The effects of derivatives on firm financial risk: an analysis of UK non-financial firms

The main aim of this thesis is to examine the effects of the use of derivatives on financial risk measures of UK non-financial firms for the period 1999-2010. This question is important in the light of attempts by regulators to curb the use of over-the-counter (OTC) derivatives as a response to the 2008 financial crisis, the introduction of European Market Infrastructure Regulation and more recently the prospect of the introduction of the financial transactions tax. Despite the significant use of derivatives by UK non-financial firms, there is a gap in literature for a study that shows the effect of derivatives use on the financial risk for UK firms. This examination is important in the UK setting as financial distress is more costly for the UK firms due to higher creditors’ right in the UK, all else being equal. In this thesis, the effects of foreign currency (FC) and interest rate (IR) derivatives are examined on the 1-year probability of default, 5-year probability of default, total risk, idiosyncratic risk, market risk and foreign exchange (FX) exposure. This thesis contributes to the corporate hedging literature by presenting, to the best of our knowledge, new evidence on the impact of derivatives on firm financial risk. Chapter 4 of this thesis examines the effects of derivatives use on the total risk, idiosyncratic risk and market risk. The results suggest that a 1% increase in the extent of all derivatives use is associated with a reduction of 2.52% in total risk, 2.22% in idiosyncratic risk and 0.0651 basis points in market risk. A 1% increase in the extent of FC derivatives use is associated with a reduction of 0.0945 basis points in market risk. We also examine the nonlinear effect of derivatives use on financial risk and find inverted Ushaped relationship with reduction in total risk and idiosyncratic risk is associated with low and high derivatives use. We also control for the problem of endogeneity by matching derivative users with non-users using a propensity score matching method. Our results suggest that derivative users have a statistically lower 5.50% to 6.80% total risk and 4.08% and 5.17% idiosyncratic risk. We provide empirical evidence that is consistent with the notion that firms use derivatives for hedging and not for speculation. In Chapter 5, we examine the effects of derivative use on expected default frequency (EDF). The results show that IR derivatives use has a greater impact on the probability of default than FC derivatives use. Furthermore, we find that hedging with derivatives has a significantly greater impact on near term default (1-year) than long-term (5-year) default probabilities. The interaction of derivatives variable with time dummies reveals that the derivatives use is associated with a large reduction in the probability of default during the period of 2000-2001 and 2007-2009. We also interact our derivatives variable with proxies for credit risk conditions and find that derivatives use has largest negative effect on the probability of default during the period of heightened credit risk conditions. In this chapter endogeneity between the probability of default, derivatives and leverage is addressed using instrumental variable analysis. The results suggest that derivatives use is associated with a reduction in the probability of default. We also use propensity score matching method to match derivative users and non-users and then examine the mean differences on the probability of default for matched firms. The results show that the mean 1-year (5-year) probability of default of derivative users is 1.60% to 2.09% (1.11% to 1.24%) lower across different matching methods than matched non-users. The findings of this chapter will be of interest to public policy makers, financial regulators and corporate as they suggest that firms are using derivatives for hedging purposes rather than speculative ones. In Chapter 6, we examine the effects of FC derivatives and FC debt on FX exposure. The results show that firms use FC derivatives and FC debt to hedge unexpected changes in FX rates as the use of FC derivatives and FC debt is associated with a significant reduction in FX exposure. The results also indicate that UK non-financial firms’ stock returns are sensitive to not only the current but also the time delayed exchange rate changes and that the use of FC derivatives also significantly reduce the sensitivity of stock return to the time delayed exchange rate changes. In respect of FC debt, the evidence suggests that the use of FC debt leads to a significant reduction in FX exposure and supports the view that FC debt works as a natural hedge. We also examined the effect of FC debt on the probability of default and Z-score after showing that FC debt works as a natural hedge. The empirical examination in this thesis provides an important understanding of the role played by derivatives in UK non-financial firms’ risk management policies. This thesis contributes to the existing body of knowledge on risk management by providing a comprehensive examination of the effect of derivatives on UK firms’ risk.