the use of options in corporate

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and not all of them use all types) and, more importantly, whether they are usedappropriately.

This paper contributes to the literature by investigating the choice of derivativefinancial instruments, particularly with regard to options, by nonfinancial firms. To

this end, comprehensive evidence on derivatives use collected by the bank of international settlements (BIS) is presented, indicating that financial options accountfor 15 per cent of global derivatives turnover attributed to nonfinancial firms. Thispercentage is with 17.5 per cent and 25.2 per cent higher in the United States and theUK, respectively. Results based on statistics focusing on notional amounts outstandingare similar. Moreover, an exhaustive account of the existing evidence fromquestionnaires on derivatives usage by firms outside the financial sector is provided tocomplete the picture. Most of this evidence is based on questionnaires, such as theprominent Wharton survey in the United States and, more recently, similar polls of CFOs in other countries. This survey evidence is complemented with data based oncorporate disclosure information, since firms in many countries provide informationabout their risk management activities in general and derivatives use in particularin their reports, either required by law or voluntarily. These results confirm theobservation that firms use derivatives on a regular basis. In particular, across differentcountries, about 50-60 per cent of nonfinancial firms are reported to use derivatives,and a significant number (between 16-44 per cent) use financial options (mostly withforeign exchange rates and interest rates as underlyings).

Subsequently, theoretical rationales for the choice of derivative instruments andparticularly the use of options are explored. On a basic level, financial theory suggeststhat if and when used for hedging purposes, derivative instruments should be chosenbased on the exposure profile of the firm and the payoff characteristics of theinstrument. Thus, instruments with linear payoff profiles such as forwards, futuresand swaps are suitable for linear exposures, while the nonlinear payoff profile of options is appropriate to hedge a nonlinear exposure[1]. In general, however, optionsare very flexible hedging instruments, and portfolios of options can be constructed tohedge simple and complex, linear and nonlinear exposures. Nonlinear exposures resultif corporate cash flows are uncertain and a nonlinear function of the risk factor, such asan exchange or interest rate, for instance as a result of price and quantity risk (Stulz,2003). The optimal hedge portfolio depends on the correlation between price andquantity risk, and often involves combinations of both linear as well as nonlinearhedging instruments (Gay et al., 2001; Brown and Toft, 2002). In addition, accountingconsiderations can favor the use of options in the absence of hedge accounting.Similarly, there may be agency-related incentives to use options because of their role topresent dual bets on both direction as well as future volatilityof the underlying.

The paper is organized as follows. Section two presents a comprehensive analysis of

the existing evidence regarding which derivative instruments nonfinancial firms useand to what extent they use options. Subsequently, Section three analyzes rationalesand motivations for the use of derivatives as part of the risk management activities of nonfinancial firms and discusses when and why the use of options can be sensible.Section four presents conclusions.

2 Evidence of the use of options by nonfinancial corporationsThe use of derivative financial products, such as forwards, futures, options and swaps,has grown exponentially over the last decades (see e.g. Bartram, 2000). This is trueprimarily for over-the-counter (OTC) instruments, but also, though to a much lesser


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degree, for the smaller market of exchange-traded derivatives. According to statisticsby the Bank for International Settlement, notional amounts outstanding of OTCderivatives still grew by 38 per cent from 1998 to 2001, reaching nearly $100 trillion in June 2001 (BIS, 2002). Contracts on foreign exchange and interest rates are the mostimportant segments of the derivatives market: Notional amounts for foreign exchangecontracts accounted for $20.4 trillion, and interest rate contracts reached $75.8 trillionin 2001. While financial institutions (banks, insurance companies, etc.) account forroughly 80 per cent of the OTC market volume (Bartram et al., 2003; Allen andSantomero, 1998), derivatives transactions by nonfinancial firms are considerable interms of their absolute value.

Table I presents a breakdown of derivatives turnover attributed to nonfinancialfirms by instrument type and country. Across all countries, the largest share of derivatives transactions pertains to foreign exchange rates (82.5 per cent), whileinterest rates are much less important as underlyings (17.5 per cent). These relativedimensions are similar for the two countries with the largest share of the worldderivatives market, the United States and the UK, who account for 22.1 per cent and20.3 per cent of world market, respectively. On a global level, the fraction of turnover of foreign exchange options is 11.4 per cent, while it is 3.8 per cent for interest rateoptions. In contrast, both foreign exchange and interest rate options are being usedmore frequently in the United States (13.0 per cent and 4.5 per cent, respectively) and inthe United Kingdom (17.1 per cent and 8.1 per cent). While the derivatives turnover inother countries is much smaller in general, options turnover constitutes a moreimportant fraction of the countrys total turnover in some countries. To illustrate,foreign exchange options have high turnover in Taiwan (41.7 per cent), Bahrain (20.5per cent), Malaysia (19.6 per cent) and Ireland (19.3 per cent). By the same token,options on interest rates are a high percentage of total turnover in Luxembourg (21.9per cent), Belgium (10.7 per cent) and Mexico (9.1 per cent).

While turnover is significantly higher for foreign exchange rate derivativescompared to interest rate derivatives, the proportions are reversed for notionalamounts outstanding (Table II)[2]. Amounts outstanding on interest rate derivativesaccount for 6070 per cent of the total amount outstanding, while foreign exchangederivatives are about half (25-40 per cent). Forwards (for foreign exchange) and swaps(for interest rates) are the most popular derivatives based on notional amounts aswell, but options still account for an important percentage of total amountsoutstanding: 5.0 per cent (foreign exchange) and 14.3 per cent (interest rates) (year-end 2002).

