (1981): Financial firmsBrown (1981): Financial firms
Haushalter (1998):Oil and Gas IndustryHaushalter (1998):Oil and Gas Industry
Koski and Pntiff (1997): Mutual fund industryKoski and Pntiff (1997): Mutual fund industry
Schneeweis, Spurgin,and Henker (1997): Oil industrySchneeweis, Spurgin,and Henker (1997): Oil industry
Why has it been difficult to test effects of corporate risk Why has it been difficult to test effects of corporate risk
management empirically ?management empirically ? Limited disclosure of risk management activitiesLimited disclosure of risk management activities
Off-balance-sheet activitiesOff-balance-sheet activities
FASB requirementsFASB requirements
SurveySurvey
Case StudyCase Study
Empirical Evidence from Gold Mining FirmsEmpirical Evidence from Gold Mining Firms
Why gold mining companies?Why gold mining companies?
Firms face a common, single macro economic variable, Volatility of Firms face a common, single macro economic variable, Volatility of gold pricesgold prices
A variety of risk management tools exist.A variety of risk management tools exist.
Competitive market and Comparable outputCompetitive market and Comparable output
Large historical volatility of gold priceLarge historical volatility of gold price
Firms’ risk management policies are vary across firms.Firms’ risk management policies are vary across firms.
Derivative Holdings of The Sample Firms: Percentage of the Hedged Production to the Total Production
Company 1991 1992 1993 1994 1995 1996 1997 1998 Mean STDEV
American Barrick 95.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 99.4% 1.77%
BEMA GOLD 96.6% 85.6% 95.0% 100.0% 90.0% 95.0% 95.1% 100.0% 94.7% 4.84%
Pegasus Gold 54.0% 100.0% 100.0% 100.0% 100.0% 100.0% 98.0% 95.0% 93.4% 16.01%
Cambior 80.2% 100.0% 100.0% 100.0% 97.1% 29.6% 93.1% 100.0% 87.5% 24.36%
Santa Fe Pacific Minerals 63.5% 81.3% 100.0% 95.4% 95.0% 85.6% 85.0% 89.0% 86.9% 11.32%
MANHATTAN MRLS. 62.5% 95.4% 98.3% 78.5% 75.2% 65.5% 98.5% 85.0% 82.4% 14.32%
Viceroy Resources 100.0% 100.0% 100.0% 33.4% 67.1% 88.9% 81.6% 26.84%
INMET MINING 44.5% 100.0% 100.0% 100.0% 100.0% 100.0% 98.0% 0.0% 80.3% 37.77%
GOLDCORP . 88.2% 85.4% 90.2% 38.0% 100.0% 95.0% 55.0% 42.6% 74.3% 24.94%
CLAUDE RES. 61.1% 100.0% 100.0% 100.0% 100.0% 100.0% 0.0% 0.0% 70.1% 45.32%
PIONEER GROUP 83.0% 83.7% 91.0% 38.1% 95.0% 85.9% 54.0% 24.0% 69.3% 26.89%
Canyon Resources 40.3% 67.7% 41.0% 56.9% 52.4% 95.0% 98.5% 79.5% 66.4% 22.78%
LYON LAKE MINES 70.0% 95.4% 100.0% 100.0% 32.4% 12.0% 32.4% 75.2% 64.7% 34.72%
MIRAMAR MINING 75.0% 95.0% 100.0% 100.0% 35.0% 0.0% 24.0% 69.2% 62.3% 38.20%
FRANCO NEVADA MINES 41.3% 75.6% 35.5% 65.2% 0.0% 100.0% 90.1% 75.0% 60.3% 32.85%
FMC Corp. 86.1% 83.7% 88.1% 38.1% 100.0% 85.9% 0.0% 0.0% 60.2% 41.37%
BOLIDEN 56.0% 25.0% 100.0% 95.0% 8.5% 85.0% 41.2% 58.7% 35.79%
Glamis Gold 69.4% 87.1% 100.0% 100.0% 16.5% 0.0% 0.0% 69.2% 55.3% 43.13%
TVX Gold 45.0% 44.0% 45.0% 60.0% 65.0% 27.0% 43.0% 15.5% 43.1% 16.02%
GREENSTONE RES. 35.4% 4.5% 35.4% 17.5% 28.4% 71.2% 54.6% 95.8% 42.9% 29.72%
Rayrock Yellowknife 43.3% 28.7% 26.0% 40.3% 46.2% 74.0% 34.1% 38.0% 41.3% 14.90%
Newmont Mining 56.1% 10.0% 16.7% 0.0% 27.4% 63.0% 52.6% 93.5% 39.9% 31.65%
