Master Thesis The use of Derivatives and Firm Market Value An empirical study on European and Russian non-financial firms

Tilburg, October 5, 2014 Mark van Dijck, 937367 Tilburg University, department Supervisor: Drs. J.H. Gieskens AC CCM QT

Master Thesis

The use of Interest Rate Derivatives and Firm Market Value An empirical study on European and Russian non-financial firms

Tilburg, October 5, 2014 Mark van Dijck, 937367 Supervisor: Drs. J.H. Gieskens AC CCM QT

2 Preface

In the winter of 2010 I found myself in the heart of a company where the credit crisis took place at that moment. During a treasury internship for Heijmans NV in Rosmalen, I experienced why it is sometimes unescapable to use interest rate derivatives. Due to difficult financial times, banks strengthen their requirements and the treasury department had to use different mechanism including derivatives to restructure their loans to the appropriate level. It was a fascinating time. One year later I wrote a bachelor thesis about risk management within energy trading for consultancy firm Tensor. Interested in treasury and risk management I have always wanted to finish my finance study period in this field. During the master thesis period I started to work as junior commodity trader at Kühne & Heitz. I want to thank Kühne & Heitz for the opportunity to work in the trading environment and to learn what the use of derivatives is all about.

A word of gratitude to my supervisor Drs. J.H. Gieskens for his quick reply, well experienced feedback that kept me sharp to different levels of the subject, and his availability even in the late hours after I finished work.

At last I want to thank my family for the unconditional support they have given me during my study period: Without your support it was impossible for me to be who I am and where I am at the moment.

Thank you,

Mark.

3 Contents

List of tables and figures ...... 5

Glossary ...... 6

Abstract ...... 7

1. Introduction ...... 8 1.1 Background ...... 8 1.2 Research question ...... 9 1.3 Thesis outline ...... 11

2. Literature review ...... 12 2.1 The universe of risk ...... 12 2.2 Derivatives ...... 14 2.3 Risk management and firm value ...... 17

3. Theoretical model ...... 21 3.1 Definition of measurement ...... 21 3.2 Hypotheses ...... 22 3.3 Research model ...... 23

4. Methodology ...... 24 4.1 Sample selection ...... 24 4.2 Research methods ...... 26 4.3 Control variables on Firm Value ...... 28

5. Empirical results ...... 32 5.1 Univariate test ...... 33 5.2 Multivariate tests ...... 35 5.3 Robustness tests ...... 37

6. Conclusions ...... 38

7. References ...... 40

Appendix A ...... 44

4 List of tables and figures

Table Content Page

Table I Notional amount outstanding derivatives Page 14

Table II Notional amount outstanding derivatives Page 14

Table III Descriptive statistics Page 25

Table IV Hedge activity per country Page 32

Table V Hedge activity over time Page 33

Table VI Firm value between users vs non-users Page 34

Table VII Interest rate derivatives use and firm value Page 36

Table VIII Multivariate test: difference before after crisis Page 37

Figure I Research model Page 23

5 Glossary

Derivatives: Financial instruments whose value depends on an underlying. E.g. interest rates, currency or commodity prices.

Euribor interest: Mean variable interest rates between European banks.

Firm market value: Price stock * number of shares outstanding

Forward/Futures: A Forward or future agreement between two parties obligates one party to buy and one party to sell a particular commodity at the contract price at a certain date in the future. Futures are listed and forwards are over-the-counter contracts.

Free Cash Flow: EBIT (1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

Hedging: Eliminates all exposure to a particular risk. E.g. price risk.

Het Financieele Dagblad: Dutch financial newspaper.

Interest rate : Can be used to swap variable interest rates into fixed interest rates on loans.

Metallgesellschaft AG: Large German Corporation who faces large financial problems due to the use of commodity derivatives.

Option: An gives the holder (the buyer of the option) the right, not the obligations, to buy or sell an underlying at a certain date at a specific price ( prize).

Tobin’s Q: Ratio between the market value of a firm and the replacement cost of their assets (book value).

Variable interest rates: Interest rates whose value depends on a fixed rate + Euribor.

6 Abstract

This study is focused on hedging, and in particular the use of interest rate derivatives to reduce the risk of interest rate sensitivity, which is a small, but important part of the firm’s risk management. Firms use interest rate derivatives for example to mitigate the of the Financial Cash Flow. In order to investigate a potential value enhancing effect of the use of interest rate derivatives univariate and multivariate regressions are used. This study examines the use of interest rate derivatives in a sample of 282 largest listed European nonfinancial firms in the year 2007 and in the year of 2012 and its impact on firm value as measured by Tobin’s Q. The results show that the use of interest rate derivatives is rewarded by investors with lower firm valuation. The negative hedging premium is statistically significant and is on average - 13.1 percent of firm value. This could be explained by the short research period. Most interest rate derivatives are used by firms to create value in the long run and firms suffer value decreasing effects on their cash flow on the short term due to the premium they have to pay (insurance). This effect is stronger (more negative) when looking at data before the credit crisis in 2007, suggesting that in the conception of investors derivatives could affect the European economy positive during financial turmoil. The results are not significant when firm fixed effects are added to the sample. This indicates a potential endogeinity problem.

Keywords: Interest rate derivatives, risk management, firm value, hedging.

Data availability: Orbis Database and manually collected mainly from annual reports.

7 1. Introduction 1.1 Background On April 17, 2014 Het Financieele Dagblad headed “Holland Casino loses €16 million on interest rate derivatives”, since the corporation announced in their last annual report (2013) that they have been forced to restructure their negative derivative portfolio in order to conform to the tighter and recently changed rules of their banks. Holland Casino, which faces turbulent financial times, speculated with their derivative contracts on future investments, but investments were never made, interest rates went down due to the financial crisis and it looks like the banks gave them a taste to their own medicine. The difficult subject regarding the use of derivatives is not a recent phenomenon. Throughout time on the derivative market several unmistakable events have earned their own place in history. Most of these events were associated with a dramatic corporate or governmental earthquake and resulted in renewed concerns about the use of financial instruments every time. In 2001, for example, weak accounting rules result in the mysterious swap construction between the Greek government and Goldman Sachs. The expert ‘adviser’ in the use of those complex financial instruments created a two component swap deal between the Greek government and Goldman Sachs, designed to restructure the national debt in order to conform to Eurostat rules. The swap, which consists of a cross-currency- and construction to mitigate exposure to both foreign currency and interest rates on these loans, resulted in a dramatic long term value destruction of Greek sovereign Treasury. Leautier (2007) and Froot, Scharfstein and Stein (1994) mentioned a huge metamorphosis in risk management over the last decades, such as firms manage their risks more from inside the company, and the increased attention of managing risk management programs in general. Historical cases such as the stories of Holland Casino, Greece, and Metallgesellschaft AG (Culp & Miller, 1995) highlighted the weakness and difficulties of risk management hedging programs. Therefore, the firms’ top management has become increasingly aware on how their organization can be attacked by risk beyond their control. This research is focused on hedging, and in particular the use of interest rate derivatives to reduce the risk of interest rate sensitivity. This particular risk is an important part within the firm’s risk management programs nowadays.

Firms have to deal with unpredictable fluctuating variable interest rates especially during a credit crunch when facing more financial requirements of their banks. In order to accommodate firms that suffer from high interest bearing debt, interest rate derivatives are created to change

8 or fix the price of debt to the appropriate firm level. Covitz & Sharpe (2005) found empirical evidence on the theory that firms who are more exposed to interest rate fluctuations tend to use derivatives that offset these exposures. Thereby they found no support on eventually speculative activity through interest rate derivatives. The firms in this study are required to comply with mandatory rules and regulations by the International Accounting Standards Board. Therefore the annual reports generally mentioned that the company does not use interest rate derivatives (any derivatives) for speculating purposes. Which is puzzling.

