The returns puzzle and non-financial firms' risk management strategies: Evidence from diverse industries

This paper examines whether non-financial firms of all sizes and from multiple industries use foreign currency, interest rate and commodity derivatives together to hedge financial risk broadly defined. Previous studies have examined the relationship of a firm's stock return and a single category of derivatives use, especially in foreign currencies, to suggest that hedging with derivatives improves a firm's rate of return for those firms that hedge. However, the results have been mixed in terms of explaining a consistent relationship and left researchers with a returns puzzle regarding this inconsistency. Further, these studies do not consider the effects of the three major categories of financial derivatives products using continuous measures of exposures that are used simultaneously by large and small firms over time, as in this study.; This paper considers total enterprise risk as this is the way that firms hedge. From public 10-K and annual report disclosures of derivatives data for U.S. and Canadian non-financial firms in the pharmaceutical, mining, metals and food processing industries during the years 1995 to 1998, this study uses modified Jorion multifactor market (1990) and Allayannis and Ofek models (2001) to estimate the sensitivity of each firm's equity exposure to interest rate, commodity and currency fluctuations.; This study finds some evidence that derivatives use reduces the interest rate, commodity or currency exposure that these firms face in some years, but in other years derivatives hedging had little measurable impact on these firms' exposures and values. These results are based on the use of various statistical methodologies, including Ordinary Least Squares (OLS) adjusted for heteroskedasticity, and Maximum Likelihood Estimation (MLE) with univariate and bivariate distributions. Furthermore, these results utilize firm returns prior to the decision to hedge with derivatives to separate hedging decisions from returns effects.; This study contrasts with prior research that considers only foreign currency or interest rate risk individually, or that considers only large firms, or that uses non-continuous derivatives data, or that examines only one year of hedging. The implications are that hedging with derivatives is not often important to a firm's rate of return.