Journal of Financial and Quantitative Analysis

Research Articles

The Effects of Derivatives on Firm Risk and Value

Söhnke M. Bartrama1, Gregory W. Browna2 and Jennifer Conrada3

a1 Lancaster University, Management School, Lancaster LA1 4YX, United Kingdom, and State Street Global Advisors, s.m.bartram@lancaster.ac.uk

a2 gregwbrown@unc.edu

a3 Kenan-Flagler Business School, University of North Carolina at Chapel Hill, CB 3490, Chapel Hill, NC 27599, j_conrad@unc.edu

Abstract

Using a large sample of nonfinancial firms from 47 countries, we examine the effect of derivative use on firm risk and value. We control for endogeneity by matching users and nonusers on the basis of their propensity to use derivatives. We also use a new technique to estimate the effect of omitted variable bias on our inferences. We find strong evidence that the use of financial derivatives reduces both total risk and systematic risk. The effect of derivative use on firm value is positive but more sensitive to endogeneity and omitted variable concerns. However, using derivatives is associated with significantly higher value, abnormal returns, and larger profits during the economic downturn in 2001–2002, suggesting that firms are hedging downside risk.

(Online publication May 17 2011)

Footnotes

We thank Hendrik Bessembinder (the editor), Evgenia Golubeva, Reint Gropp, Peter Pope, Peter Tufano (the referee), Gautam Vora, Tracy Yue Wang, Chu Zhang, and seminar participants at the 2009 Meetings of the Western Finance Association, 18th Annual Conference on Financial Economics and Accounting, 2006 Financial Intermediation Research Society Conference, 2007 Meetings of the Financial Management Association, DePaul University, Exeter University, Florida State University, Georgia State University, Göttingen University, Hamburg University, Manchester University, Münster University, Regensburg University, State Street Global Advisors, University of North Carolina at Chapel Hill, and York University for helpful comments and suggestions. Financial support by the Leverhulme Trust is gratefully acknowledged. Bartram gratefully acknowledges the warm hospitality of the Kenan-Flagler Business School of the University of North Carolina, and the Red McCombs School of Business, University of Texas at Austin, during visits to these institutions.

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