As argued by Leautier (2007), the goal of managing risk should be focused on value creation and can be managed through three channels: Provide financial flexibility e.g. protection against financial distress, Enhance capital allocation and performance management e.g. risk based project valuation, and Operational and strategic flexibility e.g. protection against operational failures. Studies of hedging found value creating evidence on this subject which is in contrast to the Modigliani and Miller (1963) approach. They argue that financial markets are efficient and financial risk management is irrelevant to firms. Theories imply that well used hedging mechanisms in an inefficient market should increase the firm's market value (e.g. Allayannis & Weston, 2001). These theories suggest that finance does matter and hedging could result for example in tax benefits, lower probability of financial distress and a lower probability that they have to forgo on interesting investment opportunities (Froot et al, 1994, Stulz & Smith 1985, Stulz 1996, Minton & Schrand 1999). A more detailed theoretical explanation on this subject can be found in chapter 2.

1.2 Research question Various issues make this an instructive thesis. First, obviously, because of the repeated scandals there is still indistinctness about the emergence and value-enhancing effect of hedging programs within organizations. Second, the higher awareness and continues growth of risk management within firms is similar to the results of several academic papers and there are contradictions between several studies on this subject. For example Tufano (1999) did not find support of the value-enhancement hypotheses in his sample in the US, which is in contrast to Allayannis and Weston (2001) who found an approximately 5% increase in firm value by derivative users. Finally, lots of studies are focused on one or two countries in Europe instead of Europe as one area. De Ceuster, Durinck, Laveren and Lodewyckx (2002) presented results for the Belgium market. De Jong, Macrae and Nijman (2000) made a similar study for Dutch

9 companies. Bodnar and Gerbrandt (1998) investigated German companies. Grant and Marshall (1997), Mallin, Ow-Yong and Reynolds (2001) and El-Masry (2006) presented results from the United Kingdom.

Fifteen years ago, the results were mixed when highlighting the general use of derivatives within European firms or worldwide. At the time, researchers find that German firms are more likely to use derivatives than Dutch firms, with 78% of German firms using derivatives (Bodnar and Gebhardt, 1998) compared to 60% of Dutch firms (de Jong, Macrae and Nijman, 2000). The result in a US study of Bodnar and Gebhardt (1998) show that 58% of the non-financial firms’ uses interest rate, currency rate or commodity price derivatives. According to a more recent survey, now 94% of Fortune 500 firms a specific sort of derivative to help manage their risk (The International Swaps and Derivatives Association (ISDA), 2007). Nowadays, it is more general to use derivatives and therefore no less interesting to test the hedging theories. Why ‘everyone’ uses those instruments? Do they really create value? As the theory suggest, most large corporations increasingly turn to hedging programs to reduce their Free Cash Flow volatility. But what are the underlying motives to use interest rate derivatives and do firms really create value by financial risk management in this way? The goal of this study is to provide better insight in the relationship between financial risk management, the use of interest rate derivatives and firm value by large listed firms in Europe. Therefore this study tries to answer the main question:

Do the largest listed non- financial European firms who use interest rate derivative experience higher firm market value than non-users?

This study will take upon the subject of the use of interest rate derivatives and its effect on firm market value, with a focus on large listed non- financial European firms who uses interest rate derivatives.

Firm’s risk management should be part of the overall strategy of the firm (Leautier, 2007). The use of interest rate derivatives is a part of the firms risk management framework to hedge a specific financial risk on loan rates and often managed by the treasury department (e.g. Annual report Adidas 2012). For firms, the use of interest rate derivatives is likely to be rewarded by shareholders with higher valuation in the market, as it should result in lower financial risk and therefore less Free Cash Flow fluctuations. Adidas (Annual report 2012) mentioned their Free

10 Cash Flow management as follows: “Our Group also puts a high priority on the optimization of non-operating components such as financial result and taxes, as these items strongly impact the group’s cash outflows and therefore the Group’s Free Cash Flow. Financial expenses are managed centrally by our Group Treasury department.”

By looking at a new and extensive dataset in Europe (including Russia) this study defines a clear geographical area that is not often tested as one region on this specific subject and has two main objectives. First, this study investigates a potential hedging premium between derivate users and nonusers. Second, due to the financial meltdown the debate about the use of derivatives has been further intensified. Are derivative users blamed for their behavior? Therefore it is interesting to look at a possible hedging premium before and after the European credit crisis in 2008. This could examine potential differences in time with regard to the use of derivatives. This study investigates these issues, which could be a contribution to the existing literature.

1.3 Thesis outline After the introduction, chapter 2 starts with a literature review. There are theories that explain firm value, the use of interest rate derivatives and their relationship. This study will briefly introduce relevant theories with respect to this subject. The theoretical model of this research is described in chapter 3. Chapter 4 describes the methodology and with the empirical method of doing research, the results will be analyzed in chapter 5. The conclusion of this study can be found in chapter 6.

11 2. Literature review

Interest of this study is primarily the value enhancing effect of risk management and firm value. Therefore section 2.1 will be based on the concept of risk and risk management in general. Different risk measures, hedging and interest rate derivatives in particular will be described in section 2.2. Building on this, section 2.3 will describe in which way financial risk management can create value to firms.

2.1 The universe of risk This paragraph starts by introducing risk. What is risk? Leautier (2007) defines risk as “the variability in the value of a firm or project”. This definition is further explained as the acknowledgement that the future – hence the profitability – of an action or project, is variable. Risk does not have to be negative per se. For example, the risk that oil price goes up is positive for oil companies, however negative for airline companies. Therefore risk managers need to be aware of the up- or downside potential. Leautier (2007) defines a clear core message of risks and risk management in his book: “Managing risks means maximizing value from the volatility inherent in a firms’ business environment” and risk management is the glue that hold the two sides of the balance sheet together: “a firm’s risk management strategy is determined by the overall corporate strategy”. In an effort to understand his message, the meaning and goal of risk management programs, a lot of academic research can be accessed. The most prevailing approach by theory of risk management is variance mitigation or risk measurement and control. For example, most risk management companies quote on their websites the risk mitigation effect of their services instead of the value creating effect. However more recent theory shows that risk management can create value through different channels, at least for those who know how to harness it. Section 2.3 will further describe a potential value creation through risk management.

All firms, either small or large, have developed approaches to manage risks to their future cash flows for years. The exposure to a certain category of risk differs per company. Every risk management paper or textbook uses their own typology. Leautier (2007) mentioned four broad categories; price, counterparty, operations and business risk. Jarrow and Chatterjea (2013) added legal risk to their list. These categories are further explained in short below.

12 Counterparty risk; the risk a counterparty cannot meet their obligation to the company. Examples are receivables risk and supplier default risk. Operational risk: the exposure to negative cash flow shocks due to failure in the firms’ daily operations and processes. Business risks: the risk is often beyond the firms control and can be divided in short- and long term exposure. Short term business risk is often created by the competitive environment in the industry and long term risk is more strategic risk; examples including regulatory- or technological changes. Market/Price risk: the variability of the firms’ cash flow due to external movements in interest rates, exchange rates or commodity prices. Legal risk: the risk of legal contractual errors. However, some important risk factors are not mentioned in the two books of Leautier (2007) and Jarrow and Chatterjea (2013). Miller (1992) mentioned the importance of Environmental risk in addition to the described risk factors above. His paper divided environmental risk in political risk, macroeconomic risk and natural uncertainties. Political risk are the risk associated with democratic changes in government, war, other political turmoil, fiscal changes and unknown future trade restrictions. Inflation is categorized as Macroeconomic risk and Natural uncertainties, also named disaster risk or “the hand of god” are the risks associated with earthquakes, hurricanes, variations in rainfall or other natural disasters.

