Why Do Firms Hedge Selectively? Evidence from the Gold Mining Industry

Why Do Firms Hedge Selectively? Evidence from the Gold Mining Industry

Why Do Firms Hedge Selectively? Evidence from the Gold Mining Industry∗ Tim R. Adam School of Business and Economics Humboldt University of Berlin Spandauer Str. 1, 10178 Berlin, Germany Tel.: +49 / 30 2093 5642; Fax: 49 / 30 2093 5643 E-mail: tadam@mit.edu Chitru S. Fernando Michael F. Price College of Business, University of Oklahoma 307 West Brooks St., Norman, OK 73019, USA Tel.: (405) 325-2906; Fax: (405) 325-7688 E-mail: cfernando@ou.edu Jesus M. Salas Michael F. Price College of Business, University of Oklahoma 307 West Brooks St., Norman, OK 73019, USA Tel.: (405) 325-1135; Fax: (405) 325-7688 E-mail: jsalas@ou.edu Abstract We examine why firms hedge selectively even though prior research shows that the gains from such speculative activities are economically insignificant.

We find that smaller firms speculate more than larger firms, and that firms with a higher probability of bankruptcy speculate more than firms with a lower probability of bankruptcy. These cross-sectional differences are the opposite of what a theory of selective hedging based on information and financial superiority would predict, and are more consistent with an agency-theoretic or financial constraints explanation. We also find that selective hedging is negatively correlated with managerial stock and stock option holdings, which is inconsistent with the notion that convexity in managerial compensation is a motive for managers to speculate.

July 2008 JEL Classification: G11; G14; G32; G39 Keywords: Corporate risk management; selective hedging; speculation; managerial compensation; bankruptcy.

∗ We thank Alex Butler, Sudheer Chava, Sean Cleary, Louis Ederington, Gary Emery, Vladimir Gatchev, Janya Golubeva, Dirk Jenter, Leonid Kogan, Olaf Korn, Scott Linn, Gustavo Manso, Bill Megginson, Jun Pan, Roberto Rigobon, Antoinette Schoar, Pradeep Yadav and seminar participants at MIT, University of Oklahoma, University of Texas at Dallas, the 2007 European Finance Association Meeting, the 2007 FMA Annual Meeting and the 2007 FMA European Conference for their comments. We also thank Ted Reeve for providing us with his derivative surveys of gold mining firms, and Sridhar Gogineni and Leung Kam Ming for excellent research assistance.

This research has been partially supported by the Research Grants Council of Hong Kong (Grant No. HKUST6138/02H). Fernando gratefully acknowledges financial support from the National Science Foundation (Grant No. ECS- 0323620) and Salas gratefully acknowledges financial support from the Center for Financial Studies, Michael F. Price College of Business. We are responsible for any remaining errors.

2 Why Do Firms Hedge Selectively? Evidence from the Gold Mining Industry ABSTRACT We examine why firms hedge selectively even though prior research shows that the gains from such speculative activities are economically insignificant. We find that smaller firms speculate more than larger firms, and that firms with a higher probability of bankruptcy speculate more than firms with a lower probability of bankruptcy. These cross-sectional differences are the opposite of what a theory of selective hedging based on information and financial superiority would predict, and are more consistent with an agency-theoretic or financial constraints explanation.

We also find that selective hedging is negatively correlated with managerial stock and stock option holdings, which is inconsistent with the notion that convexity in managerial compensation is a motive for managers to speculate.

3 Recent studies of corporate risk management have documented a considerable divergence between the theory and practice of hedging. The existing theory of corporate risk management examines the conditions under which hedging increases firm value.1 However, recent evidence suggests that many firms also speculate with derivatives by varying the size and timing of their derivatives transactions based on their market views, a practice known as “selective hedging.”2 Nonetheless, as noted by Stulz (1996), for selective hedging to be value increasing firms would need to possess private information about future market prices and the ability to act on this information without jeopardizing their core businesses.

Whether this is indeed the case is uncertain. High profile derivatives-related losses at Proctor & Gamble, Orange County, Amaranth Advisors and Asia Pulp & Paper, for example, indicate that firms may erroneously believe that they possess valuable information when in fact they do not. Furthermore, Adam and Fernando (2006) report that for a sample of North American gold mining companies the cash flow gains from selective hedging were economically insignificant on average. Brown, Crabb and Haushalter (2006) also find little evidence of successful selective hedging.