In addition to the above statistics compiled by the BIS based on its triennial survey,various researchers have sought to provide evidence on the use of derivatives bynonfinancial firms. This data is generally collected at the user, i.e. individual firm level.Early studies rely on questionnaires about derivatives usage. Their most prominentrepresentation is the Wharton survey, which has been conducted for several years inthe United States; subsequently similar surveys have been carried out in differentcountries. In recent years, regulators have often come to require firms to discloseinformation on financial derivatives usage as part of their annual reporting. Toillustrate, firms in the United States, the UK, Canada, Australia and New Zealand aswell as firms reporting according to IAS are obliged to include such information intheir annual reports. Moreover, many firms choose to disclose data on their derivativespositions and risk management activities voluntarily. Consequently, several recent


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Table IDerivatives turnov

attributed nonfinancial firms

count

F o r e i g n e x c h a n g e d e r i v a t i v e s

I n t e r e s t r a t e d e r i v a t i v e s

C o u n t r y

P e r c e n t o f

w o r l d

P e r c e n t o f

c o u n t r y

P e r c e n t

f o r w a r d s

P e r c e n t

s w a p s

P e r c e n t

p p t i o n s

P e r c e n t o f

c o u n t r y

P e r c e n t

f o r w a r d s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

A u s t r a l i a

3 . 5

7 7 . 4

6 8 . 7

1 . 6

7 . 1

2 2 . 6

1 6 . 4

5 . 7

0 . 5

A u s t r i a

0 . 1

8 5 . 0

7 9 . 4

0 . 6

5 . 0

1 5 . 0

1 3 . 1

0 . 6

1 . 3

B a h r a i n

0 . 0

9 5 . 5

6 1 . 4

1 3 . 6

2 0 . 5

4 . 5

4 . 5

B e l g i u m

0 . 6

6 9 . 7

6 3 . 6

2 . 2

3 . 9

3 0 . 3

3 . 8

1 5 . 7

1 0 . 7

B r a z i l

0 . 6

7 8 . 7

3 9 . 9

2 7 . 4

1 1 . 4

2 1 . 3

2 . 2

1 7 . 9

1 . 1

C a n a d a

3 . 9

8 4 . 0

6 6 . 4

3 . 2

1 4 . 4

1 6 . 0

1 . 4

1 0 . 9

3 . 7

C o l o m b i a

0 . 0

1 0 0 . 0

9 4 . 1

5 . 9

C z e c h

R e p u b l i c

0 . 1

9 7 . 1

8 7 . 9

0 . 7

8 . 6

2 . 9

0 . 7

1 . 4

0 . 7

D e n m a r k

1 . 8

8 9 . 4

8 4 . 9

0 . 4

4 . 0

1 0 . 6

6 . 9

2 . 8

0 . 9

F i n l a n d

0 . 4

9 6 . 7

9 2 . 8

3 . 9

3 . 3

2 . 0

0 . 9

0 . 4

F r a n c e

2 . 5

5 9 . 4

4 9 . 2

0 . 9

9 . 3

4 0 . 6

7 . 6

2 7 . 9

5 . 0

G e r m a n y

4 . 3

5 9 . 1

5 5 . 3

0 . 9

2 . 9

4 0 . 9

7 . 4

2 8 . 8

4 . 7

G r e e c e

1 . 0

9 9 . 9

9 9 . 7

0 . 2

0 . 1

0 . 1

H o n g K o n g

1 . 8

9 5 . 2

8 4 . 3

1 . 1

9 . 7

4 . 8

1 . 0

2 . 1

1 . 6

H u n g a r y

0 . 0

1 0 0 . 0

9 0 . 2

9 . 8

I n d i a

0 . 3

9 8 . 5

9 7 . 7

0 . 6

0 . 3

1 . 5

1 . 5

I n d o n e s i a

0 . 1

9 9 . 0

9 8 . 0

1 . 0

1 . 0

1 . 0

I r e l a n d

0 . 4

8 8 . 6

6 8 . 0

1 . 3

1 9 . 3

1 1 . 4

1 . 8

5 . 7

3 . 9

I t a l y

0 . 8

7 8 . 5

6 4 . 5

2 . 0

1 2 . 0

2 1 . 5

0 . 6

1 5 . 6

5 . 4

J a p a n

8 . 5

9 1 . 3

7 6 . 5

1 . 1

1 3 . 6

8 . 7

8 . 0

0 . 8

K o r e a

0 . 5

9 9 . 5

8 4 . 6

2 . 1

1 2 . 8

0 . 5

0 . 5

L u x e m b o u r g

0 . 4

7 7 . 4

7 2 . 7

0 . 7

4 . 0

2 2 . 6

0 . 7

2 1 . 9

M a l a y s i a

0 . 3

1 0 0 . 0

8 0 . 4

1 9 . 6

M e x i c o

0 . 0

8 6 . 4

8 1 . 8

0 . 0

4 . 5

1 3 . 6

2 . 3

4 . 5

9 . 1

N e t h e r l a n d s

1 . 6

9 0 . 4

8 2 . 6

1 . 5

6 . 3

9 . 6

1 . 2

7 . 0

1 . 4

N e w Z e a l a n d

0 . 3

9 1 . 4

8 7 . 6

1 . 8

2 . 0

8 . 6

1 . 5

7 . 1

N o r w a y

0 . 6

8 1 . 5

8 0 . 2

0 . 4

0 . 9

1 8 . 5

1 6 . 0

2 . 0

0 . 5

P h i l i p p i n e s

0 . 1

1 0 0 . 0

9 7 . 9

2 . 1

P o r t u g a l

0 . 1

9 2 . 7

9 0 . 1

2 . 6

7 . 3

7 . 3

( c o n t i n u e d )


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Table I.