Firms most well known risk management activities are diversification, insurance and hedging (Merton 1993). Diversification is described as the percentage of firms operates in industries other than their main industry. Therefore firms can manage their risk exposure when a specific industry faces difficult times. Insurance strategies protect firms only against falling prices while retaining upside potential. This is the case when a firm buys a . Then the firm has the right to sell a specific product for the option price in a specific future time area, but not the obligation. Therefore the firm lost any downside potential, because of the option, but could still benefit from the upside potential. The option premium may be viewed as the price (premium) everyone pays when purchasing insurance. As described by Tufano (1999) this is a non-linear strategy which differs from linear hedging strategies. The main difference is the fact that hedging eliminates all exposure to price volatility. The best examples are forward agreements, which are private agreements between two parties. Price is fixed, and the settlement occurs at the end of the contract period. Therefore no up-or downside potential is possible (when ignoring the possible default risk of the counterparty).

13

Managing market or price risk (interest rates) and the potential value creation is the main subject of this paper. To hedge interest rate exposure, firms mainly use derivatives. In order to understand interest rate derivatives, an explanation about hedging and derivatives in general will be described below.

2.2 Derivatives “Hedging involves taking a financial position to eliminate parties’ exposure to a particular risk” (Stulz, 1996). Or “protect one’s investment or an investor against loss by making balancing or compensating contracts or transactions” (Jarrow & Chatterjae, 2013). Therefore a perfect hedge should reduce all firms’ exposure to rate or price fluctuations. There is larger need for hedging price fluctuations in interest rates, exchange rates or commodity prices because those risks occur out of firms control. Firms often use derivatives to protect themselves against those risks. A derivative is a financial contract that derives its value from an underlying asset price such as interest rates, exchange rates or commodity prices. Most derivative contracts are traded over-the-counter (e.g. forwards, swaps) or through an exchange (futures). Over the counter agreements are transactions between two parties without the use of an exchange. Derivatives have been used for decades and retain excessive worldwide growth due to different factors such as standardization, population growth, political changes, economy’s internationalization and the expansion in the IT industry (Jarrow & Chatterjae, 2013). Table I show that in December 2012, the notional amount of outstanding derivatives agreements was $632.6 trillion according to the International Swap and Derivatives Association (2012).

Table I: Notional amount outstanding derivatives as mentioned by Jarrow & Chatterjae, 2013 & ISDA Market survey 2012.

14 2.2.1 Interest rate derivatives

As the introduction already reveals, academics and managers are sometimes surprised by the world of interest rate derivatives. As it sounds a fair instrument, recent examples of Holland Casino and Greece are very clear examples of the recent problems within the market. However, interest rates derivatives play an important role in the overall derivative market and the total volume increases from 50 trillion in 1996 to 554 trillion dollar in the first half of 2011 as pictured in table II. This is approximately 75% of total derivatives usage in the world.

Table II Global Derivative Market Amounts outstanding, in billions of US dollars Variable 2009 2010 2011 (H1) Total 604000 601000 708000 Interest rate derivatives 450000 465000 554000 FRAs 52000 52000 56000 Swaps 349000 348000 442000 Options 49000 48000 56000 Exchange rate derivatives 49000 58000 65000 Commodity price derivatives 2900 2922 3200

Table II: notional amount outstanding interest rate, exchange rate and commodity price derivatives (ISDA Market survey 2012).

It started in the late 1970s, when oil price fluctuations and other supply-side disturbances hiked up inflation, resulting in highly volatile interest rates. Firms started looking for tools that could manage their interest rate risk. In short, interest rate derivatives are financial instruments whose value depends on their underlying interest rate. Well known derivative instruments are swaps, options and futures who are explained briefly below.

A Swap agreement between two parties (mostly between firms and banks) is used to switch variable firm loans into fixed loans. Two parties obligate to exchange their interest loan rates. As shown in table II the interest rate swaps are the most used interest rate derivatives in the world. Therefore a detailed example of an interest rate swap between two parties is conducted in appendix A.

15 An option gives the holder (the buyer of the option) the right, not the obligations, to buy or sell an underlying at a certain date at a specific price (exercise prize). The option seller has the potential obligation to sell or buy a specific underlying product at a certain date at a specific time in the future. Therefore it is much riskier to sell an option, because of the contractual obligations.

A forward or future agreement between two parties obligates one party to buy and one party to sell a particular commodity at the contract price at a certain date in the future. Futures are listed and forwards are over-the-counter contracts. For example an airplane uses gasoline to power its airplanes may find it necessary to buy a on gasoline. If gasoline prices go up in the future, then the forward contract takes away more financial losses. The seller of a forward or future contract sets its selling price fixed. For example a goldmine sells gold forward and reduces potential losses when gold prices go down.

In recent years several approaches about derivatives are made. Some theorists and managers are positive about the use of derivatives in the field of risk management and argue that the use of derivatives give firms lots of possible strategies to maintain to create value. On the other hand users are critical about the financial instrument. In line with the last statement, it is almost impossible to ignore the well-known quote of the economic icon Warren Buffet while writing a master thesis about the value of derivatives. He called derivatives “weapons of financial mass destruction” and called the creators of those financial instruments “geeks bearing formulas.” This is an apt metaphor of the line from Virgil’s Aeneid, written by Virgil between 29 and 19 B.C: “Beware of bearing gifts”(such as the Trojan horse). Derivatives (makers) are not trustworthy either. Therefore a more detailed theoretical framework about potential value creating risk management activities will be established in section 2.3.

16 2.3 Risk management and firm value The academic consensus on how risk management actually creates value starts with Modigliani-Miller irrelevance propositions in 1958. It is interesting to know more about this irrelevant risk management perfect world as described by Nobel Prize winner Modigliani and Miller. Therefore a short explanation on the Modigliani and Miller theory will be discussed.

In a perfect capital market, capital structure and risk management decisions are irrelevant for firms, as shareholders can replicate on their own any choice made by the firm. For example by holding well diversified portfolios. Modigliani and Miller argue that, with zero cost of financial distress, contracting costs or taxes, shareholders are not better off if a firm manage its financing policy, because they can manage their risk at zero costs. In a growing field of corporate risk management several questions were raised whether markets were as efficient as formerly assumed. In fact, the market contains several frictions and nowadays many academics and practitioners believe in the value creating benefits of risk management.

The increase of risk management programs is an interesting future. As argued by Leautier (2007), the goal of managing risk should be focused on value creation through volatility reduction and not, as often experienced, minimizing risks by managing volatility. This can be managed through three channels, which are, as argued by Leautier (2007) “largely untapped”. Provide financial flexibility, Enhance capital allocation and performance management and strategic flexibility. Financial flexibility ensures a firm to make value-enhancing investments even when facing adverse cash flow shocks. Throughout time on one of the most important task a manager faces is to attain and preserve financial flexibility to their firm. The term financial flexibility is used to interpret a firm’s ability to finance its operations or investments even facing negative cash flow volatility. In difficult times less healthy firms cannot rely on their balance sheet and may have to forgo on value-creating opportunities (on a stand-alone basis), because they do not have the financial resources to pursue them (the underinvestment problem). Other examples are selling value-creating divisions to refinance the company or, when things go really bad, a value-creating firm may have to file for bankruptcy due to financial constraints. However, if markets are efficient, also less healthy firms or less financial flexible firms should take those opportunities because investors will always fund value enhancing investments. The second channel means that by incorporating risk within project valuations, firms can select and structure better investments. And finally, risk

17 management enables firms to strategic and operational flexibility, which is focused on for example risk-based pricing and the timing of capacity addition.

