Hedging not so evil, study

For the first time, a study has found that hedging can increase firm value.

The overuse of derivatives, which were created to help firms hedge against risk, was largely blamed for causing the 2008 financial crisis and the Great Recession that followed it.

Even Warren Buffet attacked derivatives as “time bombs – both for the parties that deal in them and the economic system.”

In an innovative study, Hayong Yun, from Michigan State University, and Francisco Pérez-González show, from Stanford University, demonstrated that gas and electric utilities that used derivatives to hedge against unforeseen weather conditions experienced a “positive and significant effect” on the value of their companies.

The study – “Risk Management and Firm Value: Evidence from Weather Derivatives”- was published in The Journal of Finance.

Yun, an assistant professor of finance, said:

“Many people have a perception that derivatives are evil, that they helped destroy the economy … and while there is some truth to the argument that derivatives were overused, our research provides the first fundamental evidence that hedging with derivatives can improve company value.”

Derivatives are extensively used by companies, from corn futures to a CEO’s stock options. In the case of corn futures the cereal maker may, for example, buy 2,500 corn bushels from a farmer at today’s prices for delivery in three months’ time.

Another type of derivative, mortgage-backed securities, are believed to have caused the housing bubble and the recession it left in its wake.

Hedging with derivatives can improve a company’s value

Yun emphasizes that he is not arguing for the total deregulation of derivatives. However, his study suggests derivatives – when used properly and wisely – have a positive effect and should not be ruled out as a potential instrument for company growth.

In this study, Yun and Pérez-González assessed the value of publicly traded gas and electric utilities in the US, both before the weather derivatives market opened in the late 90s and afterwards. The market allowed utility companies to sell weather futures to interested investors.

Before the weather derivatives market opened, the utilities that were vulnerable to unforeseen weather events, such as those in the Midwest, had a 3% to 4% lower value compared to their counterparts in Texas or California where weather conditions were more stable.

After the opening of the weather derivatives market, that difference in company values vanished. Investors were no longer influenced by a utility company’s location.

Derivatives can level the playing field

The authors explain that the derivatives leveled the playing field for the utility firms in areas of unstable weather conditions. Not only were there no discrepancies in their values, these companies also enjoyed increased leverage and investments.

In the wider sense of the word, we all engage in hedging whether we know it or not. For example, when we take out an insurance policy to reduce the risk of injury, damage or income loss, or life insurance to support our family in case of death, we are involved in hedging.