F o r e i g n e x c h a n g e d e r i v a t i v e s

I n t e r e s t r a t e d e r i v a t i v e s

C o u n t r y

P e r c e n t o f

w o r l d

P e r c e n t o f

c o u n t r y

P e r c e n t

f o r w a r d s

P e r c e n t

s w a p s

P e r c e n t

p p t i o n s

P e r c e n t o f

c o u n t r y

P e r c e n t

f o r w a r d s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

S a u d i A r a b i a

0 . 1

9 8 . 8

8 4 . 7

1 4 . 1

1 . 2

1 . 2

S i n g a p o r e

6 . 6

9 9 . 2

9 0 . 7

0 . 2

8 . 2

0 . 8

0 . 1

0 . 5

0 . 2

S o u t h A f r i c a

0 . 8

9 9 . 7

9 6 . 8

2 . 9

0 . 3

0 . 2

0 . 1

S p a i n

0 . 5

8 0 . 1

5 7 . 1

1 0 . 1

1 2 . 9

1 9 . 9

1 . 2

1 2 . 3

6 . 5

S w e d e n

5 . 4

8 1 . 7

8 0 . 3

0 . 3

1 . 0

1 8 . 3

1 7 . 3

1 . 0

0 . 1

S w i t z e r l a n d

8 . 6

9 9 . 4

8 5 . 8

0 . 0

1 3 . 5

0 . 6

0 . 4

0 . 1

0 . 0

T a i w a n

0 . 5

9 7 . 7

5 5 . 5

0 . 5

4 1 . 7

2 . 3

1 . 8

0 . 5

T h a i l a n d

0 . 2

9 8 . 0

9 2 . 9

4 . 1

1 . 0

2 . 0

2 . 0

U K

2 0 . 3

8 0 . 1

6 0 . 7

2 . 3

1 7 . 1

1 9 . 9

2 . 9

8 . 9

8 . 1

U S A

2 2 . 1

7 8 . 6

6 5 . 2

0 . 3

1 3 . 0

2 1 . 4

1 . 4

1 5 . 5

4 . 5

W o r l d

1 0 0 . 0

8 2 . 5

6 9 . 7

1 . 3

1 1 . 4

1 7 . 5

3 . 6

1 0 . 2

3 . 8

N o t e s : T h i s t a b l e r e p o r t s d e r i v a t i v e s u s a g e b a s e d o n t h e b a n k f o r i n t e r n a t i o n a l s e t t l e m e n t s ( B I S ) t r i e n n i a l s u r v e y s . T h e s t a t i s t i c s a r e b a s e d o n d a i l y

a v e r a g e s o f O T C d e r i v a t i v e s t u r n o v e r ( i n m i l l i o n s o f U S d o l l a r s ) w i t h n o n f i n a n c i a l c u s t o m e r s b y c o u n t r y i n A p r i l 2 0 0 1

, n e t o f l o c a l i n t e r - d e a l e r d o u b l e -

c o u n t i n g . T h e f i r s t c o l u m n r e p o r t s t h e f r a c t i o n ( i n p e r c e n t ) o f t h e t o t a l O T C t u r n o v e r p e r c o u n t r y r e l a t i v e t o t h e w o r l d t o t a l . T h e f o l l o w i n g c o l u m n s

r e p o r t t h e t u r n o v e r o f d i f f e r e n t i n s t r u m e n t s ( f o r w a r d s

, s w a p s , o p t i o n s ) b y u n d e r l y i n g ( f o r e i g n e x c h a n g e r a t e s , i n t e r e s t r a t e s ) r e l a t i v e t o t h e c o u n t r y t o t a l .

F o r e i g n e x c h a n g e f o r w a r d s i n c l u d e o u t r i g h t f o r w a r d s a n d f o r e i g n e x c h a n g e s w a p s a n d a r e c a l c u l a t e d a s t h e d i f f e r e n c e b e t w e e n t h e c o u n t r y t o t a l a n d t h e

s u m o f o p t i o n s a n d c u r r e n c y s w a p s . I n t e r e s t r a t e d e r i v a t i v e s r e f e r t o s i n g l e c u r r e n c y i n t e r e s t r a t e i n s t r u m e n t s

. M i s s i n g v a l u e s a r e d e n o t e d b y

( r e p o r t e d s i z e o f t h e p o s i t i o n i s z e r o ) . T h e t a b l e i s b a s e d o n t h e f o l l o w i n g t a b l e s o f t h e 2 0 0 1 B I S T r i e n n i a l S u r v e y ( B I S

, 2 0 0 1 ) : E . 2

7 , E . 2 8

, E . 2 9 , E . 3 2

, E . 3

3 ,

E . 3 4 a n d E . 3 5


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studies have collected information on derivatives usage by nonfinancial firms on thebasis of their annual reports.