In search for a theoretical explanation economists started to deviate from the efficient market hypothesis, starting with papers from Smith & Stulz (1985), Bessembinder (1991), and Froot et al. (1993). In order to understand how risk management creates value to firms, it is necessary to understand the incentives to hedge. The incentives to make use of derivatives can largely be divided into five different categories (Graham & Rogers, 2002). These categories are the reduction of financial distress costs, tax incentives, the reduction of the underinvestment problem, the management’s risk aversion and other incentives as the existence of informational asymmetries between managers and shareholders. Now these arguments are further explained in short:

2.3.1 Financial distress costs Financial risk management can be used to reduce the chance of costly financial distress and therefore create firm value. In the extreme case, a highly debt firm which faces a low operational cash flow, could file for bankruptcy when high financial costs such as high variable interest rates aren’t hedged (Stulz, 1996). Thereby, a risk management program reduces possible deadweight costs. Deadweight costs are the cost associated with inefficiency in the market. For example governmental actions, such as taxes or supply controls.

2.3.2 Tax Managing risks to mitigate the volatility in net income result in tax benefits (Stulz, 1996). Smith and Stulz (1985) and Batram (2000) found evidence on tax value creation by firms, when managing taxes to the optimal firm level by the use of leverage positions. Another tax benefit found by firms is focused on tax beneficial geographical areas. Firms use tax islands to pay less taxes and create value for shareholders.

2.3.3 The underinvestment problem The mainly studied theories of Froot, Scharfstein, and Stein (1993), Stulz (1996) and Lessard (1990) suggest that risk management programs helps the investment policy of the firm through less Cash Flow variation and less costly external financing. Several researchers found evidence regarding this subject. Minton and Schrand (1999) argue that higher cash flow volatility results in less investment in capital expenditures, R&D, and advertising. This is interesting in the choice of hedging the firms’ Free Cash Flow volatility in order to create value. For example,

18 hedging may help creating additional financial flexibility when the firm needs it. It mitigates volatility and increases investment on average. But also Myers (1977) and Smith and Watts (1992) already wrote about this subject. Their result assists the main goal of risk management as described by Froot et al. (1994): “Reducing the cash flow volatility by hedging results in more financial flexibility and firms do not have to forgo on interesting investment opportunities”.

2.3.4 Risk aversion management Less diversified managers prefer to minimize their risk. This is easier and less costly throughout the firms risk management program than to manage it on their own account. And therefore the risk aversion of managers could direct their firms to engage in hedging activities. Also Tufano (1996) studied the influence on managerial behavior on hedging activities in the goldmine industry. He found support to the earlier theories because firms whose managers hold more options manage less gold price risk than firm’ managers with stock.

2.3.5 Other incentives Other incentives are for example asymmetries between managers and shareholders because of industrial diversification (Graham & Rogers, 2002).

Contradictory findings have been documented in studies based on the use of interest rate, currency rate or commodity price derivatives and firm value. On the one hand the use of derivatives is rewarded by investors with higher firm valuation. Graham & Rogers (2002) presented that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. But also argue that the largest firms rather use their debt structure than derivatives to decrease their interest exposure. A widely appreciated paper of Allayannis and Weston (2001) found that the use of currency derivatives increases the value of a firm. They studied a large sample of 720 large US nonfinancial firms between 1995 and 1999 and find a positive 5% hedging premium between users and non-users. Allayannis and Miller. (2012) found strong evidence that the use of currency derivatives for firms with strong internal firm- level or external country-level governance is associated with a significant value premium. Finally Carter et al (2004) finds that firms in the airline industry that use commodity derivatives to hedge fuel prices volatility have a higher market valuation relative to the book value of their assets than firms that do not hedge.

19 On the other hand, Tufano (1999) and Jin & Jorion (2006) found less powerful results. They did not accept the hypothesis about shareholders’ value creating through hedging in the American gold mining industry. Leautier (2007) mentioned three possible explanations about the theories against value creating. First, derivatives are often used (currency) within highly diversified firms. Second, the market risk is small compared to the overall risk of the firm and hedging programs are extremely costly.

Now that a clear theoretical view has been established, the theoretical model will be formulated in the next chapter.

20 3. Theoretical model

A theoretical model is established in this chapter. First the definition of measurement is described in section 3.1. The main components of this study to test the hypotheses will be described. Secondly, in section 3.2 the main hypotheses will be explained and the research model of this study is figured in section 3.3.

3.1 Definition of measurement

3.1.1 Dependent variable

The empirical part of this research paper investigates the impact of risk management programs on firm value, and the potential impact on economic changes over time in firms’ hedging policy by the largest European non-financial listed companies. Tobin’s Q, is used as proxy for firm value and the dependent variable of this study. This variable is defined by Allayannis and Weston (2001) as the ratio of the book value of assets minus the book value of equity plus the market value of equity divided by the book value of assets. There are other measures to build Tobin’s Q, however Allayannis & Weston (2001) use three different measures and conclude that a different construction does not change the outcomes of their study significantly. This study uses the Tobin’s Q as below:

Tobin’s Q = (Total Assets – Shareholders’ Equity + MV equity)/Total Assets.

The natural log is used because of the difference between the mean (1.74) and median (1.40).

3.1.2 Independent variable

To test the value creation of risk management, interest rate derivatives are used as proxy. A dummy variable is created which indicates a firm uses interest rate derivatives or not in that specific year. Complaints about this binary variable is the fact that small users are also measured as derivative users which are according to Guay & Kothari (2003) more similar to non-users. As they suggest, potential results should be less significant if this is actually the case. Information about the use of derivatives and the existence of a hedging program is manually search on the fillings and collected from the annual reports of the firm. The key words for searching were: hedge, hedging, derivative, forward, future, swap, options, exchange rate risk, interest rate risk, price risk, fair value hedge, commodity price and financial instruments.

21 Of course, there are theories that pointed comments on this proxy for risk management as it measures only a portion of the total risk of the firm. However, other risk types are very difficult to value and most studies focuses on hedging programs as proxy for risk management.

3.2 Hypotheses Do the largest listed European firms who use interest rate derivative experience higher firm market value than non-users? To guide us through the problem indication and research question of this study a main hypothesis is constructed:

Hypothesis 1: Firms that use interest rate derivatives are rewarded by investors with higher valuation.

If derivatives are fully or partly responsible for the crisis, investors should value firms different before and after the crisis when one examines the use of derivatives. Some theorists (Jarrow & Chatterjea, 2013) argue that “derivatives are a god senses”. Highlighted the growing derivative market and argue that “they must be serving a useful role in the economy”. This study uses year dummies to control for time in the regressions and test whether there is a difference between 2007 and 2012. Therefore the second hypothesis is conducted:

Hypothesis 2: After the credit crisis firms who use derivatives are valued less than before crisis, because derivatives are blamed by investors to financial risks and losses.