PLACER DOME 30.5% 3.9% 22.9% 16.3% 27.4% 63.0% 52.6% 93.5% 38.8% 29.14%
Echo Bay 30.5% 3.9% 22.9% 16.3% 27.4% 63.0% 52.6% 93.5% 38.8% 29.14%
MERIDIAN GOLD 13.5% 46.3% 40.8% 58.5% 59.3% 26.5% 41.0% 14.8% 37.6% 17.84%
Battle Mountain Gold 0.0% 0.0% 78.0% 100.0% 0.0% 47.9% 17.1% 2.2% 30.7% 39.93%
Teck 27.0% 21.0% 31.6% 37.0% 22.0% 31.0% 32.0% 30.0% 29.0% 5.37%
MCWATTERS MNG. 22.0% 7.6% 31.6% 3.3% 24.0% 30.3% 31.8% 29.5% 22.5% 11.16%
DAYTON MINING 0.0% 0.0% 40.0% 9.3% 36.0% 30.6% 30.6% 9.0% 19.4% 16.53%
Hecla Mining 0.0% 0.0% 40.0% 9.3% 36.0% 30.6% 30.6% 9.0% 19.4% 16.53%
HI.RIVER GD.MINES 12.0% 24.0% 21.0% 17.0% 5.8% 32.8% 9.2% 17.4% 9.35%
BLACK HAWK MNG. 2.5% 3.3% 0.0% 0.0% 3.5% 50.2% 11.9% 22.0% 11.7% 17.26%
Coeur d'Alene 2.5% 3.3% 0.0% 0.0% 3.5% 50.2% 11.9% 22.0% 11.7% 17.26%
GEOMAQUE 0.0% 13.4% 0.0% 0.0% 4.9% 0.0% 6.2% 50.5% 9.4% 17.28%
IAMGOLD INTL.AFN.MNG. GOLD8.0% 14.0% 0.0% 16.0% 17.0% 11.0% 7.0% 0.0% 9.1% 6.64%
GETCHELL GOLD 0.0% 12.0% 0.0% 31.0% 17.0% 4.0% 0.0% 0.0% 8.0% 11.33%
ELDORADO GOLD NEW 0.0% 0.0% 0.0% 0.0% 5.8% 32.8% 9.2% 6.8% 12.03%
Golden Knight 0.0% 0.0% 0.0% 0.0% 0.0% 50.0% 0.0% 0.0% 6.3% 17.68%
Homestake 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 27.0% 3.4% 9.55%
Euro Nevada 0.0% 0.1% 1.0% 0.0% 1.0% 0.0% 0.0% 0.0% 0.3% 0.46%
PENOLES 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.00%
KINROSS GOLD 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.00%
Wheaton River 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.00%Agnico-Eagle 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.00%
Average 35.6% 40.5% 47.5% 45.7% 40.0% 45.5% 38.8% 40.9% 41.7%
Standard Dev. 33% 41% 42% 42% 38% 37% 35% 39% 32%
# of firms 42 42 44 42 44 44 44 43 345
Each year, the hedged percentage is calculated by:
[The amount of Hedged production by derivatives / Total amount of the expected production]
Descriptive Statistics For the Sample Firms: Financial and Accounting Information
Item Portf. 1991 1992 1993 1994 1995 1996 1997 1998 AverageH 384.01 375.45 421.35 624.30 564.35 653.21 753.60 721.35 562.20
Market Valueof the Equity M 565.37 514.99 546.15 405.32 728.53 884.41 756.35 824.35 653.18(US$ Mil.) L 425.31 310.80 223.85 428.30 566.14 510.54 827.55 557.63 481.26
All 455.53 456.92 475.85 884.28 801.28 945.04 1058.81 718.00 724.46H 1056.02 1036.24 1150.29 1748.04 1551.96 1828.99 2117.62 2012.57 1562.72
Firm Size M 1520.86 1349.27 1469.16 1114.63 2010.74 2485.20 2095.09 2275.21 1790.02L 1139.83 823.62 608.88 1156.40 1517.24 1347.83 2201.27 1500.02 1286.89All 1238.90 1069.71 1076.11 1339.69 1693.31 1887.34 2137.99 1929.26 1546.54H 506.34 470.31 540.47 602.50 625.05 712.02 621.20 610.47 586.05
Annual Gold Production M 385.10 406.32 470.37 490.33 428.06 381.07 407.04 361.07 416.17(,000 Ounce) L 410.70 437.04 506.33 522.07 490.27 421.26 410.94 390.27 448.61
All 434.05 437.89 505.72 538.30 514.46 504.78 479.73 453.94 483.61H 2531.56 2635.87 2564.35 2651.35 2465.01 2612.55 2756.31 2631.52 2606.07
Total Reserves (,000 Ounce) M 1856.35 1752.30 1654.85 1866.31 1722.90 1684.36 1880.12 1852.69 1783.74L 2012.01 2120.36 2301.23 2405.36 2103.65 2238.50 2357.61 2405.21 2242.99All 2133.31 2169.51 2173.48 2307.67 2097.19 2178.47 2331.35 2296.47 2210.93H 80.61% 95.86% 99.83% 100.00% 98.21% 95.68% 89.34% 94.52% 94.26%
