The Determinants of the Corporate Hedging Decision: An Empirical Analysis

I presented my paper at the FMA Annual Financial Planning and Analysis Round Table and received the following comments: - The paper is generally interesting but requires more yearly data in order to make the conclusions hold more generally. - One of the variables (fixed coverage) should be renamed in order to be more in-sync with current terminology - Foreign asset holdings should be included as one of the variables that describe corporate hedging - An explanation provided and agreed upon by all participants for the fact that preferred shares are always treated like debt by financial managers, and therefore the results obtained in my paper are actually reflecting this fact. - Due to the implementation of new accounting rules on derivative instruments in the US, the estimation of fair market value using marking-to-market is now more involved and will perhaps yield better estimates than ten years ago. - Better explanations of the effects of convex tax functions on hedging decision should be included in the paper. As a response to these comments, collection of additional annual data on Fortune 500 companies from 1998 to 2008 will commence immediately. These will also include new data on foreign asset holdings and fair market values of derivative instruments. Similar methodology will be used to analyze these additional data and the results will be used to reach a generalized conclusion on what makes companies hedge with derivatives. As well, the variables used in this study will be renamed to follow naming convention in the literature. Two new paragraphs will be added to the paper, one on the perceived equivalence of preferred shares with debt which will be included in the Results section, and the other to explain why convex tax function is necessary for hedging to increase firm value which will be included in the Literature Review section.This paper is concerned with testing the hypotheses put forth by Smith and Stulz (1985) and Nance, Smith and Smithson (1993) regarding the four reasons for which a firm will hedge. In this paper, we extend the analysis by assuming that the factors influencing the decision to hedge are different from those influencing the decision on the level of hedging. Our results show that hedgers had lower investment tax credits, had lower fixed claims coverage, were larger, issued more preferred shares, were less liquid, and maintained higher levels of reserves, while the tax level, expenditures on research and development, management ownership, and the level of reserves may influence the decision on the level of hedging. Our results suggest that, indeed, the variables that decide whether or not a firm hedges are quite different from those determining the level of hedging it will engage in. The results from our study indicate that the probability of hedging and the amount of hedging are also influenced by the industry to which a firm belongs