22 3.3 Research model

The research model of this study in figure:

Research model

Before crisis (2007) Interest rate derivative usage Firm value (Tobin's Q) After crisis (2012)

Controls Growth Financial Health Profitabilty Size Other derivative usage Acces to financial markets Legal origin Industrial diversification Geographic Segment Year fixed effects Country fixed effects Firm fixed effects

Figure I: research model

23 4. Methodology

This chapter is divided into three sections. Section 4.1 starts with the sample used in this study. In section 4.2 the different research methods will be described. Finally, in section 4.3 the control variables used in the regressions with expected signs will be explained.

4.1 Sample selection This study’s sample consist of the firms listed on European largest exchanges from the Netherlands, France, the UK, Germany, Spain, Belgium, Austria, Switzerland and Russia, because they are required to comply with mandatory rules and regulations by the International Accounting Standards Board in disclosing information on the derivative instruments and hedging activities (e.g. IAS 39). This rule stands from 2005, which is perfect for this study. The period includes year 2007 (before credit crisis) and year 2012 (‘after’ credit crisis) and most of the data, mainly the items in financial statements, are collected from the Orbis Database 1 . Excluded are financials because they are also market makers in interest rate derivatives. Allayannis et al. (2001) also excluded financials because they are also market makers in currency derivatives. The usage of derivatives is manually search on the fillings. For example Volkswagen is defined as ‘Derivative User’ in both years: “Volkswagen Group companies use derivatives to hedge balance sheet items and future cash flows (hedged items). Derivatives, such as interest rate swaps, forward transactions and options, are used as the primary hedging instruments.’’ Annual report 2012 – Volkswagen

Table III, panel A, displays descriptive statistics of the variables used in this study. In the table caption all main variables are explained.

1 If a firm has missing data for one of the two years, only the respective firm year is excluded from the sample.

24 Table III: Descriptive statistics:

Table summary statistics Variable No of Obs. Mean Std. Dev. Min. Max. Panel A: All firms Sample description Total Assets (Mil) 520 35100 59400 71,223 409000 Total Sales (Mil) 519 24100 45900 28,04 467000 MV (Mil) 520 24033 37718 58,43 333014 Derivatives use 520 0,74 0,44 0 1 Tobin's Q (Median) 520 1,74 (1.40) 1,06 0,47 10,61 Controls Market to Book value 520 3,55 11,29 -5,61 246,18 Debt ratio 520 0,19 0,14 0 0,92 Return on Assets 520 0,08 0,29 -0,27 0,62 Other derivatives 520 0,78 0,42 0 1 Dividend dummy 520 0,79 0,4 0 1 Legal origin 520 0,27 0,44 0 1 Diversification dummy 520 0,51 0,4 0 1 Geographic dummy 520 0,53 0,5 0 1 Variable No of Obs. Mean Std. Dev. Min. Max. Panel B: Firms before crisis (Year data 2007) Sample description Total Assets (Mil) 238 32900 54600 71,22 347000 Total Sales (Mil) 237 22700 43100 28,04 356000 MV (Mil) 238 27733 43852 58,43 333014 Derivatives use 238 0,75 0,43 0 1 Tobin's Q 238 1,91 1,14 0,81 10,61 Controls Market to Book value 238 4,71 16,33 0,33 246,18 Debt ratio 238 0,18 0,15 0 0,75 Return on Assets 238 0,11 0,44 -0,27 0,62 Other derivatives 238 0,79 0,41 0 1 Dividend dummy 238 0,82 0,39 0 1 Legal origin 238 0,27 0,45 0 1 Diversification dummy 238 0,54 0,5 0 1 Geographic dummy 238 0,56 0,5 0 1 Panel C: Firms after crisis (2012) Sample description Total Assets (Mil) 282 37000 632000 121,7 409000 Total Sales (Mil) 281 25300 497000 68,5 467000 MV (Mil) 282 20911 31374 200,74 209685,9 Derivatives use 282 0,74 0,44 0 1 Tobin's Q 282 1,59 0,97 0,47 8,53 Controls Market to Book value 282 2,57 2,88 -5,61 23,47 Debt ratio 282 0,19 0,14 0 0,92 Return on Assets 282 0,05 0,06 -0,26 0,36 Other derivatives dummy 282 0,77 0,42 0 1 Dividend dummy 282 0,77 0,42 0 1 Legal origin 282 0,26 0,44 0 1 Diversification dummy 282 0,49 0,5 0 1 Geographic dummy 282 0,5 0,5 0 1

This table documents summary statistics for my sample of all non-financial largest listed European firms with no missing values on size or market value of equity and for the subsamples of year data before (2007) and after the European credit crisis (2012). The interest rate derivative dummy equals 1 if the firm reports the use of interest rate derivatives in any form in the

25 yearly annual report. Tobin’s Q is the ratio of total assets minus the book value of equity plus the market value of equity to the book value of assets. This study uses the method of Allayanis & Weston (2001) to construct the Tobin’s Q as proxy for firm value. Profitability is provided by the return on assets, which is measured by net income divided by total assets. Growth opportunities are proxied by the market to book ratio. MtB is the ratio of market value of equity to book value of equity. The debt ratio is the ratio between long term debt and total asset. The dividend dummy is set equal to 1 if the firm paid dividends that year and 0 otherwise. Legal origin is determined through the difference between common-law and civil-law countries. This study follows the theory of La Porta et al. (2007) to create a dummy variable on legal origin. The dummy variable takes the value 1 if the firm is originated in a common-law country and zero otherwise. The diversification dummy is set equal to 1 if the firm is active in a difference industry compared to their primary business segment. Multi-nationality is captured through the geographical dummy, which values one if the firm is active in another country than her home country.

4.2 Research methods In order to find an answer to the hypotheses, this research will make use of the ordinary least square (OLS) method. This method helps to estimate the coefficient of the linear relationship between the dependent and independent variables.

4.2.1 Univariate test First, this study uses an univariate to compare firm values, as measured by Tobin’s Q, for users and non-users (of interest rate derivatives) in order to test the main hypothesis.

4.2.2 Multivariate test Second, a multivariate test is conducted to exclude the effect of all other determinants that could have an impact on firm value (Tobin’s Q). Therefore this study controls for growth opportunities, capital structure, profitability, size, industrial and geographical diversification, time, country and firm fixed effects. An ordinary least square regression model with control variables will be used for this research. The formula is as follows:

′ Firm Market Value (Tobin s Q) = 훼 + 훽1 훿1 + ∑ 훽푘 ∗ 퐶표푛푡푟표푙 푉푎푟𝑖푎푏푙푒푠푘 + 푢

1 𝑖푓𝑖푛푡푒푟푒푠푡 푟푎푡푒 푑푒푟𝑖푣푎푡𝑖푣푒푠 푎푟푒 푢푠푒푑 훿 { 1 0 표푡ℎ푒푟푤𝑖푠푒

When βeta1 is zero, the usage of derivatives does not have an impact on firms’ market value.

26 4.2.3 Robustness

First, to test the robustness of this study an alternative measure, the market to book value, will be used for the dependent variable. This is computed as the ratio of Market capitalization to Book value of equity. Second, the natural logarithm of Tobin’s q will be used to erase potential outliers on the dependent variable. They are figured in parentheses in the tables. And finally to test the robustness of the study’s sample Russia will be moved from the sample due to the large difference between Russia firms and the other firms within the dataset.

