Financial Derivatives Use and Firm Value: A Literature Review

Introduction

The correlation between firms' use of financial derivatives and firm value has been a subject of ongoing academic discussion. Hedging corporate risks by means of financial derivative contracts is noted by Kapitsinas (2008) to be a practice that has increasingly become a popular corporate activity over the last couple of decades. This constant evolution is directly related to the gradual shift of attention toward the high volatility that characterizes financial and capital markets globally, as well as the effects of this volatility on the performance and profitability of organizations.

Capital Structure and Risk Management

The ongoing transformation of financial markets, coupled with firms operating in an increasingly globalized environment, makes it necessary to identify the best possible ways of managing corporate exposure to a wide range of financial risks. This paper uses a series of peer-reviewed studies to examine whether financial derivatives use adds value to firms or not.

Does Derivative Use Add or Destroy Firm Value?

Modigliani and Miller's capital structure irrelevance principle clearly states that the value of any given firm is entirely independent of its financing structure in the absence of market frictions in an efficient market. When real-world frictions — such as bankruptcy costs, asymmetric information, taxes, and costly external financing — are introduced, the perfect market condition upon which the Modigliani and Miller model depends disappears entirely. It is precisely this departure from perfect market conditions that introduces the concept of a value-adding risk management policy.

Naito and Laux (2011, p. 41) argued that among the known market frictions, financial derivative instruments possess a real opportunity to add value to a firm. Their work empirically investigated whether derivative usage is value-adding or value-destroying, and found that the answer remained largely inconclusive due to a general lack of statistically significant results concerning the notional value of derivative contracts. The ambiguity was mainly attributed to limited sample size. To obtain more accurate results, it would be necessary to separate firms that are not exposed to the various risks that can be mitigated by derivative instruments. Ultimately, Naito and Laux (2011) concluded that firms neither add value nor destroy value solely through their use of financial derivatives (p. 45).

Khediri (2010) empirically investigated whether investors assign value to a firm's use of financial derivatives, using evidence from France. The results indicated that the decision to use financial derivatives has no direct influence on firm valuation. Moreover, the study found that a greater degree of derivative usage is generally associated with reduced firm value. Investors, therefore, do not appear to assign a premium to derivative use. This finding, however, applies specifically to French firms and contradicts the evidence from U.S. firms, meaning the ambiguity cannot be ignored.

Conclusion

The literature broadly suggests that hedging has a value-adding effect on firms. The magnitude of that effect, however, depends on the type of exposure — whether short- or long-term — as well as the type of instruments employed, such as options, forwards, foreign currency debt, or swaps. The effect is also more sensitive to endogeneity and omitted variable concerns than is sometimes recognized. These nuances underscore the importance of context when evaluating the relationship between financial derivative use and firm value.