With banks using increasingly complex instruments to hedge their investments, risk-management experts recently gathered in Miami for a Federal Reserve Bank of Atlanta conference on derivatives and similar tools.
Robert A. Eisenbeis, the Atlanta Fed's research director, said he called the conference to explore why hedging has suddenly become so popular.
"The issue is important because in finance there is no obvious reason to worry about hedging," he said. "As long as shareholders can diversify their investments, there is no reason for them to care about hedging. These papers try to provide some insights into what might be motivating managers to hedge."
For copies of the four papers, call 404-521-8747.
Researchers Douglas Breeden of Duke University and S. Viswanathan of the University of Pennsylvania have found a theoretical reason why firms hedge. Past studies have questioned the need for corporations to hedge, arguing that investors may diversify their investments more efficiently than corporations can hedge.
But the researchers argue that managers who hedge successfully signal to the market that they truly understand their business. The market can then reward these companies with higher stock prices.
Derivatives can do more than just hedge against financial risks. Sonku Kim of Hong Kong University of Science and Technology and Sheridan Titman of the University of Texas write that firms can use derivatives to help manage personnel.
Derivatives significantly reduce fluctuations in income from foreign exchange and interest rate swings, they said. This means managers may use derivatives to manipulate the financial results of their business units.
A solution is to centralize all hedging in a single office. This would prevent a manager from using derivatives to bolster poor financial results, they said.
Long-term futures contracts can be hedged with shorter-term contracts, write Ehud I. Ronn of the University of Texas and Chang N. Xuan of J.P. Morgan & Co.
The two used a so-called "barbell" hedge involving a combination of short and intermediate contracts. The resulting hedge caused the investment to outperform identical investments that either were not hedged or were hedged unsuccessfully with short-term contracts.
Previous research has questioned whether a long-term contract can be successfully hedged with shorter-term instruments.
Firms that do not use derivatives may still be hedging against potential losses, according to Mitchell A. Petersen and S. Ramu Thiagarajan of the J.L. Kellogg Graduate School of Management at Northwestern University.
The researchers studied two gold firms. One used derivatives to hedge against price fluctuations, and the other did not. Yet both firms reported stable earnings.
The economists determined that the firm without derivatives was using creative accounting to keep its books stable. During boom times the firm increased accruals to dampen earnings, and during busts it reduced accruals to boost income. "Firms which do not use derivatives are hedging through alternate means," they said.
The researchers said the study supports calls for greater transparency in accounting reports because it shows that firms may manipulate their books.