The divergence between the theory and practice of hedging raises important concerns for shareholders and regulators alike, and generates interesting issues from an academic standpoint. The objective of our paper is to study selective hedging in the North American gold mining industry in order to understand what factors motivate managers to speculate in this way. The gold mining industry is a perfect laboratory for this study as it is, to our knowledge, the only 1 See, for example, Stulz (1984), Smith and Stulz (1985), Stulz (1990), Froot, Scharfstein and Stein (1993), DeMarzo and Duffie (1995), and Mello and Parsons (2000) for further discussion on the theoretical motives for hedging.

2 See, for example, Dolde (1993), Stulz (1996), Bodnar, Hayt and Marston (1998), Glaum (2002), Faulkender (2005), Adam and Fernando (2006), Brown, Crabb and Haushalter (2006), Beber and Fabbri (2006), Géczy, Minton and Schrand (2007), and Faulkender and Chernenko (2007).

4 industry that makes sufficient detailed transaction-level data available to enable a systematic study of corporate speculation with derivatives within the context of a hedging program. Stulz (1996) argues that firms may acquire private information through their regular business activities.

For example, a large gas pipeline company or electricity transmission company might acquire valuable private information about market conditions and price trends through the operation of its network. In such cases, firms may be tempted to speculate in order to benefit from their proprietary information. However, selective hedging exposes a firm to considerably more risk than if it hedged without taking a market view because the firm’s private information may be noisy or turn out to be irrelevant ex post. Stulz (1996) therefore predicts that only firms with sufficient financial strength will engage in selective hedging.

Stulz (1996) also notes that from an agency-theoretic standpoint, speculating could be a rational strategy for shareholders of firms in financial distress. Additionally, as argued by Campbell and Kracaw (1999), speculation may also be optimal for firms that have minimum- scale projects and meager internal resources, and for which external financing is costly. Finally, Stulz (1996) argues that some incentive compensation schemes may induce managers to engage in selective hedging. For example, the value of stock options increases with the volatility of a firm’s stock. Tufano (1996) shows that stock options reduce the likelihood that managers will hedge a firm’s risk exposure, thereby increasing stock price volatility.

It is possible that stock options may cause managers to become even more risk tolerant and engage in explicit market timing activities that further increase volatility and hence the value of their stock options. Brown, Crabb and Haushalter (2006) examine how firm size, Altman’s Z-score, insider ownership and managerial compensation are related to selective hedging in a sample of 44 gold producers, as part of their study of whether selective hedging results in economic gains for the

5 firms that engage in it. While they do not report their results, they state that they find no significant relationship between selective hedging and any of these variables. Géczy, Minton and Schrand (2007) provide a comprehensive study of the drivers of selective hedging. Using survey data from the Wharton Survey of Derivatives Usage (Bodnar, Hayt and Marston, 1998), they examine cross-sectional differences between firms that speculate and those that do not. They find that the sensitivity of CFO compensation to stock price movements (delta) is positively associated with the probability of actively taking positions, while the sensitivity of CEO compensation to stock price movements is negatively related to speculation.

They argue that these findings are consistent with the CFO rather than the CEO being the active executive in determining day-to-day derivatives transactions. Beber and Fabbri (2006) also examine the link between CEO compensation and selective hedging for a sample of large U.S. non-financial firms with foreign currency exposure. They document a weakly significant positive relation between CEO delta and selective hedging, although they also show that managers whose compensation is tied to stock return volatility will hedge less. While providing important new insights, the studies by Géczy, Minton and Schrand (2007) and Beber and Fabbri (2006) have significant data limitations.

First, unlike our data set from the gold mining industry, neither study utilizes a data set that permits the authors to undertake an in-depth examination of selective hedging at the level of individual derivatives transactions. Additionally, the data sets utilized by Géczy, Minton and Schrand (2007) and Beber and Fabbri (2006) do not have a level of detail sufficient to determine whether or not selective hedging is successful in their respective samples and thereby provide a context for what may motivate firms to hedge selectively. The evidence documented by Adam and Fernando (2006) and Brown, Crabb and Haushalter (2006) clearly shows that selective hedging gains in the gold

6 mining industry are not economically significant. Finally, both Géczy, Minton and Schrand (2007) and Beber and Fabbri (2006) examine selective hedging in foreign currency markets where even large corporations are unlikely to have information advantages. In contrast, the gold mining industry is a more specialized commodity industry and it is easier to conceive of the possibility that some firms in this industry have a comparative advantage in predicting future gold price trends.3 We find a negative relationship between selective hedging and firm size. If firm size is a proxy for proprietary information in the gold market then this result is the opposite to what one would expect under a rational, value-maximizing model of corporate behavior.