Table III reports the results of these studies, with Panel A referring to generalderivatives use, and Panels B, C and D pertaining to foreign exchange rate, interest rateand commodity price derivatives, respectively. As one of the first studies, Nance et al.(1993) study 169 US non-financial firms in a survey and report 62 per cent of them asusing derivatives (Panel A). Mian, (1996) studies a large sample of 3,022 firms andfinds percentages of derivatives users of 26 per cent for all derivatives, 15 per cent forcurrency, 15 per cent for interest rate and 5 per cent for commodity price derivatives.Similarly, in an analysis of the derivatives use of 372 Fortune 500 firms, Geczy et al.(1997) report derivatives usage by 59 per cent and 41 per cent for general derivatives

use and foreign exchange rate derivatives, respectively. In the 1998 Wharton survey,Bodnar et al., (1998) find that in a sample of 399 US non-financial firms, 50 per cent usederivatives. In particular, 42 per cent use foreign exchange, 38 per cent use interest rate,and 28 per cent use commodity price derivatives. A study of 451 firms by Howton andPerfect, (1998) results in percentages of derivatives use of 62 per cent for all derivativescontracts, 45 per cent for FX derivatives, and 45 per cent for interest rate derivatives.The most recent and most comprehensive study on derivatives usage based onaccounting information is Bartram et al., (2003), covering a sample of 7,263 firms in 48countries. While there is variation across countries and industries, roughly 60 per centof the firms use derivatives across the entire sample. Derivatives use is most frequent

Table IINotional amounts

derivatives outstandinwith nonfinancial firm

1995 1998 2001 2002

Foreign exchange (total) 42.1 40.3 35.9 25.3Forwards and FX swaps 24.1 24.7 20.3 12.8Currency swaps 10.6 0.6 9.8 7.4Options 7.4 14.9 5.8 5.0

Bought 3.5 6.7 3.1Sold 3.9 8.2 2.7

Interest rates (total) 57.9 57.1 60.7 71.5Forwards 4.3 5.2 6.8 4.2Swaps 42.0 38.1 40.8 53.0Options 11.5 13.8 13.1 14.3

Bought 4.7 5.8 4.6Sold 6.8 8.0 8.5

Equity (total) 3.5 3.7 3.2Forwards and swaps 0.6 0.6 0.7Options 2.0 2.0 2.5

Bought 0.8 1.1

Sold 1.2 0.9Other (total) 0.3 0.8

Notes: This table reports derivatives usage based on the bank for international settlements (BIS)triennial surveys and quarterly reviews. The statistics are based on global amounts outstandingof OTC derivatives with nonfinancial customers at the end of June 1995, 1998, 2001 and at theend of December 2002. The table shows the fraction (in per cent) of notional amounts outstandingattributed to different underlyings (foreign exchange, interest rate, equity) and instruments(forwards, swaps, options). The data is obtained from the following tables: Panel A, tables E.49 in2001 BIS (2001) and 20A in BIS (2003). Panel B, tables E.28, E.29, E.33, E.34, and E.35 in 2001BIS (2002), tables E-10, E-11, E-28, E.29, E-33, E-34, and E-35 in 1998 BIS (1999), and tables 1-J,1-K, 9-I, 9-J, 10-E, 10-F, and 10-G in 1995 BIS (1996)


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Table III.Survey evidence of derivatives use bynonfinancialcorporations

S t u d y

S o u r c e S a m p l e

C o u n t r y

P e r c e n t

d e r i v a t i v e s

P e r c e n t

f o r w a r d s

p e r c e n t

f u t u r e s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

P e r c e n t

e x o t i c /

o t h e r

P a n e l

A :

F o r e i g n e x c h a n g e r a t e d e r

i v a t i v e s u s e

B a r t r a m e t a

l . , 2 0 0 3

A R

7 2 6 3 f i r m s

4 8 c o u n t r i e s

6 0 . 3

3 7 . 9

4 . 4

3 2 . 1

1 6 . 3

E l - M a s r y , 2

0 0 3

Q

1 7 3 f i r m s

U K

6 7 . 0

2 9 . 0

1 3 . 0

2 3 . 0

4 6 . 1

8 . 0

[ 6 . 0

/ 2 . 0

]

G u a y a n d K o t h a r i , 2 0 0 3

A R

4 1 3 f i r m s

U S A

5 6 . 7

B e r k m a n e t a

l . , 2 0 0 2

A R

1 5 8 m i n i n g a n d

i n d u s t r i a l f i r m s

A u s t r a l i a

5 5 . 7

G r a h a m a n d R o g e r s , 2

0 0 2

A R

4 4 2 f i r m s

U S A

3 5 . 7

J u d g e , 2 0 0 2

A R , Q

5 9 8 F T 5 0 0 f i r m s

U K

7 0 . 6

5 2 . 0

4 . 0

4 6 . 3

2 7 . 8

N g u y e n a n d F a f f , 2 0 0 2

A R

4 6 9 f i r m s

A u s t r a l i a

7 4 . 2

5 6 . 3

5 6 . 1

2 7 . 1

S h e e d y

, 2 0 0 2

Q

1 3 1 f i r m s

S i n g a p o r e ,

H o n g K o n g

7 8 . 0

2 2 . 9

a

B o d n a r e t a

l . , 2 0 0 1

Q

8 4 f i r m s ( A S E )

T h e N e t h e r l a n d s

5 9 . 5

5 7 . 7

2 . 0

2 8 . 6

2 0 . 3

[ 1 9 . 3 / 1

. 0 ]

8 . 8

[ 6 . 9

/ 1 . 9

]

H e n t s c h e l a n d K o t h a r i , 2 0 0 1

A R

4 2 5 F o r t u n e 5 0 0

U S A

5 1 . 4

M a l l i n e t a

l . 2 0 0 1

Q

2 3 1 f i r m s ( L S E )

U K

5 9 . 9

D e C e u s t e r , D u r i n c k ,

L a v e r e n , L o d e w y c k x

, 2 0 0 0

Q

7 3 f i r m s

B e l g i u m

6 5 . 8

F a t e m i a n d G l a u m , 2

0 0 0

Q

7 1 f i r m s ( F S E )

G e r m a n y

8 8 . 0

P r e v o s t e t a

l . , 2 0 0 0

Q

1 5 5 f i r m s ( N Z S E )

