Why Firms Use Non-Linear Hedging Strategies

This paper examines how firms hedge, what instruments firms use and whether there are systematic differences between firms adopting different risk management strategies. I find that the decision to use non-linear hedging strategies (options strategies) is mostly a function of market conditions and to a lesser extent due to the non-linearity of the exposure. Consistent with Stulz (1996), larger firms are more likely to incorporate a market view in their risk management programs and use asymmetric hedging strategies (buy or sell options). Financially less constrained firms are more likely to buy options, while financially more constrained firms are more likely to sell options. This result is consistent with the hypothesis that financial constraints affect firms’ discount factors, and hence their hedging decisions. Finally, if market volatility is high firms are less likely to choose option strategies. This is consistent with the fact that option strategies expose a firm to volatility risk, which may be undesirable. JEL Classification: G32 ∗I would like to thank Greg Brown, Kalok Chan, Gunter Dufey, Joseph Fan, Charles Hadlock, David Haushalter, Tim Opler, Peter Tufano and seminar participants at the University of Michigan, the Hong Kong University of Science & Technology, and Nanyang Technological University of Singapore for valuable comments and suggestions. I claim responsibility for any remaining errors and omissions. I am also grateful to Ted Reeve for providing me with his derivatives surveys. Contact information: Department of Finance, HKUST, Clear Water Bay, Kowloon, Hong Kong, Tel.: (+852) 2358-7675, Fax: (+852) 2358-1749, E-mail: adam@ust.hk