Fracton of M 28.39% 32.34% 45.37% 37.39% 33.11% 43.40% 34.04% 35.06% 36.14%Gold Production Hedged L 0.00% 0.00% 0.00% 0.00% 0.45% 0.98% 0.00% 0.00% 0.18%
All 36.36% 42.52% 47.70% 46.23% 41.43% 45.93% 39.49% 41.32% 42.62%H 1.75 1.76 1.73 1.8 1.75 1.8 1.81 1.79 1.77
Debt ratio M 1.69 1.62 1.69 1.75 1.76 1.81 1.77 1.76 1.73L 1.68 1.65 1.72 1.7 1.68 1.64 1.66 1.69 1.68All 1.72 1.69 1.71 1.78 1.76 1.81 1.79 1.78 1.75
Total Number of Firms 42 42 44 42 44 44 44 43 345Market Value of the equity is the total market value of the firm's equity outstanding at the beginning of the year (Mil. US$) obtained from Datastream.
Firm Size is measured by the sum of market value of equity and book value of liabilities obtained from Compustat.
Annual Gold Production is obtained from Scotia Capital Market's Data.
Total reserves and devloped reserves are obtained from firms' financial statements.
Fraction of Gold production hedged are the averages of their hedging position in next 3 years of their total production.Debt ratio is the ratio of their book value of liability to market value of equity which captures the firm's derivative information.
Descriptive Statistics For the Sample Firms: Market Risk Measurement
Item Portf. 1991 1992 1993 1994 1995 1996 1997 1998 Average
H 0.4321 0.3908 0.6628 0.4252 0.4085 0.4262 0.5489 0.6306 0.4906Annual STDEV of M 0.4997 0.3998 0.5991 0.4292 0.4718 0.4300 0.5472 0.5404 0.4897Equity Return L 0.4920 0.5359 0.8291 0.4700 0.5153 0.4058 0.5366 0.7137 0.5623
All 0.4746 0.4422 0.6970 0.4295 0.4332 0.4206 0.5842 0.6042 0.5107S&P 500 GOLD 0.4653 0.4597 0.6225 0.4880 0.4912 0.4434 0.3880 0.4671 0.4782S&P 500 0.2270 0.1477 0.1277 0.1645 0.1641 0.2136 0.2625 0.2768 0.1980
H 1.9036 2.6449 5.1885 2.5853 2.4902 1.9951 2.0911 2.2783 2.4781Normalized STDEV of M 2.2014 2.7060 4.6895 2.6099 2.8758 2.0127 2.0845 1.9525 2.4731Equity Returns L 2.1673 3.6271 6.4900 2.8578 3.1408 1.8994 2.0441 2.5783 2.8399
All 2.0907 2.9927 5.4560 2.6114 2.6406 1.9691 2.2256 2.1830 2.5794COMEX Gold Return STDEV 0.1628 0.1467 0.2162 0.1348 0.0993 0.1009 0.1242 0.2184 0.1504
Annual SDTEV of equity return is measured by daily returns' STDEV during the year. Normalized SDTEV is measured by annual STDEV devided by STDEV of S&P500 in order to avoid possible biases from a spurious correlation between derivatives reporting in our sample and market volatility.Portfolio H consists of firms ranked in the top 10 percent of the total firms in their hedge position.Portfolio L consists of firms ranked in the bottom 10 percent of the total firms in their hedge position.Portfolio M consists of firms ranked in the middle between firms in H and L portfoliosin their hedge position.Bolded Italic numbers indicate 90% level of significant difference between highly hedged and lowly hedged group.
Regression AnalysisRegression Analysis
Model 1:
of production hedged) ln(MV of equity) leverage) +
Model 2:
I.V. of production hedged) ln(MV of equity) leverage) +
where
the standard deviation of daily stock returns for firm in year
I.V. the implied volatility of daily stock returns for firm in quarter
MV of equity the average of the begining year and ending year' s market value of
common equity obtained from Compustat.
