Whether risk management practices such as hedging actually have an effect on firm value of those engaging in such practices is highly debated in wider economic circles. Those involved in hedging or risk management sectors such as reinsurance can of course see the value in a well placed hedge, but for others who are less familiar with these practices the benefits aren’t so obvious. Now a research study from two U.S. universities shows that actively hedging risk can lead to an increase in firm value.
Notre Dame and Stanford University are the two institutions who have released the study and the type of hedging they chose to look at was weather hedging through instruments such as weather derivatives. Hedging is a form of insurance where one entity hedges against extreme fluctuations in factors such as price or availability of materials or commodities. Weather hedging is a prime example of this type of ‘active risk management’ as the study calls it.
The study is titled ‘Risk Management and Firm Value: Evidence from Weather Derivatives’ and it is due to be published in a future edition of the respected Journal of Finance. The research looks specifically at a number of gas and electric utilities and seeks to examine the impact of the introduction of weather derivatives trading as a hedging strategy within these firms.
To undertake the study, researchers looked at stock market and financial statement data from 203 companies from 1960 to 2007. The research shows that naturally the companies who engaged in weather hedging where the ones who had the greatest cash flow sensitivity to the weather. Those who did make use of weather derivatives significantly decreased the volatility of their cash flows, which results in an increase in debt borrowings, investments and ultimately in their share prices.
Co-author of the study Hayong Yun, an assistant professor of finance in Notre Dame’s Mendoza College of Business, said; “Our research tries to overcome this endogeneity, or non-random choice of hedging, by comparing examples with and without the possibility of hedging, specifically focusing on utilities heavily exposed to weather risk. For example, utilities in San Diego where weather is always mild and predictable, and in Minnesota, where weather varies greatly from year-to-year, have different weather risk exposure. Before 1997, we believe San Diego utilities enjoyed smoother cash flow than those in Minnesota. However, after 1997, this weather risk-driven advantage began to disappear because utilities in harsher climates could buy weather derivatives to financially hedge weather risk.”
Explaining why the result of hedging can be an increase in firm value Yun said; “It is partially explained by investment and tax benefits. Banks are reluctant to lend when a company’s cash flow is low, hence, companies may be forced to pass up valuable investment projects during those times. Also, by borrowing debt, there is an added benefit of tax exemption for the interest payments.”
This is a very interesting study and the first we’ve seen that takes a deep look into the benefits of weather hedging on firm value. It clearly describes how these utilities gain firm value from their use of hedging with weather derivatives and suggests that other sectors with exposure to weather fluctuation can similarly benefit. You can view a copy of the study here in PDF format.