N e w Z e a l a n d

6 7 . 1

1 4 . 4

2 . 7

3 0 . 2

3 3 . 6

0 . 7

A l k e b a c k , H a g e l i n

, 1 9 9 9

Q

1 6 3 f i r m s ( S S E )

S w e d e n

5 1 . 5

B o d n a r a n d G e b h a r d t , 1 9 9 9

Q

1 2 6 f i r m s

G e r m a n y

7 7 . 8

G u a y , 1 9 9 9

A R

4 9 6 6 f i r m s

U S A

3 7 . 2

J a l i l v a n d , 1

9 9 9

Q

1 5 4 f i r m s ( M S E )

C a n a d a

7 5 . 3

B o d n a r e t a

l . , 1 9 9 8

Q

3 9 9 f i r m s

U S A

5 0 . 0

3 4 . 0

H o w t o n a n d P e r f e c t , 1 9 9 8

A R

4 5 1 f i r m s

U S A

6 1 . 7

2 5 . 8

2 7 . 9

9 . 3

B e r k m a n e t a

l . , 1 9 9 7

Q

7 9 f i r m s ( N Z S E )

N e w Z e a l a n d

5 3 . 1

G e c z y e t a

l . 1 9 9 7

A R

3 7 2 f i r m s

U S A

5 9 . 1



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Table III. S t u d y


C o u n t r y

P e r c e n t


P e r c e n t

f o r w a r d s

p e r c e n t

f u t u r e s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

P e r c e n t

e x o t i c /

o t h e r

B o d n a r e t a

l . , 2 0 0 1

Q

1 2 6 f i r m s ( A S E )


5 7 . 1

4 3 . 9

0 . 0

1 . 1

6 . 9

[ 6 . 9

/ 0 . 0 ]

5 . 1

[ 4 . 0

/ 1 . 1

]

M a l l i n e t a

l . , 2 0 0 1

Q

2 3 1 f i r m s ( L S E )

U K

4 6 . 8

3 . 9

1 7 . 3

2 1 . 2

[ 1 9 . 0 / 2 . 2 ]

D e C e u s t e r , D u r i n c k , L

a v e r e n ,

L o d e w y c k x

, 2 0 0 0

Q

7 3 f i r m s

B e l g i u m

6 4 . 4

5 9 . 8

4 7 . 3

5 2 . 3

[ 4 6 . 1 / 6 . 2 ]

1 2 . 5


0 0 0

Q

7 1 f i r m s ( F S E )

G e r m a n y

8 3 . 6

2 2 . 0

J a l i l v a n d a n d S w i t z e r , 2

0 0 0

Q

1 5 4 f i r m s ( M S E )

C a n a d a

6 7 . 5

L o d e r e r a n d P i c h l e r , 2 0 0 0

Q

1 1 4 f i r m s ( Z S E )

S w i t z e r l a n d

8 4 . 4

4 4 . 0

1 2 . 9

[ 1 0 . 3 / 2 . 6 ]

P r e v o s t e t a

l . , 2 0 0 0

Q

1 5 5 f i r m s ( N Z S E )

N e w Z e a l a n d

5 3 . 7

1 . 7

1 4 . 3

2 9 . 4 [ 2 9 . 4 / 0 . 0 ]

A l k e b a c k a n d H a g e l i n

, 1 9 9 9

Q

1 6 3 f i r m s ( S S E )

S w e d e n

9 3 . 0

2 3 . 2

2 3 . 2

2 2 . 7

1 3 . 1

[ 1 0 . 3 / 2 . 8 ]


Q

1 2 6 f i r m s

G e r m a n y

7 4 . 6

G u a y , 1 9 9 9

A R

4 9 6 6 f i r m s

U S A

3 3 . 5

1 . 0

B o d n a r e t a

l . , 1 9 9 8

Q

3 9 9 f i r m s

U S A

4 1 . 5

2 2 . 0

G a y a n d N a m , 1

9 9 8

A R

4 8 6 f i r m s

U S A

2 8 . 4

1 0 . 1

9 . 3


A R

4 5 1 f i r m s

U S A

4 5 . 0

3 9 . 9

1 0 . 9

1 2 . 0

B e r k m a n e t a

l . , 1 9 9 7

Q

7 9 f i r m s ( N Z S E )

N e w Z e a l a n d

3 8 . 3

2 . 3

1 5 . 3

2 4 . 4

[ 1 6 . 5 / 7 . 9 ]

G e c z y e t a

l . , 1 9 9 7

A R

3 7 2 f i r m s

U S A

4 1 . 4

2 9 . 3

1 2 . 1

G r a n t a n d M a r s h a l l , 1 9 9 7

Q

5 5 f i r m s

U K

4 6 . 9

K h i m a n d L i a n g , 1 9 9 7

Q

6 9 f i r m s

S i n g a p o r e

6 5 . 2

6 2 . 3

3 3 . 3

5 2 . 1

[ 0 . 0

/ 5 2 . 1 ]

1 5 . 9

B o d n a r e t a

l . , 1 9 9 6

Q

3 5 0 f i r m s

U S A

3 0 . 9

2 3 . 9

9 . 0

1 2 . 1

2 0 . 4

[ 1 5 . 5 / 4 . 9 ]

7 . 7

[ 5 . 5

/ 2 . 2

]

M i a n , 1 9 9 6

A R

3 0 2 2 f i r m s

U S A

1 4 . 6



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Table III S t u d y


C o u n t r y

P e r c e n t


P e r c e n t

f o r w a r d s

p e r c e n t

f u t u r e s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

P e r c e n t

e x o t i c /

o t h e r

B o d n a r e t a

l . , 1 9 9 5

Q

5 3 0 f i r m s

U S A

1 2 . 7

2 . 3

5 . 8

9 . 2

[ 6 . 7

/ 2 . 5 ]