Leverage ratio of book value of liability to the market value of common equity.
sample si
i,t
i,t
i t i t i t i t i t
i t i t i t i t
i t i t
i t
N
, , , , ,
, , , ,
,
(% (
(% (
.
.
0 1 2 3
0 1 2 3
ze (either firm years or firm quarters) used in each regression.
Use of Derivatives and Equity Return Volatility: Historical Volatility Analysis For The Period of 1991-1999.
Regressions1 2 3
Intercept 1.86(65.17) 3.91(13.80) 3.39(13.95)
% of production hedged -0.022(-1.84)-0.034(-2.98)
ln(MV of Equity) -0.27(-8.09) -0.28(-8.26)
Leverage 0.032(6.35) 0.028(6.71)
Adjusted R^ 4.82 38.41 37.91(%)N 403 391 391
The numbers in parentheses are t statistics.
Model
of production hedged) ln(MV of equity) leverage) +
where
the standard deviation of daily stock returns for firm in year
MV of equity measured by average of the begining and years' market value of common equity
obtained from Compustat.
Leverage ratio of book value of liability to the market value of common equity.
number of firm years used in each regression.
i t i t i t i t i t
i t i t
N
, , , , ,
,
(% (
,
.
0 1 2 3
Use of Derivatives and Equity Return Volatility: Implied Volatility Analysis For The Period of July, 1997-September, 1999.
Regressions1 2 3
Intercept 2.12(42.31) 3.57(9.85) 2.74(12.75)
% of production hedged -0.047(-2.86) -0.051(-3.65)
ln(MV of Equity) -0.31(-7.94) -0.36(-6.45)
Leverage 0.072(4.96) 0.051(7.24)
Adjusted R^ 12.73 42.16 35.96(%)N 304 297 297
The numbers in parentheses are t statistics.Model
of production hedged) ln(MV of equity) leverage) +
where
the standard deviation of daily stock returns for firm in quarter
MV of equity measured by average of the begining and ending quaters market value of common equity
obtained from Compustat.
Leverage ratio of book value of liability to the market value of common equity.
number of firm quarters (9 quarters number of firms) used in each regression.
I V
I V i t
N
i t i t i t i t i t
i t
. . (% (
,
. . .
, , , , ,
,
0 1 2 3
Regression Analysis for Testing Marginal EffectsRegression Analysis for Testing Marginal Effects
The Model:
(1.8) of equity) + Leverage)
and
(1.9) of equity) + Leverage)
3
3
i t k i k i tk
i t k i k i tk
P MV
I V P MV
, , ,
, , ,
ln( (
. . ln( (
0 21
5
0 21
5
where
the estimated historical volatility of daily stock returns for firm in year
I.V. the estimated implied volatility of options on firm i in qaurter t.
one if firm is in portfolio and zero otherwise.i,t
i t
i k
i t
P i k
,
,
.
Portfolio Dummy Firms ranked by use of derivatives
5 Firms ranked on top 20 %4 Firms ranked on top 20-40%3 Firms ranked on top 40-60%2 Firms ranked on bottom 20-40%1 Firms ranked on bottom 20%0 Non-derivative users
Use of Derivative and Equity Return Volatility: Marginal Effect Analysis Using Historical Equity Volatility
Average HedgingPortfolio Position (SE)
0 0% 41.124 0.1261 12% -2.268 0.1412 26% -2.988 0.1573 48% -2.868 0.1754 74% -3.672 0.1785 96% -4.392 0.243
ln(MV of Equity) -0.175 0.063Leverage 0.137 0.007Adjusted R^(%) 38.33N (firm years) 391
Model:
The dependent variable is a historical standard deviation of the daily equity return for firm I in year t.All the standard errors are corrected for the possible hetero scedasticity bias using White's (1980) method.
i t k i k i tk
i t
i k
P MV
i t
P i k
, , ,
,
,
ln( (
.
0 2
1
5
of equity) + Leverage)
where
the historical standard deviation of daily stock returns for firm in year
one if firm is in portfolio and zero otherwise.
MV of equity measured by average of the begining of the year and
ending of the year' s market value of common equity obtained from Compustat.
Leverage the ratio of book value of liability to the market value of common equity.
3
i
Risk Characteristics of Derivative User and Non-UserRisk Characteristics of Derivative User and Non-UserSelected Sampel Firms' Equity Value versus Implied Volatility
For Three-Month Equity Options For The Period July 1997 - September 1999
Agnico-Eagle has zero percent of their gold production hedged using derivativesfor the year 1997, 1998, and 1999.Barrick Gold has hundered percent of their gold production hedged using derivativesfor the year 1997, 1998, and 1999.