27 4.3 Control variables on Firm Value Since within this study a new area to test the value enhancing effect of the use of derivatives on firm value is created, the focus of this study is mainly on the use of interest rate derivatives and firm value. Because not only interest rate derivatives influences firm value, this study need to control for several factors that also could influence firm value. Therefore several control variables (sub-hypotheses with regard to firm value effects) will be tested. Explanations about the control variables used in the multivariate test will be described below. Also the theoretical explanations are given. The study uses the main variables from the Allayannis and Weston’s paper of 2001, because they are highly rewarded in the academic world. Some extra variables as legal protection and extra interest in time effects during the recent credit crisis will be added. Find below an overview of all variables used in this study multivariate regression:

Tobin’s Q = 훼 + 훽1 퐼푅퐷 + β2GROWTH + β3LEVERAGE + β5PROFITABILITY + β6SIZE +

β7OTHERDER + β8DIVIDEND + β9LAW + β10DIVERSIF + β11GEO + β12COUNTRY k+ β13FFE + u.

Where: Tobin’s Q = Total book value of Assets – Book value of Equity + Market value of Equity)/Total book value of Assets. IRD = 1 if interest rate derivatives are used, 0 otherwise GROWTH = Market capitalization / Book value of equity LEVERAGE = Long term Debt / Total book value of Assets PROFITAB. = Net income / Total book value of Assets SIZE = LN Total book value of Assets OTHER DER = 1 if firm uses currency and/or commodity derivatives DIVIDEND = 1 if firm paid dividend LAW = 1 if firm is based in common law country DIVERSIF = 1 if firm operates in ‘secondary’ segment GEO = 1 if firm operates in non-based country/countries COUNTRY k = 1 if firm is based in same country k FFE = Firm fixed effects The underlying relevance and sub hypotheses of the control variables of this study are briefly described below.

28 Growth: Market to book ratio Another important measure for firm value is the firm’s potential to growth. Future investment opportunities influence firm value according to Myers (1977) and Smith and Watts (1992). Froot et al. (1993) highlighted the importance of such control. They extended the theory, which argue that hedgers face larger investment opportunities than firms whose do not use derivatives and growth firms should be rewarded by investors with higher valuation. Gezcy et al. (1997) found also empirical evidence on this factor arguing that hedgers have more future investment opportunities.

Hypotheses 3a: Firm value is positively correlated to market to book ratio (growth)

Capital structure: Leverage This study is interested in the capital structure and their influence on firm value. Leverage is defined as the long term debt divided by book value of equity as used by Allayannis & Weston (2001). Some value-enhancing theories about leverage suggest that leverage increase firm value because of the tax advantages of debt.

Hypotheses 3b: Firm value is positively correlated to the leverage ratio.

Profitability: Return on assets Return on assets is used as proxy for the profitability of the firm. More profitable firms should be valued more by investors, because they are more attractive in the market. The more profitable, the ‘hotter’ the firm. If derivative users are more profitable, they will be valued at a premium.

Hypotheses 3c: A more profitable firm should be rewarded by investors with higher valuation.

Size: LN Total Assets There is ambiguous evidence. Peltzman (1977), for example suggest size result in higher firm value because of higher efficiency. However, Lang and Stulz (1994) reported a negative sign, because large firms are more diversified, and diversifications lead to lower Q values. An explanation could be that more agency problems arise when a firm is more diversified and are therefore lower valued by shareholders.

Hypotheses 3d: Size is ambiguous.

29 Other derivatives usage: uses also currency and/or commodity derivatives The use of other derivatives should results in more firm value because managers with more experience on how to manage their price risk should be rewarded by investors with higher valuation. More hedge activity leads to lower transaction costs, and more experienced risk management by managers on this factor.

Hypotheses 3e: Experienced hedgers are rewarded by investors with higher valuation because they value well known risk management.

Access to financial markets: Dividend dummy The dividend dummy is used to test if the firm is credit constraint or not. When firms pay dividends it is less likely to be credit constraint. Investors value the firm less, because they are more exposed to negative NPV project (e.g. more cash availability results in more projects and higher chance of negative outcomes) (Servaes, 1996).

Hypotheses 3f: Dividend dummy is negatively correlated to firm value

Legal protection: Common law dummy According to La Porta et al. (2007), investors have the best legal protection in firms that operate in common-law countries. Firms operating in French civil law countries the worst and German-Scandinavian civil law countries are somewhere in the middle. Investors are more likely to invest in common-law countries such as England because they have more investor protection and therefore value firms more. This study uses a dummy variable which equals 1 if the firm is based in a common law country.

Hypotheses 3g: Firms that operate in common-law countries have higher firm values

Industrial diversification: Industrial diversification dummy Industrial diversification is widely discussed in academic papers. There is ambiguous evidence on the value increase potential of diversification. Positive studies suggest for example diversification result in less cash flow shock when facing difficult times within the primary industry. Negative studies argue diversification leads to problems between managers and shareholders because of for example the differences in knowledge about industries (Graham & Rogers, 2002). This study uses a variable that values 1 if the firm operates in a ‘secondary’ segment based on the Orbis Database. As presented in table III, approximately 51% of this

30 study is diversified across different industries. This is in line with for example the study of Allayannis & Weston (2001) who presented 63% diversification within their sample.

Hypotheses 3h: Firm value and industrial diversification are ambiguous

Geographical diversification: Geographical diversification dummy Negative studies argue that geographical diversification leads to problems between managers and shareholders because of for example the differences in knowledge about countries (Morck and Yeung, 1991). Positive studies found value enhancing results due to the use of intangible assets abroad, the increase in size, become more established, which lowers the chances of competitors (Dunning 1973).

Hypotheses 3i: Firm value and geographical diversification are ambiguous

31 5. Empirical results

After a clear theoretical explanation, a sample description, and hypotheses development, this chapter describes the results of several research techniques that are used to test the previously formulated hypotheses. Since this study is interested in a potential hedging premium by interest rate derivatives users in Europe it interesting to show the difference between countries. The total ‘firm’ number is the total year data observations within this study. The last column of table IV presents an 82% derivative usage within the sample. Russian firms use least derivatives (32%) and almost every firm use derivatives in Austria (96%).

Table IV Hedge activity per country Table Hedge activity per country Country Firms IRD user Derivative user Austria 28 24 86% 27 96% Belgium 28 23 82% 23 82% France 66 56 85% 57 86% Germany 99 70 71% 86 87% Netherlands 38 33 87% 34 89% Spain 42 28 67% 35 83% Switzerland 30 23 77% 25 83% United Kingdom 139 114 82% 125 90% Russia 50 16 32% 19 38% Total 520 387 74% 431 82%

The sample contains of 282 largest listed European firms. Information about the use of derivatives and the existence of a hedging program is manually search on the fillings and collected from the annual reports of the firm. Interest rate derivative users are tabulated as IRD user and Derivative users hedge their risk with interest rate, currency or commodity derivatives. Firms are classified per country.

Table V presents summary statistics on firms’ hedging behavior over time. There is no large difference in data of firms that use interest rate derivatives between 2007 and 2012.

32 Table V Hedge activity over time Table Hedge activity over time 2007 Percent of sample 2012 Percent of sample Interest rate derivative users 179 75% 208 74% Currency derivative users 187 79% 213 76% Commodity derivative users 60 25% 79 28% Any derivative users 200 84% 232 82%

This table presents a summary of firms’ use of derivatives over time. A firm is a derivative user if they reported a certain hedging program in their yearly annual report. The information is manually search on the fillings and collected mainly from annual reports per firm. The table provides an inside in the usage of derivatives through time.

