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Lookman [2005b] conducts the analysis using a sample of oil and gas E&P (exploration
and production) firms that are exposed to commodity price risk with data for the years
1992-1994 and 1999-2000. He classifies commodity price as a primary risk for firms that
derive at least 80% of their revenues from E&P. These firms are labeled pure-play firms.
For the complement of the sample, it is classified as a secondary risk, firms being labeled
as diversified firms.
His results contradict the frictional cost hypothesis since hedging primary risk is associated
with a discount of about 17% of firm value in the sample (measured with a proxy for
Tobin’s Q), however, hedging secondary risk is associated with a premium of about 27% –
even after including the various controls for factors considered in the literature to correlate
a firm’s hedging policy and value. 198 This reaffirms the critique of Guay and Kothari
[2003], who question whether hedging interest rate, foreign exchange, and commodity
price risks – contemplated as minor risks in this setting – can have such a marked impact
on firm value. Guay and Kothari [2003] conclude that the economic significance of these
risks is rather modest, derivatives use being a small piece of non-financial firms’ overall
risk profile. Hence, they suggest rethinking past empirical research documenting the
importance of firms’ derivative use.
Also, some earlier papers using the indirect approach find conflicting evidence. Tufano
[1996] concludes that virtually no relationship exists between risk management and firm
characteristics that value-maximizing risk management theories would predict. Brown
[2001] concludes that several commonly cited reasons for corporate hedging are probably
not the primary motivations for why that specific US firm (HDG 199 ) in his study
undertakes a risk management program. He finds three major reasons for currency
hedging: 1. smoothing earnings volatility to lessen informational asymmetries with outside
investors, 2. supporting planning and pricing decisions with locking in future rates to
increase the certainty of operating margins and to allow for more efficient internal
contracting, 3. reducing negative impacts from currency movements to obtain competitive
pricing advantages in the product market. In addition to Brown’s [2001] findings, Lel
198 Such as, size, profitability, credit rating, financial constraints, level of exposure to the hedged risk, and
growth options.
199 HDG Inc. is a United States based industry-leading manufacturer of durable equipment with sales in more
than 50 countries.
195