P h i l l i p s , 1 9 9 5

Q

6 5 7 f i r m s

U S A

4 7 . 6

3 6 . 9

4 . 1

1 5 . 2

1 4 . 0

B a t t e n e t a

l . , 1 9 9 3

Q

9 4 f i r m s

A u s t r a l i a

7 6 . 6

3 9 . 4

4 . 3

2 2 . 3

2 0 . 2

2 . 1

P a n e l

C :

I n t e r e s t r a t e d e r

i v a t

i v e s u s e

B a r t r a m e t a

l . , 2 0 0 3

A R

7 2 6 3 f i r m s


3 3 . 0

0 . 7

0 . 5

2 9 . 0

7 . 4

E l - M a s r y , 2

0 0 3

Q

1 7 3 f i r m s

U K

3 1 . 5

3 . 2

3 . 2

1 7 . 6

2 0 . 4

1 2 . 4 [ 8

. 5 / 3

. 9 ]

G u a y a n d K o t h a r i , 2 0 0 3

A R

4 1 3 f i r m s

U S A

3 4 . 6

2 . 2

3 3 . 2

3 . 6

B e r k m a n e t a

l . , 2 0 0 2

A R

1 5 8 m i n i n g a n d


A u s t r a l i a

2 3 . 4

G r a h a m a n d R o g e r s , 2

0 0 2

A R

4 4 2 f i r m s

U S A

2 4 . 9

J u d g e , 2 0 0 2

A R , Q

1 3 1 F T 5 0 0 f i r m s

U K

5 4 . 2

3 1 . 3

1 8 . 4

4 1 . 7

N g u y e n a n d F a f f , 2 0 0 2

A R

4 6 9 f i r m s

A u s t r a l i a

5 1 . 0

S h e e d y

, 2 0 0 2

Q

8 4 f i r m s

S i n g a p o r e ,

H o n g K o n g

5 4 . 6

2 7 . 3

B o d n a r e t a

l . , 2 0 0 1

Q

1 2 6 f i r m s ( A S E )


4 8 . 2

1 3 . 5

1 . 4

2 5 . 1

8 . 2

[ 8 . 2

/ 0 . 0 ]

8 . 2

M a l l i n e t a

l . , 2 0 0 1

Q

2 3 1 f i r m s ( L S E )

U K

0 . 9

0 . 9

3 4 . 6

1 0 . 8

[ 9 . 5

/ 1 . 3 ]

D e C e u s t e r , D u r i n c k ,

L a v e r e n , L o d e w y c k x

, 2 0 0 0

Q

7 3 f i r m s

B e l g i u m

5 6 . 2

3 1 . 6

2 5 . 0

4 9 . 0

2 8 . 8

[ 2 6 . 1 / 2

. 7 ]

1 8 . 5


0 0 0

Q

7 1 f i r m s ( F S E )

G e r m a n y

7 1 . 0


0 0 0

Q

1 5 4 f i r m s ( M S E )

C a n a d a

6 0 . 4

P r e v o s t e t a

l . 2 0 0 0

Q

1 5 5 f i r m s ( N Z S E )

N e w Z e a l a n d

2 6 . 0

6 . 7

4 9 . 5

5 1 . 8 [ 4 9 . 3 / 2

. 5 ] (

c o n t i n u e d )


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C o u n t r y

P e r c e n t


P e r c e n t

f o r w a r d s

p e r c e n t

f u t u r e s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

P e r c e n t

e x o t i c /

o t h e r


, 1 9 9 9

Q

1 6 3 f i r m s ( S S E )

S w e d e n

2 5 . 8

6 . 7

1 3 . 9

2 3 . 2

9 . 3

[ 3 . 6

/ 5 . 7 ]


Q

1 2 6 f i r m s

G e r m a n y

6 9 . 1

G u a y , 1 9 9 9

A R

4 9 6 6 f i r m s

U S A

5 1 . 2

B o d n a r e t a

l . , 1 9 9 8

Q

3 9 9 f i r m s

U S A

3 8 . 0

2 2 . 0

3 2 . 5

1 4 . 0

G a y a n d N a m 1 9 9 8

A R

4 8 6 f i r m s

U S A

5 . 3

4 3 . 2

1 4 . 6


A R

4 5 1 F o r t u n e 5 0 0 f i r m s

U S A

4 5 . 4

4 . 9

2 7 . 3

4 . 9

B e r k m a n e t a

l . , 1 9 9 7

Q

7 9 f i r m s ( N Z S E )

N e w Z e a l a n d

2 1 . 8

1 5 . 9

[ 1 5 . 9 / 0

. 0 ]


Q

5 5 f i r m s

U K

3 4 . 4

K h i m a n d L i a n g , 1 9 9 7

Q

6 9 f i r m s

S i n g a p o r e 4 2 . 0

3 7 . 7

3 9 . 1

3 0 . 4

B o d n a r e t a

l . , 1 9 9 6

Q

3 5 0 f i r m s

U S A

2 9 . 6

5 . 3

6 . 8

2 8 . 1

1 0 . 1

[ 8 . 3

/ 1 . 8 ]

M i a n , 1 9 9 6

A R

3 0 2 2 f i r m s

U S A

1 4 . 5

B o d n a r e t a

l . , 1 9 9 5

Q

5 3 0 f i r m s

U S A

2 . 5

1 . 0

1 7 . 7

5 . 1

[ 3 . 0

/ 2 . 1 ]