Graham and Harvey (2001) note that smaller firms are financially less sophisticated than larger firms. Thus, smaller firms may be more likely to erroneously believe that they have an information advantage. It is also possible that smaller firms are more constrained in raising external capital due to asymmetric information, and engage in selective hedging to supplement their smaller internal resources, as predicted by Campbell and Kracaw (1999). Furthermore, we find that firms that are closer to financial distress, as measured by Altman’s Z-score, also speculate more. This result supports the agency-theoretic notion articulated by Stulz (1996) that shareholders of firms that are closer to bankruptcy have incentives to speculate at the expense of bondholders.

This finding is also consistent with the argument in Campbell and Kracaw (1999) that more financially constrained firms have stronger incentives to speculate.

3 Indeed, Brown, Crabb and Haushalter (2006) provide anecdotal evidence that markets react significantly to hedging announcements by some gold producers, which is consistent with the possibility that these firms may have superior information about the gold market. Nonetheless, Brown, Crabb and Haushalter (2006) also conclude that on average, market timing by gold producers does not create substantial shareholder benefits.

7 Given the findings in Adam and Fernando (2006) and Brown, Crabb and Haushalter (2006) that speculation does not create value for shareholders, we would expect managers who act in the interest of shareholders to refrain from speculation.

This is what we find for incentive compensation. In particular, we find no evidence that convexity in managerial compensation packages provides managers with incentives to speculate. In fact, our findings support the opposite view, that stock and stock option compensation are more likely to mitigate a manager’s incentive to hedge selectively, thus confirming the traditional view that stock-based compensation aligns the incentives between managers and shareholders. Our results are in stark contrast to recent findings by Burns and Kedia (2006) and Denis, Hanouna and Sarin (2006) that stock option compensation is positively related to the likelihood that managers will engage in behaviors that destroy shareholder value.4 Finally, we also find that insider ownership is weakly negatively correlated with the extent of selective hedging.

Given that selective hedging does not appear to add value, this finding suggests that larger ownership stakes by insiders may also deter managers from speculating.

Our findings are considerably stronger and less ambiguous than the results in the three prior studies that have examined the determinants of selective hedging. In contrast to Brown, Crabb and Haushalter (2006) who find no significant relationships between selective hedging and firm size, Altman’s Z-score, or managerial compensation in their study of gold producers, we find strong and consistent results for all these relationships. The stark difference between our findings and their findings can be attributed to the considerably smaller sample utilized by Brown, Crabb and Haushalter (2006).

While our finding of a negative relation between 4 Burns and Kedia (2006) find that the sensitivity of the CEO's option portfolio to stock price is significantly positively related to the propensity to misreport earnings. Denis, Hanouna and Sarin (2006) find that stock options increase the incentive for managers to engage in fraudulent activity.

8 speculation and CEO compensation delta is consistent with the finding in Géczy, Minton and Schrand (2007) (and the opposite of the finding in Beber and Fabbri (2006)), our finding for CFO compensation delta, which is also negatively related to speculation in our study, is the opposite of what Géczy, Minton and Schrand (2007) find. Overall, our findings for both CEO and CFO compensation, measured in terms of both delta and vega, paint a consistent picture of a negative relation between speculation and incentive compensation.

The rest of our paper is organized as follows. In Section I we briefly review the existing evidence on selective hedging and formulate our empirical hypotheses.

Section II describes our data set. Section III examines the relationships between selective hedging, firm size and other firm characteristics. Section IV analyzes the relationship between selective hedging and managerial compensation. Section V presents additional robustness checks of our findings and Section VI concludes. I. Empirical Hypotheses The traditional theory of corporate risk management assumes that firms use derivatives purely for hedging purposes and that the benefits of hedging accrue solely from the alleviation of market imperfections. In contrast, there is now considerable survey evidence that managers also speculate with derivatives, i.e., incorporate their market views into their hedging programs.

