Derivatives usage by New Zealand companies

Abstract

This study examines how derivatives are used by New Zealand companies. The analysis of risk characteristics of firms with and without derivatives show that, on average, firms with derivatives hedge firm-specific risks - users have lower standard deviations of equity returns and idiosyncratic risks. Their market risk, exchange rate exposure and interest rate exposure are not significantly higher or lower than those of non-users. Derivatives are also found to explain close to I 0% of the total variation in equity returns. However, the tests do not rule out possible speculative activities. The observation of motivations for derivatives usage by New Zealand companies indicate that the likelihood of firms using derivatives increases the higher the financial risk and the larger the firm size. The incentive for managerial self-utility maximisation is another reason. These findings are not completely consistent with optimal hedging theories. The departure of the results from that predicted by theory may be attributed to New Zealand's imputation taxation system. Under the classical taxation system, firms are hypothesised to hedge because of taxation, costs of financial distress, debt capacity, underinvestment problems, managerial risk-aversion, use of alternative hedging instruments and economies of scale in information and transaction costs. Under the imputation taxation system, firms are unlikely to have incentives to use derivatives to hedge because of taxation and debt capacity considerations nor will the decision to use derivatives be influenced by the use of alternative hedging instruments. But firms under imputation are still expected to use derivatives to hedge because of financial distress costs, managerial risk aversion and economies of scale in information and transaction costs. Underinvestment problem is likely to remain a motivator for derivatives usage under imputation, but results find no support for this.