Barrick Gold(Hedge)
05
1015202530
7/1/
1997
8/13
/199
7
9/25
/199
7
11/7
/199
7
12/2
2/19
97
2/3/
1998
3/18
/199
8
4/30
/199
8
6/12
/199
8
7/27
/199
8
9/8/
1998
10/2
1/19
98
12/3
/199
8
1/15
/199
9
3/1/
1999
4/13
/199
9
5/26
/199
9
7/8/
1999
8/20
/199
9
Equ
ity V
alue
(US
$)
0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%4.00%4.50%
Impl
ied
Vol
atili
ty(%
)
Equity Value Implied Volatility
Agnico-Eagle (Unhedge)
02468
1012
7/1/
1997
8/13
/199
7
9/25
/199
7
11/7
/199
7
12/2
2/19
97
2/3/
1998
3/18
/199
8
4/30
/199
8
6/12
/199
8
7/27
/199
8
9/8/
1998
10/2
1/19
98
12/3
/199
8
1/15
/199
9
3/1/
1999
4/13
/199
9
5/26
/199
9
7/8/
1999
8/20
/199
9
Equ
ity V
alue
(US
$)0.00%1.00%2.00%3.00%4.00%5.00%6.00%7.00%
Impl
ied
Vol
atili
ey(%
)
Equity Value Implied Volatility
Risk Characteristics of Derivative User and Non-UserRisk Characteristics of Derivative User and Non-UserImplied Volatility Spread Between Firms with Opposite Hedging Strategy
versus Gold Price Movement For The Period 1997 - 1999.
250
270
290
310
330
350
7/1/
1997
8/5/
1997
9/9/
1997
10/1
4/19
97
11/1
8/19
97
12/2
3/19
97
1/27
/199
8
3/3/
1998
4/7/
1998
5/12
/199
8
6/16
/199
8
7/21
/199
8
8/25
/199
8
9/29
/199
8
11/3
/199
8
12/8
/199
8
1/12
/199
9
2/16
/199
9
3/23
/199
9
4/27
/199
9
6/1/
1999
7/6/
1999
8/10
/199
9
9/14
/199
9
Gol
d P
rice
0.40%
0.50%
0.60%
0.70%
0.80%
0.90%
COMEX Gold Price Implied Volatility of Options on Gold Futures
DC
A
B
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
Impl
ied
Vol
atili
ty
AGNICO-EAGLE (Unhedge) BARRICK GOLD (Hedge)
Risk Characteristics of Derivative User and Non-UserRisk Characteristics of Derivative User and Non-User
1.1. Cashflow ExposureCashflow Exposure
Froot, Scharfstein, and Stein (1993) and Lessard (1990):Froot, Scharfstein, and Stein (1993) and Lessard (1990):
““Objective of hedging program should be a firm’s cashflow stability.”Objective of hedging program should be a firm’s cashflow stability.”
1. Sales Revenue Exposure to Gold Price Changes1. Sales Revenue Exposure to Gold Price Changes
2. Operating Costs Exposure to Gold Price Changes2. Operating Costs Exposure to Gold Price Changes
3. Equity Return Exposure to Gold Price Changes3. Equity Return Exposure to Gold Price Changes
Sensitivity of Sales Revenue and Its Components to Gold PricesBarrick Gold (1991-2000)
Sales Revenue Sales Quantity Average Price ($ per oz)Intercept 0.365 0.359 0.352 0.354 0.013 0.005
(0.054) (0.059) (0.054) (0.055) (0.019) (0.013)Gold Price 0.095 0.072 -0.027 -0.017 0.122 0.09Change (%) at t (0.424) (0.453) (0.423) (0.458) (0.146) (0.102)Gold Price 0.207 -0.089 0.297Change (%) at t-1 (0.453) (0.457) (0.102)R^ 0.007 0.041 0.001 0.007 0.091 0.622
Sensitivity of Sales Revenue and Its Components to Gold PricesAgnico-Eagle (1991-2000)
Sales Revenue Sales Quantity Average Price ($ per oz)Intercept 0.073 0.055 0.055 0.054 0.018 0.001
(0.063) (0.047) (0.043) (0.044) (0.044) (0.020)Gold Price 0.368 0.192 -0.242 -0.257 0.611 0.449Change (%) at t (0.242) (0.187) (0.165) (0.175) (0.170) (0.078)Gold Price 0.687 0.058 0.629Change (%) at t-1 (0.180) (0.169) (0.075)R^ 0.119 0.539 0.113 0.119 0.432 0.895
Notes:1. These tables contain estimated coefficients of the regressions.2. Percentage changes are calculated as the difference in the log of the variable.3. The regressions are conducted by quarterly data from the firm's quarterly report.4. The percentage changes in the gold price are calculated based on the average price of gold in the quarter.5. The italic number denotes two-tailed significance at 95 percent level.6. The bolded italic number denotes two-tailed significance at 99 percent level.7. Standard error are in paranthesis.