5.1 Univariate test In order to test the main hypothesis of this study if the use of interest rate derivatives results in higher firm value the univariate test compares Tobin’s Q’s hedgers versus non-hedgers. The behavior of investors during economic crises regards derivatives is also likely to influence the value of firms that use derivatives. When financial turmoil occurs, several economists blame derivatives for their complexity and less transparency of the financial world. Therefore, this study tests the data separately before and after the credit crisis. Derivate use (derivatives in general) could either be blamed (negative sentiment, scandals, news etc.) or positively rewarded by investors (derivatives help to restructure financial frictions within firms and economy) during difficult financial times. Table VI present the mean statistics of Tobin’s Q for all firms and separately between the years 2007 and 2012. Row 1, column5 displays the difference of Tobins’Q between firms that use derivatives and nonusers. The results suggest a 0, 49 higher mean Tobin’s Q for firms that do not use derivatives (mean value 2, 1 versus 1, 61 of users). This result is not consistent with the hypothesis of this study. The table presents both before and after the European credit crisis a significant hedging premium for non-users. The difference between users and nonusers decrease after crisis. This result could suggest that non-users suffer more from credit crisis and are more devaluated by investors based on Tobin’s Q than firms who use interest rate derivative. This rejects the hypothesis that derivatives (derivative users) are blamed by investors more.

33 Table VI: firm value between derivative users vs non-users Table Difference Tobin's Q: Hedgers vs Non-Hedgers Users Non-Users Difference t-statistic Differrences in means All years Mean 1,61 2,1 -0,49 4,68 Std. Dev. 0,75 1,63 N 387 133 Before crisis Mean 1,72 2,47 -0,75 4,54 .(2007) Std. Dev. 0,75 1,78 N 179 59 After crisis Mean 1,51 1,8 -0,29 2,24 .(2012) Std. Dev. 0,73 1,44 N 208 74

This table presents a univariate test of Tobins’Q between derivative users compared to non-derivative users with year data before (2007) and after the European credit crisis (2012). The sample contains of 282 largest listed European firms with no missing values on size or market value of equity for 2006 and 2012. A firm is a user of interest rate derivatives if they report a certain hedging program in their yearly annual report.

34 5.2 Multivariate tests Several factors could influence firm value. As the univariate test in the previous section do not control for other factors that could influence firm value. To further investigate a real relationship between the use of derivatives and firm value this study need to control for the factors as described in section three. Therefore this study uses a multivariate analysis to run pooled and fixed effect regression (see table VII). The hedging premium is negative and significant for the total sample of this study. Therefore it can be concluded that interest rate derivatives usage decreases firm value. Contrary to this result, e.g. Graham & Rogers (2002) (interest), Allayannis & Weston (2001) (currency) do find a significant hedging premium. Table VIII shows the results before and after the crisis. Results are less negative in 2012 which could indicate that investors value derivative users higher during financial turmoil. Indicating that derivatives could help to restructure the financial markets. When controlling for fixed effects, the coefficient of a potential hedging premium based on the interest rate derivative dummy is not significant (not tabulated in Table VIIII). A potential endogeneity problem arises and the result indicates that undefined firm fixed factor(s) such as managerial influence should also influence the valuation of firms.

As previously explained, the control variables of section 4.3 are used. The coefficient value indicates that interest rate derivative users have a lower firm value as measured by Tobin’s Q than nonusers by 13.1 percent.

Several control variables are statistically significant and have reasonable signs: Growth, as measured by the market to book ratio has a positive sign, which is consistent with the theory that investors value growth firms more. This study find a negative sign on firm size. Larger firms could be less efficient and lower valued by investors. Leverage is also negative and significantly correlated to firm value, which could suggest that leverage is negatively seen by investors through for example higher possibility of financial distress. Tax benefits of debt are not found through the used ratio. Profitability has the expected positive sign though not significant in panel A. Common law dummy controls for the difference in legal origin. Investors are more protected in common law countries (La Porta et al. 2007). In this study, the expected positive sign is found for firms that are originated in common law countries. The use of other derivatives is positively correlated to firm value, which could be explained by the assumption that shareholders value firms more if managers are experienced risk managers. The firm is, therefore, less exposed to risks and rewarded with higher valuation.

35

Regressions show similar results (not tabulated) when controlling only for the Russian area, this country has a notable lower amount of derivative users compared to the mean value of the sample and therefore could bias the tests. Multivariate regressions based on the use of any derivatives give similar results and are not tabulated.

Table VII Interest rate derivatives use and firm value Table multivariate results on IRD use and firm value Y= Tobin's Q (LN TobinsQ) OLS t-statistic Fe t-statistic Panel A: all firms Observations 520 520 R-sq 0,27 (-0,29) 0,16 IRD use dummy .-0,342*** (-0,131***) -2,71 .-0,198 -0,86 Growth (MtB ratio) .0,024*** (0,100***) 6,63 .0,010*** 2,73 Leverage (Debt ratio) .-1,353*** (-0,518***) -4,38 .-1,078** -2,04 Profitabilty (ROA) .0,104 (-0,039) 0,76 .-0,118 -0,87 Size (Ln total assets) .-0,4*** (-0,213***) -6,29 .-1,276*** -4,67 Other derivative use dummy 0,218 (-0,893) 1,70 .-0,394 -1,58 Dividend dummy 0,189 -1,665 1,80 0,094 0,70 Legal origin (Common law dummy) .0,282*** (3,244***) 2,97 Diversification dummy -0,022 (-1,383) -0,26 Geographic Segment 0,139 (-1,665) 1,61 0,132 0,21 Year fixed effects No No Yes Country fixed effects No No Yes Firm fixed effects No No Yes 0,21

Table VII displays the hedging premium for ols and fixed-effects regressions of the use of interest rate derivatives between interst rate derivative users and nonusers. The sample contains of 282 largest listed European firms with no missing values on size or market value of equity for 2006 and 2012. Panel B and C are regressions based on data only for one specific year in 2007 and 2012. A firm is a user of interest rate derivatives if they report a certain hedging program in their yearly annual report. ). The interest rate derivative dummy equals 1 if the firm reports the use of interest rate derivatives in any form in the yearly annual report. Tobin’s Q is the ratio of total assets minus the book value of equity plus the market value of equity to the book value of assets. Profitability is proxied by the return on assets.. Growth opportunities are proxied by the market to book ratio. The debt ratio is the ratio between long term debt and total asset. The dividend dummy is set equal to 1 if the firm paid dividends that year and 0 otherwise. The dummy of legal origin takes the value 1 if the firm is originated in a common- law country and zero otherwise. The diversification dummy is set equal to 1 if the firm is active in a difference industry compared to their primary business segment. Multi-nationality is captured through the geographical dummy, which values one if the firm is active in another country than its home country. Fixed effects regression is captured by year, country and firm fixed dummies. The significance of the coefficients is displayed; ***, **, and *, for significance at the 1%, 5% and 10% level, respectively.