In a survey of 244 Fortune 500 firms, Dolde (1993) reports that almost 90% of firms at least sometimes base the size of their hedges on their views of future market movements. Bodnar, Hayt and Marston (1998) survey derivatives policies by 399 U.S. non-financial firms and find that about 50% of their sample firms admit to sometimes (and 10% frequently) altering the size and/or the timing of a hedge based on their market views. Glaum (2002) surveys the risk

9 management practices of the major non-financial firms in Germany. He finds that the majority follows forecast-based, profit-oriented risk management strategies. Faulkender (2005) examines whether firms are hedging or timing the market when selecting the interest rate exposures of their new debt issuances. He finds that the interest rate exposure chosen is a function of the slope of the yield curve. Faulkender and Chernenko (2007) further explore the reasons for the interest rate timing behavior documented by Faulkender (2005). Their empirical findings suggest that the choice of interest rate exposure is primarily driven by a desire to meet consensus earnings forecasts and to raise managerial pay.

Adam and Fernando (2006) find considerable evidence of selective hedging in their sample of gold mining firms but find no economically significant cash flow gains on average from selective hedging. Brown, Crabb, and Haushalter (2006) also study selective hedging in the gold mining industry and arrive at a similar conclusion. Beber and Fabbri (2006) analyze the time-series variation of foreign currency derivatives in a sample of large U.S. non-financial firms and document a substantial time-series variation in currency derivatives holdings in excess of what can be explained by changes in currency exposure, which they attribute to selective hedging.

Collectively, these studies suggest that the practice of selective hedging is widespread in the corporate world. In the next subsection we develop a series of hypotheses to guide our empirical analysis of selective hedging and help understand why firms engage in this practice. A. Empirical Hypotheses Stulz (1996) argues that some firms may incorporate their market views into their hedging programs if they possess valuable private market information. He cites as an example a large copper consuming firm, which obtains access to private information about the copper

10 market as a result of its copper purchasing activities.

Another example might be a large gas transmission and distribution company, which acquires valuable information about gas demand and supply through the operation of its gas pipeline network. The extent of private information a firm acquires is, of course, unobservable. However, as in the above examples, a firm’s access to valuable private information is likely to increase with its presence in the market and the resources it can expend to gather such information, both of which can be proxied by the size of the firm (Brown, Crabb and Haushalter (2006)). Therefore, we can state our first empirical hypothesis as follows: Hypothesis 1: Larger firms speculate more than smaller firms.

The second criterion stipulated by Stulz (1996) for successful value-maximizing speculation is that firms have the financial strength to bear the additional risk of acting on their market views without jeopardizing their core businesses. This gives rise to our second empirical hypothesis: Hypothesis 2: Financially stronger firms speculate more than financially weaker firms. Wealth transfer motives as in Jensen and Meckling (1976) and Myers (1977) would provide managers of financially distressed firms with an incentive to speculate regardless of whether or not they have an information advantage.

Campbell and Kracaw (1999) argue that financially constrained firms may also have incentives to speculate to supplement their internal

11 cash reserves and thereby overcome the constraints of accessing external capital markets. If speculation in our sample of firms is driven by such motives, we expect to find that: Hypothesis 3: Financially constrained or distressed firms speculate more than unconstrained firms. It is important to note that Hypotheses 2 and 3 make opposing predictions. If managers act in their self-interest then selective hedging may also be driven by managerial incentives. For example, the value of stock options increases with the volatility of the underlying stock. To the extent that selective hedging increases the volatility of a firm’s equity, managers that hold significant stock option portfolios may be more inclined to speculate than managers with few or no stock options.

We therefore expect to find a positive relationship between speculation and the sensitivity of executives’ compensation packages to their firm’s stock price volatility.

Hypothesis 4: Corporate speculation increases with the sensitivity of managerial stock option holdings to the volatility of a firm’s stock price. The findings by Adam and Fernando (2006) and Brown, Crabb and Haushalter (2006), that firms do not earn significantly positive cash flows on average from selective hedging, imply that corporate speculation is value-destroying or, at best, value-neutral. If this is common knowledge among a firm’s managers and other insiders, we would expect that managers who receive higher equity-based compensation will speculate less.

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