Sensitivity of Operating Costs to Gold PricesBarrick Gold (1991-2000)
Unit CostsIntercept -0.034 -0.046 -0.039
(0.065) (0.098) (0.574)Gold Price Change (%) at time t 0.199 0.149 0.527
(0.058) (0.098) (0.574)Gold Price Change (%) at time t-1 0.466 0.37
(0.517) (0.498)Gold Price Change (%) at time t-2 0.669
(0.523)R^ 0.022 0.138 0.351
Sensitivity of Operating Costs to Gold PricesAgnico-Eagle (1991-2000)
Unit CostsIntercept -0.036 0.021 0.015
(0.028) (0.020) (0.019)Gold Price Change (%) at time t 0.237 0.162 0.197
(0.103) (0.075) (0.072)Gold Price Change (%) at time t-1 0.296 0.256
(0.075) (0.073)Gold Price Change (%) at time t-2 0.129
(0.072)R^ 0.281 0.651 0.72
Notes:1. These tables contain estimated coefficients of the regressions.2. Percentage changes are calculated as the difference in the log of the variable.3. The regressions are conducted by quarterly data from the firm's quarterly report.4. The percentage changes in the gold price are calculated based on the average price of gold in the quarter.5. The italic number denotes two-tailed significance at 95 percent level.6. The bolded italic number denotes two-tailed significance at 99 percent level.7. Standard error are in paranthesis.
Sensitivity of Equity Returns to Gold Prices(1991 - 2000)
Equity ReturnFirms Barrick Gold Agnico-EagleIntercept 0.027 0.008
(0.010) (0.009)Market Return 0.876 0.541
(0.253) (0.241)Gold Return 1.402 1.605
(0.294) (0.275)R^ 0.286 0.288
Sample Period 1/1/1991 - 12/31/1998
Model:
Notes:1The dependent variable is the monthly excess return calculated by the monthly stock return minus one-month T-bill.2.The independent variables are the excess return on the market(the return on the S&P500 minus the risk free rate) andthe excess gold return (the percentage changes in the gold priceminus the risk free rates).3. The bolded italic number denotes two-tail significance at 99 percent level.4. The italic number denotes two-tail significance at 95percent level.5. Standard errors are in parenthesis.
R R R R R Requity rf mkt rf gold rf 0 1 2( ) ( )
2. I/B/E/S Forecasts and Use of Derivatives2. I/B/E/S Forecasts and Use of Derivatives
Investigating ex-ante estimates of the equity Investigating ex-ante estimates of the equity earnings and riskearnings and riskss based on forecasted accounting based on forecasted accounting numbers in order to explore numbers in order to explore the the potential potential impacts of impacts of the different hedging strategies of firms on analysts' the different hedging strategies of firms on analysts' perception and behaviorperception and behavior..
(2.4) Stock Price Adjusted EPS =
(2.5) EPS Growth Rate =
where i and t denote the sample firm and the time, respectively.
