Does derivatives use reduce the cost of equity?

Ahmed, Shamim; Judge, Amrit; Mahmud, Syed Ehasn

Abstract

This paper examines the impact of hedging on the cost of equity capital. Using handcollected data on derivatives use for a sample of German non-financial firms, we find that user firms have a 109 basis point lower industry-adjusted cost of equity than non-users. This reduction in the cost of equity of users is attributable to their lower market, size, and value risk factor exposures. The observed negative relation between derivatives use and the cost of equity remains robust to specifications that account for potential endogeneity arising from a firm’s derivatives hedging and capital structure decisions. We find that the reduction in the cost of equity is largest for smaller firms and for firms making use of foreign currency and interest rate derivatives. Moreover, new derivatives users experience a significant reduction in the cost of equity in the first year of adoption. Finally, using expected default frequency data, we show direct evidence that firms’ derivatives use reduces financial distress risk.

Citation

Ahmed, S., Judge, A., & Mahmud, S. E. (2018). Does derivatives use reduce the cost of equity?. International Review of Financial Analysis, 60, 1-16. https://doi.org/10.1016/j.irfa.2018.09.004

• Journal Article Type: Article
• Acceptance Date: Sep 9, 2018
• Online Publication Date: Sep 13, 2018
• Publication Date: 2018-11
• Deposit Date: Sep 11, 2018
• Publicly Available Date: Mar 14, 2020
• Print ISSN: 1057-5219
• Publisher: Elsevier
• Peer Reviewed: Peer Reviewed
• Volume: 60
• Pages: 1-16
• DOI: https://doi.org/10.1016/j.irfa.2018.09.004
• Keywords: Derivatives, Risk management, Asset pricing, Financial distress risk.
• Public URL: https://nottingham-repository.worktribe.com/output/1068540
• Publisher URL: https://www.sciencedirect.com/science/article/pii/S1057521918303776
• Contract Date: Sep 11, 2018