Who benefits from using Derivatives?

By Praveen Gupta
What is CGR PhD's research about?
Introducing research projects of CGR PhD members

Financial Derivatives are instruments that were invented, at least in theory, to protect us from various risks arising in uncertain markets. In an ideal world, they were expected to work like this:

However, a combination of weak regulatory framework, individual greed and financial innovation gone rouge, resulted in 2008 financial crisis, which many blame on excessive and sometimes illegitimate use of Financial Derivatives.

Praveen03

Before joining academia in 2017, I was an Investment banker for two decades, one on either side of 2008 financial crisis, leading a team of derivatives marketers to corporate clients. I have personally seen development, explosive growth, sudden decline and subsequent resurgence of these instruments over last twenty-five years. Therefore, at the start of my academic career, I found it natural to study usage of derivatives by various participants in the financial markets and try to establish empirically whether this usage is of any real benefit to them. This blog summarises my research efforts on this topic.

The first part of our research exclusively focuses on impact of derivative usage on firm valuation, which is a subject of intense debate, especially in emerging markets. Most current research on corporate hedging focuses on advanced economies, not directly relevant to emerging markets, due to Illiquidity, regulations and accounting standards. Lack of data availability and inconsistent disclosure left a gap in existing research for Indian firms, which our research attempts to fill by estimating the impact of derivative usage on firm value for BSE-100 non-financial corporates over the period 2010-2017, using hand-collected data from their annual reports.

We find that the usage of all types of derivatives studied, except rates-derivatives, has significant positive impact on firm value through channels of reduced earnings-volatility and increased tax-shields. Corporate use of rates-derivatives turned positively significant only when we consider firms’ usage of derivatives alongside their level of leverage, suggesting that the use of rates-derivatives adds value only for firms which are highly leveraged. We find the results to be robust even when we consider a matched sample to overcome any identification problem by separating firms into derivatives-using firms and non-users. We conclude that, in addition to firm characteristics, corporate hedging behaviour can also affect firm valuation for emerging market corporates, suggesting that easing regulatory controls on derivatives dealings can be beneficial even in the context of growing emerging economies.

The first part of our research exclusively focuses on the impact of derivative usage on firm valuation, especially in emerging markets. Having established the value of derivatives usage for firms in India, second part of our study tries to ascertain the same for banks. Finally, it will compare and contrast our results from the Indian study with other emerging markets.

Having established the value of derivatives usage for firms, second part of our study tries to ascertain the same for banks. Unlike corporates who use derivatives only for hedging purposes, banks use derivatives for twin reasons of hedging and trading. Existing theory states that hedging through derivatives should improve bank stability and thus parameters like income volatility, Z score, CDS spreads, distance to default, etc. Similarly, trading in derivatives should improve performance measures like Return on Assets (ROA), Return on Capital (ROC), and other operating parameters. Hand collecting data from annual reports of Indian banks from 2010-2018, we try to establish whether usage of FX derivatives and rates derivatives have any impact on bank profitability and stability. We find that the use of FX derivatives did not have any significant effect on either profitability or stability of banks. Rates derivatives usage was however found to be positive and significant on both profitability and stability of Indian banks through channels of reduced earnings-volatility and higher percentage of other income. We conclude that, in addition to bank characteristics of size, leverage and Loan Losses, bank hedging behaviour, especially its usage of rates derivatives, can also affect its profitability and stability.

In the last part of the study we plan to compare and contrast our results from the Indian study with other Emerging/Developed markets.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s