EPSS
EPSEPS
i t
i t
i t
i t
,
,
,
,
11
Accounting Performance Measures from the I/B/E/S Consensus Barrick Gold (ABX) vs. Agnico-Eagle (AEM)1991 1992 1993 1994 1995 1996 1997 1998 1999 AVG STD
Hedge ABX 95% 100% 100% 100% 100% 100% 100% 100% 100% 0.99 0.02Ratio AEM 0% 0% 0% 0% 0% 0% 0% 0% 0% 0.00 0.00EPS1 ABX 0.66 0.60 0.72 0.73 0.68 0.60 0.29 0.05 0.23 0.51 0.25
AEM 0.38 0.18 0.27 0.66 0.61 0.36 0.18 -0.05 0.09 0.30 0.23SPREAD 0.28 0.43 0.45 0.07 0.07 0.24 0.12 0.10 0.14 0.21 0.15
EPS2 ABX 0.76 0.65 1.11 1.52 0.91 0.61 0.32 0.06 0.18 0.68 0.46AEM 0.49 0.04 0.42 0.98 0.69 0.47 0.19 0.11 0.10 0.39 0.31SPREAD 0.27 0.61 0.69 0.53 0.22 0.14 0.13 -0.05 0.08 0.29 0.26
EPS1V ABX 0.04 0.08 0.12 0.08 0.14 0.11 0.05 0.03 0.07 0.08 0.04AEM 0.25 0.20 0.37 0.11 0.11 0.03 0.15 0.10 0.12 0.16 0.10SPREAD -0.22 -0.12 -0.24 -0.03 0.03 0.08 -0.10 -0.07 -0.05 -0.08 0.10
EPS2V ABX 0.10 0.08 0.03 0.08 0.10 0.13 0.08 0.06 0.09 0.08 0.03AEM 0.10 0.04 0.16 0.10 0.12 0.04 0.09 0.05 0.13 0.09 0.04SPREAD 0.00 0.04 -0.13 -0.02 -0.02 0.08 -0.01 0.02 -0.04 -0.01 0.06
EPS1G ABX -0.01 -0.03 0.00 0.01 0.04 0.12 -0.04 0.02 0.05 0.02 0.05AEM -0.02 0.28 -0.07 0.07 -0.05 -0.01 0.11 0.02 0.03 0.04 0.11SPREAD 0.01 -0.31 0.08 -0.06 0.09 0.13 -0.15 0.00 0.02 -0.02 0.14
EPS2G ABX -0.03 0.03 0.00 0.00 -0.01 0.00 -0.07 -0.38 0.06 -0.05 0.13AEM -0.10 0.08 0.25 0.05 -0.04 -0.03 -0.20 -0.11 0.04 -0.01 0.13SPREAD 0.07 -0.06 -0.26 -0.05 0.04 0.03 0.13 -0.27 0.02 -0.04 0.14
EPS1/S ABX 0.07 0.05 0.03 0.03 0.02 0.02 0.02 0.02 0.03 0.03 0.02AEM 0.02 -0.03 0.03 0.02 0.03 0.02 0.01 -0.02 0.02 0.01 0.02SPREAD 0.05 0.08 0.01 0.00 -0.01 0.00 0.00 0.04 0.01 0.02 0.03
EPS2/S ABX 0.06 0.06 0.05 0.04 0.04 0.03 0.02 -0.06 0.05 0.03 0.04AEM 0.02 0.01 0.01 0.03 0.04 0.02 0.03 -0.01 0.04 0.02 0.01SPREAD 0.04 0.05 0.04 0.01 0.01 0.01 -0.01 -0.06 0.01 0.01 0.03
Hedge Ratio: A ratio of the gold production hedged by derivatives to the total gold production on that year.
EPS1 indicates a mean of all the earnings per share forecasts supplied by analystsfor the current financial year of the company, that is, the financial year not yet reported. It is provided by I/B/E/S consensus.
EPS2 indicates a mean of all the earnings per share forecasts supplied by analystsfor the next financial year of the company, the next financial year is defined as that following the current year. It is provided by I/B/E/S consensus.
EPS1V indicates a standard deviation of the EPS1 for the year.EPS2V indicates a standard deviation of the EPE2 for the year.EPS1G is the forecasted EPS1 growth rate obtained from I/B/E/S consensus.EPS2G is the forecasted EPS2 growth rate obtained from I/B/E/S consensus.EPS1/S is the EPS1 devided by the stock price on that peiord, which is measured by
inverse value of the PER1 (P/E ratio forecasts) obtained from I/B/E/S consensus.EPS2/S is the EPS2 devided by the stock price on that peiord, which is measured by
inverse value of the PER2 (P/E ratio forecasts) obtained from I/B/E/S consensus.The number in a dark-cell indicates statistical significance in 95 percent level.
3. Value at Risk (VaR)3. Value at Risk (VaR)
““The maximum expected losses of a portfolio or an The maximum expected losses of a portfolio or an asset that will occur with a given probability over a asset that will occur with a given probability over a certain time period.”certain time period.”
Marginal Value at Risk (M-VaR)Marginal Value at Risk (M-VaR)
(2.2) Pr( ( ) )v w VaR 1
(2.3) , M VaRVaR
bi ki
i
1,...,
Value at Risk for Portfolios with Hedging Firms versus Unhedging Firms
VaR for Hedge Firms VaR for Unhedge Firms VaR Difference (Hedge - Unhedge)Year Mean Max Min STDEV Mean Max Min STDEV Mean STDEV1991 1.69% 2.35% 1.13% 0.32% 2.42% 2.92% 2.01% 0.20% -0.73% 0.12%1992 1.72% 2.36% 1.31% 0.25% 2.32% 2.79% 1.84% 0.23% -0.60% 0.02%1993 2.42% 3.07% 1.42% 0.47% 2.94% 3.78% 2.13% 0.52% -0.52% -0.04%1994 1.65% 2.60% 1.22% 0.32% 1.99% 2.48% 1.47% 0.33% -0.34% -0.01%1995 1.58% 1.93% 1.20% 0.21% 2.16% 2.75% 1.56% 0.32% -0.58% -0.10%1996 2.11% 3.13% 1.36% 0.48% 1.96% 2.25% 1.68% 0.14% 0.15% 0.35%1997 2.26% 4.94% 1.61% 0.91% 2.66% 4.58% 1.92% 0.69% -0.40% 0.23%1998 3.65% 8.25% 1.59% 2.27% 3.79% 5.09% 2.80% 0.70% -0.15% 1.57%
The bolded number in the column of spread indicates statistical significance at 95 percent level.All the VaR measures are daily basis and calculated by the standard variance-covariance method with 95 percent confidence level.Stocks are chosen based on their hedging position in each year and are equally weighted into the portfolio.