36 Table VIII Multivariate test: difference before after crisis

Table multivariate results on IRD use and firm value before and after crisis Y= Tobin's Q (LN TobinsQ) OLS t-statistic OLS t-statistic Panel B: before crisis; 2007 C: after crisis; 2012 Observations 238 Observations 282 R-sq 0,27 R-sq 0,63 IRD use dummy .-0,499*** (-0,236***) -2,41 .-0,231** (-0,054) -2,08 Growth (Market to Book ratio) .0,018*** 4,49 .0,171*** 11,83 Leverage (Debt ratio) .-1,782*** -3,56 .-0,351 -1,26 Profitabilty (ROA) -0,074 -0,49 .4,481*** 6,67 Size (Ln total assets) .-0,370*** -3,54 .-0,191*** -3,26 Other derivative use dummy 0,231 1,11 .0,220* 1,93 Dividend dummy -0,109 -0,61 0,164 1,75 Legal origin (Common law dummy) 0,101 0,66 0,081 0,92 Diversification dummy -0,155 -1,13 0,102 1,30 Geographic Segment 0,176 1,28 .0,159* 2,03

Table VIII displays the hedging premium for ols regressions of the use of interest rate derivatives between interst rate derivative users and nonusers. The sample contains of 282 largest listed European firms with no missing values on size or market value of equity for 2006 and 2012. Panel B and C are regressions based on data only for one specific year in 2007 and 2012. A firm is a user of interest rate derivatives if they report a certain hedging program in their yearly annual report. The interest rate derivative dummy equals 1 if the firm reports the use of interest rate derivatives in any form in the yearly annual report. Tobin’s Q is the ratio of total assets minus the book value of equity plus the market value of equity to the book value of assets. Profitability is proxied by the return on assets. Growth opportunities are proxied by the market to book ratio. The debt ratio is the ratio between long term debt and total asset. The dividend dummy is set equal to 1 if the firm paid dividends that year and 0 otherwise. The dummy of legal origin takes the value 1 if the firm is originated in a common-law country and zero otherwise. The diversification dummy is set equal to 1 if the firm is active in a difference industry compared to their primary business segment. Multi-nationality is captured through the geographical dummy, which values one if the firm is active in another country than its home country. The significance of the coefficients is displayed; ***, **, and *, for significance at the 1%, 5% and 10% level, respectively.

5.3 Robustness tests The first robustness test was conducted on another variable which measures firm value. The Market to Book value is used as dependent variable. The test shows a statistically insignificant and negative sign for the interest rate derivative dummy. The model has a lower prediction power because of the lower R-squared (0.04 versus 0.26 by Tobin’s Q). The insignificant results argue, again, the model need to be enhanced by more (firm specific) factors to test if the use of interest derivative really creates (negative) firm value. Due to potential outliers the second robustness test was conducted on a natural logarithm of Tobin’s Q. Results are less negative and mainly used in this study report. The outcomes are presented in parentheses within the tables. The last robustness test was conducted on the whole dataset. Russia data was erased from the sample to see what the outcomes where without this outlier (see Table IV to see the large difference between Russian firms and other firms within the sample). There was no large difference is significance and variable signs.

37 6. Conclusions

This study uses a sample of the largest non-financial firms from the Netherlands, France, the UK, Germany, Spain, Belgium, Austria, Switzerland and Russia from year 2007 and year 2012. The study finds that interest rate derivative users are rewarded by investors with lower valuation.

The problem of this study is to understand a potential value enhancement effect of the use of interest rate derivatives. Incentives to hedge are for example against financial distress or to create tax advantages. However, the basic principle is that firms use interest rate derivatives to minimize their interest rate risk in order to protect their financial flexibility and Free Cash Flow (Froot et al., 2003). Throughout time on the derivative market, however, several striking events have earned their own place in history and continuing the debate about the value-enhancing effect of the use of derivatives. This study uses Tobin’s Q as a proxy for firm value and control for several factors that could also influence firm value. The variables and tests are broadly based on the methodology of Allayannis & Weston (2001), who studied a significant hedging premium by foreign currency derivative users compared to nonusers. This study finds a negative relation between firm value and the use of interest rate derivatives about 13.1 percent. However, after controlling for firm fixed effects, there is no significant hedging premium. This indicates a potential endogeneity problem within this sample. Lack of data regarding managerial behavior and characteristics are omitted variables who could explain this problem. The negative premium could be explained by the fact that the study uses a very short time period. The use of interest rate derivatives is expensive and the premium (insurance) firms have to pay result in a lower Free Cash Flow and a lower firm value. Interest derivatives are often used to protect firms against volatility in the financial cash flow over several years. Studies which found positive hedging premiums were mostly based on longer time periods.

The difference between users and nonusers decrease after the credit crisis. This result could suggest that non-users suffer more from credit crisis and are more devaluated by investors based on Tobin’s Q than firms who use interest rate derivatives. This rejects the hypothesis that derivatives (derivative users) are blamed by investors more during a credit crunch. The overall negative sign, however, could be explained by a negative sentiment before the years covered in this study. Investors have already captured unfavorable events and are therefore not

38 shocked by eventually financial turmoil. At least, they do not specifically blame derivatives or derivative users for it.

This study found some significant evidence against the hypothesis that hedging is valuable. However after controlling for several factors which also could influence firm value, the results are mixed though less significant. According to the theory, management behavior and the relationship between management and shareholders determines also the risk management strategy of firms. This studies dataset does not capture managerial and ownership influence and therefore, future work could take into account the relation between ownership-managerial behavior on the use of interest rate derivatives and their influence on firm value. Covitz & Sharp (2005) argue that large firms rather use debt structure instead of financial instruments to limit their interest rate exposure. Smaller firms, however, uses derivatives in particular to protect themselves against interest rate risk. This could suggest that large firms value derivative use less. This study only uses the largest listed firms in Europe and therefore the results could be less positive than if this study had used a sample with, on average smaller firms. At last, this study does not capture a potential reverse causality problem. Firms with higher Q’s could have more incentives to hedge. Gezcy, Minton and Schrand (1997) found empirical evidence on the fact that derivative users have higher growth opportunities. Higher growth opportunities could be an incentive for investors to value a firm more. This indicates a potential reverse causality problem. Due to the low difference between the use of derivatives in 2007 and 2012 a time series regression to test reverse causality is not conducted. Future research could take those biases into account.

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41 - Merton, R.C., 1993, "Operations and Regulation in Financial Intermediation, A Functional Perspective," in P. Englund, Ed., Operation and Regulation of Financial Markets, Stockholm, The Economic Council.

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Books: - Covitz, D. M., & Sharpe, S. (2005). Do nonfinancial firms use interest rate derivatives to hedge?. Divisions of Research and Statistics and Monetary Affairs, Federal Reserve Board.

- Léautier, T. O. (2007). Corporate Risk Management for Value Creation: A Guide to Real-life Applications. Risk Books.

- Robert A. Jarrow & Arkadev Chatterjea (2013) An Introduction to Derivative Securities, Financial Markets, and Risk Management

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Other readings - The International Swaps and Derivatives Association (ISDA), 2007,2012. - Het Financieele Dagblad - The Wallstreet Journal - Economist.com - Accountancy news

43 Appendix A

Interest rate swap example Suppose that the firm borrowed € 2.000.000, - for three years by the bank at a floating rate of Euribor tariff (let’s say 4%) + 1.5%. The firm is exposed to risk due to possible price increases in the market interest rate (Euribor) when the firm has to pay more interest. Of course a price decline would result less payment. The firm can enter into an interest rate swap with the bank to switch their variable interest payment into a fixed interest payment. The firm would agree to make payments to a counterparty, in this case a bank but other firms are also optional, equal to a fixed interest rate applied to € 2.000.000, - In exchange, the bank would pay the firm a floating rate applied to € 2.000.000, With this interest rate swap, you would use the floating- rate payments received from the bank to make the variable payments. The only payments the firm would make out of their cash balance would be the fixed interest payments to the bank, as if the firm had a fixed-rate loan. Therefore, an increase of market interest rates would no longer affect the firms’ loan payments.

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