How corporate hedging affects firm value: Empirical evidence from European experience

Abstract

Risk is linked to a condition of partial lack of knowledge and information in the time to come. This characteristic makes it challenging for economic agents to provide an accurate measure of the probability distribution concerning a particular event and the magnitude of consequences related to its occurrence. Although risk can have very negative influences, it is also the reason why businesses are compensated with higher returns. Therefore, it should not be perceived only in a downward perspective, since it can offer to companies the opportunity to create additional value, increase competitive power and achieve targets. In particular, the implementation of appropriate risk management programs allows enterprises to proactively manage risky forces, while still complying with their short and long-term objectives. The purpose of the thesis is investigating the rational underlying the decision of implementing risk management programs and their effect on firm’s value. The analysis will start with a review of the theoretical and methodological perspectives, providing rationales on risk management and corporate hedging. In the theoretical assumption of perfect capital markets, the risk management discipline is considered to be irrelevant for the creation of firm value. Without taxes, agency costs, asymmetric information, costly external sources of finance, direct and indirect costs of bankruptcy, a company is equally likely to perform well regardless its financing choices and risk management decisions. In practice, the occurrence of risk along with the presence of financial market imperfections, makes companies behave in a risk-adverse manner. Considering the increasing centrality that risk has assumed on the decision-making process, the discipline of risk management has become a meaningful element incorporated into the strategy of the firm. Generally, risk management is considered to be primarily a defensive move, thereby the decision of companies to hedge their position is associated with the activity of holding financial derivatives and insurance policies. Actually, this practice represents just one side of the coin. Risk management has to be analyzed more broadly in order to include all the facets and actions taken by firms to deal with uncertainty and it has to consider also the managerial capability to exploit opportunities and the ability to gain competitive edge. Since businesses are vulnerable to a comprehensive risk package, theoretical literature operates an important classification on the basis of the risk nature. More precisely, it clusters risk into two components: the market and corporate risk. While market risk has an exogenous nature and it arises from macroeconomic factors, corporate risk has an endogenous nature since it is related to specific characteristics that are distinctive and specific for the single business. Depending on the nature of risk source, businesses handle risk and uncertainty by adopting financial or operational hedging programs. While financial derivatives and insurance contracts have been preferred at the firm level for handling respectively market and insurable risk, operational hedging techniques manage the risk associated with the specific characteristics of the business. Each company that is involved in risky activities need to estimate the extent of risk to which it is exposed and the impact of its endogenous and exogenous component. In order to understand the reason why some firms hedge their risk exposure and how they do so, an empirical analysis based on the European experience will be conducted. The purpose of the analysis consists in verifying whether a particular correlation or pattern among the set of companies operating in the Euro Area actually exist. Furthermore, demographic and financial information will be examined in order to carry out a more detailed and in-depth analysis of the object of study.