P h i l l i p s , 1 9 9 5

Q

6 5 7 f i r m s

U S A

5 7 . 1

9 . 2

2 . 4

3 7 . 1

6 . 8

1 9 . 5

H a k k a r a i n e n , K

a s a n e n ,

P u t t o n e n , 1 9 9 7

A R , Q

8 4 f i r m s ( H S E )

F i n l a n d

1 8 . 0

7 1 . 0

4 5 . 0

3 4 . 0

B l o c k a n d G a l l a g h e r , 1

9 8 6

Q

1 9 3 F o r t u n e 5 0 0 f i r m s

U S A

1 9 . 2

P a n e l D : C o m m o d i t y p r i c e d e r i v a t i v e s u s e

B a r t r a m e t a

l . , 2 0 0 3

A R

7 2 6 3 f i r m s


1 0 . 0

2 . 8

3 . 1

2 . 9

2 . 4

B r o w n , C r a b b , H a u s h a l t e r , 2 0 0 3

A R , Q

4 4 g o l d m i n i n g f i r m s

U S A

, C a n a d a

8 4 . 6

E l - M a s r y , 2

0 0 3

Q

1 7 3 f i r m s

U K

6 . 0

1 . 0

1 . 0

1 . 1

2 . 9

G u a y a n d K o t h a r i , 2 0 0 3

A R

4 1 3 f i r m s

U S A

8 . 7

6 . 1

3 . 1

B e r k m a n e t a

l . , 2 0 0 2

A R

1 5 8 m i n i n g a n d


A u s t r a l i a

1 7 . 7



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171

Table III S t u d y


C o u n t r y

P e r c e n t


P e r c e n t

f o r w a r d s

p e r c e n t

f u t u r e s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

P e r c e n t

e x o t i c /

o t h e r

J u d g e , 2 0 0 2

A R , Q

1 3 1 F T 5 0 0 f i r m s

U K

1 4 . 8

N g u y e n a n d F a f f , 2 0 0 2

A R

4 6 9 f i r m s

A u s t r a l i a

2 6 . 4

S h e e d y

, 2 0 0 2

Q

8 4 f i r m s

S i n g a p o r e ,

H o n g K o n g

1 4 . 8

B o d n a r e t a

l . , 2 0 0 1

Q

1 2 6 f i r m s ( A S E )


1 1 . 9

0 . 0

0 . 7

2 . 1

5 . 6

[ 4 . 2

/ 1 . 4 ]

3 . 6

[ 2 . 9

/ 0 . 7

]

M a l l i n e t a

l . , 2 0 0 1

Q

2 3 1 f i r m s ( L S E )

U K

0 . 4

3 . 0

3 . 0

2 . 6

[ 1 . 3

/ 1 . 3 ]

D e C e u s t e r , D u r i n c k , L

a v e r e n ,

L o d e w y c k x

, 2 0 0 0

Q

7 3 f i r m s

B e l g i u m

1 1 . 0

H a u s h a l t e r , 2 0 0 0

A R , Q

1 0 0 o i l a n d g a s f i r m s

U S A

5 7 . 0

4 4 . 1

2 9 . 0


0 0 0

Q

1 5 4 f i r m s ( M S E )

C a n a d a

2 5 . 3

P r e v o s t e t a

l . , 2 0 0 0

Q

1 5 5 f i r m s ( N Z S E )

N e w Z e a l a n d

4 . 2

3 . 3

2 . 1

1 . 7

[ 1 . 7

/ 0 . 0 ]


, 1 9 9 9

Q

1 6 3 f i r m s ( S S E )

S w e d e n

6 . 2

1 . 0

3 . 1

2 . 1

1 . 5

[ 1 . 0

/ 0 . 5 ]


Q

1 2 6 f i r m s

G e r m a n y

3 4 . 2

G u a y , 1 9 9 9

A R

4 9 6 6 f i r m s

U S A

2 0 . 9

B o d n a r e t a

l . , 1 9 9 8

Q

3 9 9 f i r m s

U S A

2 8 . 0

1 4 . 0

G a y a n d N a m , 1

9 9 8

A R

4 8 6 f i r m s

U S A

5 . 8

7 . 2

4 . 3

B e r k m a n e t a

l . , 1 9 9 7

Q

7 9 f i r m s ( N Z S E )

N e w Z e a l a n d

3 . 6

9 . 5

4 . 7

2 . 3

[ 2 . 3

/ 0 . 0 ]


Q

5 5 f i r m s

U K

1 5 . 0

B o d n a r e t a

l . , 1 9 9 6

Q

3 5 0 f i r m s

U S A

1 5 . 0

7 . 8

9 . 9

8 . 1

9 . 2

[ 6 . 5

/ 2 . 7 ]

1 . 8

[ 1 . 7

/ 0 . 1

]

M i a n , 1 9 9 6

A R

3 0 2 2 f i r m s

U S A

5 . 2

T u f a n o , 1

9 9 6

A R , Q

4 8 g o l d m i n i n g f i r m s

U S A

8 5 . 4

6 4 . 6



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MF32,2

172



C o u n t r y

P e r c e n t


P e r c e n t

f o r w a r d s

p e r c e n t

f u t u r e s

P e r c e n t

s w a p s

P e r c e n t

o p t i o n s

P e r c e n t

e x o t i c /

o t h e r

B o d n a r e t a

l . , 1 9 9 5

Q

5 3 0 f i r m s

U S A

3 . 9

4 . 4

3 . 0

6 . 7

[ 3 . 9

/ 2 . 8 ]

