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Does Hedging Maximize Firm Value"? A Case Study of EU & Norway Oil and Gas Producers between 2000 and 2010

Does Hedging Maximize Firm Value


This study will examine whether hedging significantly increases the value of the company or not. This research will also examine that hedging increases firm value by reducing the deadweight costs caused by fluctuations in earnings and cash flows. Using a sample of EU and Norway oil and gas exploration and production (E and P) firms that hedge commodity price for my analysis, I believe that among diversified firms and R E, where fluctuations in commodity prices is one of the main risks associated with hedging with the lower cost firm. In contrast, for diversified firms with E and C segment, where fluctuations in commodity prices are a secondary risk hedging related to the high cost firm. In addition, I will discuss that hedging primary (secondary) risk is a proxy for bad (good) governance or high (low) agency costs. Once these factors were taken into account when assessing the impact of hedging has become insignificant. Taken together, these results indicate that the effect of hedging on firm value, if any, is negligible.

In the classic Miller-Modigliani world of hedging activities do not matter in determining firm value. However, in the real financial markets, firms face various frictions, such as financial difficulties and bankruptcy costs, taxes, costly external financing, incomplete contracts and asymmetric information. Risk management theory argues that the deadweight costs caused by this friction are reduced if the firm cash flow volatility is reduced. Thus, hedging increases firm value by reducing cash flow volatility. I refer to this hypothesis as the costly volatility hypothesis. An important issue for academics and practitioners, whether the increase in the value of the firm due to hedging is high. Several recent papers that examine this issue, that the growth is indeed significant, the estimated hedging premium being higher than 40% (Allayannis and Weston (2001), Allayannis, Lel and Miller (2003), Bartram et al. (2003), Carter et al. (2004) and Graham and Rogers (2002)). However, most existing empirical studies, the risks insured, such as foreign or interest rate risk, are not major risks, but the secondary risks. As Guay and Kothari (2003) show, the management of such risks mean only a small impact on the firm's cash flows. Thus, the source of firm value, which is attributed to hedge the existing literature is not clear. This study will make two contributions to the literature. First, I will provide a new test for the costly volatility hypothesis. Unlike the existing literature, I first would be to disaggregate the risk of exposure to the primary risks that have a significant impact on the EU, the company's financial condition and the average risk that only a small, second-order effects, and then separately analyzed the impact assessment of each type of hedging risk.

If hedging causes firm to maximize value, hedging primary risks should lead to an increase in premiums, compared with the average hedge risks, as a result of ...
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