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Hedging Portfolio Unhedging Portfolio
cconclusiononclusion Negative association between volatility of a firm’s stock return and the size of the Negative association between volatility of a firm’s stock return and the size of the
firm’s derivative position.firm’s derivative position.
Negative relation between volatility of a firm’s stock return and the market value Negative relation between volatility of a firm’s stock return and the market value of of its equity.of of its equity.
Positive relation between volatility of a firm’s stock return and the firm’s leveragePositive relation between volatility of a firm’s stock return and the firm’s leverage
Consistent but stronger results are found using the Implied volatility of individual Consistent but stronger results are found using the Implied volatility of individual firm’s options data.firm’s options data.
Financial Analysts incorporate and value a firm’s hedging program.Financial Analysts incorporate and value a firm’s hedging program.
Hedging Firms’ cashflow Exposures are Statistically Less Sensitive to Gold Price Hedging Firms’ cashflow Exposures are Statistically Less Sensitive to Gold Price ChangesChanges
Lower VaR for a Portfolio of hedging firm’s stocks.Lower VaR for a Portfolio of hedging firm’s stocks.
Innovations of The Derivatives MarketsInnovations of The Derivatives Markets New types of transactions:
New types of underlying risks:commodity price risk, interest rate risk, currency risk, equity price risk, credit risk, tax rate risk, inflation risk, catastrophic risk, etc. …
New purposes for which the derivatives themselves are used:Swap example ,
World Bank-IBM’s contract vs. GM’s contract.
Path-Dependent Options (Asian, Knockout Options, Other Exotics)
Options on Swaps
Swaps Caps, Floors, and Colors
Forward Options
Lessons for End Users from Others’ MistakesLessons for End Users from Others’ Mistakes
Derivative dealers and users would not be as successful as they are today Derivative dealers and users would not be as successful as they are today if they did not draw whatever lessons they could from the ‘misfortunes’ in if they did not draw whatever lessons they could from the ‘misfortunes’ in the cases like Gibson Greetings, Procter & Gamble, Orange County, the cases like Gibson Greetings, Procter & Gamble, Orange County, Barings, and Daiwa.Barings, and Daiwa.
1. It is not what product you are using to manage risk or take risk, it is how you use it !
2. If you cannot manage the risk, do not take the risks !
3. Study and update your knowledge (ex. Read the group of 30 report).
4. Take quick action to resolve firms’ problems !(cut your losses, let bygones be bygones, do not throw good money after bad.)
Dr. Chung is an Assistant Professor of Finance at the Long Island University in New York, USA. He is also a Senior Research Analyst and Advisory Board Member of SSARIS Advisors LLC. He has been also worked at the Center for International Securities and Derivatives Markets (CISDM) in the University of Massachusetts as a research associate and served as an Editorial Board Member of the Journal of Alternative Investments. In addition, he has been written columns in the Financial News Daily-Korea. Dr. Chung received his Ph.D. in Finance from the University of Massachusetts-Amherst, Master of Finance from Boston College, and M.B.A from Illinois State University. He has published various articles in journals such as the Journal of International Business and Finance, Journal of Derivatives Accounting and the Journal of Alternative Investment along with numerous research and consulting endeavors in the area of financial risk management and measurement. His current research interests include: Risk Measurement (VaR) and Management through Derivatives Markets, Alternative Investment (Hedge Funds, CTAs, Managed Futures, etc.) strategies, Futures Market Microstructure, and International Banking and Finance.
School of Business and Public Administration
Long Island University, Brooklyn, NY 11201
Tel: 718.488.1149 fax: 718.488.1125 email: [email protected]
Speaker Background
SSARIS Advisors LLC
Financial Centre
695 East Main Street, Stamford, CT 06901
Tel: 203.328.7215 fax: 203.328.7299
Email: [email protected]