P h i l l i p s , 1 9 9 5

Q

6 5 7 f i r m s

U S A

2 3 . 1

9 . 2

5 . 5

4 . 6

4 . 8

N o t e s : T h e t a b l e s h o w s f o r e a c h e m p i r i c a l s t u d y t h e d a t a s o u r c e ( A R = a n n u a l r e p o r t ,

Q = q u e s t i o n n a i r e ) , s a m p l e s i z e ,

t h e c o u n t r y

s t u d i e d , t h e

p e r c e n t a g e o f f i r m s u s i n g d e r i v a t i v e s ( i n g e n e r a l ) , a s w e l l a s t h e p e r c e n t a g e o f f i r m s u s i n g p a r t i c u l a r i n s t r u m e n t s

. F o r o p t i o n s ,

p e r c e n t a g e s o n O T C

o p t i o n s a n d e x c h a n g e - t r a d e d o p t i o n s a r e r e p o r t e d i n b r a c k e t s

. S i m i l a r l y , t

h e s t a t i s t i c s f o r s t r u c t u r e d d e r i v a t i v e s a n d h y b r i d d e b t a r e r e p o r t e d i n b r a c k e t s

f o r e x o t i c / o t h e r d e r i v a t i v e s . P a n e l A r e f e r s t o g e n e r a l d e r i v a t i v e s u s e , P a n e l B t o f o r e i g n e x c h a n g e r a t e d e r i v a t i v e s , P

a n e l C t o i n t e r e s t r a t e d e r i v a t i v e s ,

a n d P a n e l D t o c o m m o d i t y p r i c e d e r i v a t i v e s ; a E x c l u d i n g c o m m o d i t y p r i c e o p t i o n s


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for foreign exchange rate risk (45 per cent), followed by interest rate risk (33 per cent)and commodity price risk (10 per cent).

With regard to the instruments used, about 15-30 per cent of all firms use options.Bartram et al., (2003) find about 16 per cent of the nonfinancial firms in their global

sample using options. The survey evidence also suggests that there is substantialvariation across countries. To illustrate, options are more popular risk managementinstruments in the United States (32 per cent in Phillips, 1995; 34 per cent in Bodnar et al. 1998) and in the UK (44 per cent in Grant and Marshall, 1997) (Table III, Panel A).The choice of instrument also varies across underlyings. Based on evidence for a globalsample, nonfinancial firms mostly use forwards (36 per cent) to manage foreignexchange rate risk, while swaps (11 per cent) and options (10 per cent) are less popular(Bartram, et al., 2003). For interest rate risk management, swaps are used mostfrequently (29 per cent); interest rate options are used as well, but less often (seven percent). Commodity price derivatives are generally used less frequently, and there are fewdifferences across different instruments (3 per cent for futures; 2 per cent for options),with some variation across industries. Survey evidence corroborates that options areused more often to manage foreign exchange rate risk (e.g. by 44 per cent in the UK(El-Masry, 2003), or 22 per cent in the United States (Bodnar et al., 1998)) (Table 3, PanelB). In contrast, options are less popular when interest rates are the underlying (20 percent in the UK (El-Masry, 2003), 14 per cent in the United States (Bodnaret al., 1998)).

To summarize, nonfinancial firms have come to use financial derivatives on aregular basis, as demonstrated by the statistics on derivatives usage. This pertainsprimarily to instruments on foreign exchange rate and interest rate risk and includes avariety of instruments, most important of which are basic derivatives products(forwards, futures, options and swaps). Derivatives use can be interpreted as a proxyfor corporate risk management, and various theories have established a case forhedging at the firm level of nonfinancial firms in order to increase shareholder value.These hedging motives are generally based on capital market imperfections such asfinancial distress (Smith and Stulz, 1985; Shapiro and Titman, 1986; Stulz, 1996), taxes(Smith and Stulz, 1985), underinvestment problems (Myers, 1977; Bessembinder, 1991;Froot, Scharfstein and Stein, 1993) or management incentives (Stulz, 1984; Stulz, 1990;Mayers and Smith, 1982). Several studies put these theories to a test and find some,though limited empirical support (e.g. Nance et al., 1993; Mian, 1996; Geczy et al., 1997).

Although it is thus evident that nonfinancial firms use a variety of instruments aspart of their risk management activities, little is known about the motivations of nonfinancial firms to choose particular types of derivative instruments. Consequently,rationales for the choice of derivatives in general and the use of options in particularfor corporate risk management are explored in the next section.

3 Rationales for the use of options in corporate risk managementWhile nonfinancial firms could use financial derivatives for speculative as well as forhedging purposes, the existing empirical evidence suggests that derivatives are beingused mostly to reduce (rather than increase) financial exposures at the firm level. On afundamental level, nonfinancial firms around the world that use foreign exchange ratederivatives generally have higher foreign sales, foreign income and foreign assets, andfirms that use interest rate derivatives have higher leverage compared to nonusers(Bartram et al., 2003). There is also direct evidence from a sample of S and P 500nonfinancial firms that the use of currency derivatives significantly reduces theirexchange rate exposure (Allayannis andOfek, 2001). Hentschel andKothari (2001)show


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that derivatives users have few if any measurable differences in risk (measured by thevolatility of a firms stock price or its exposures to variations in exchange rates andinterest rates) associated with the use of derivatives compared to firms that do not usederivatives,which suggests that derivatives are notbeing used forspeculative purposes.

Similarly, for a global sample of firms, Bartram (2003) shows that consistent withhedging motives of corporate derivatives use users of derivatives havehighergross (orpre-hedging) exposures, but significantlylower net (or post-hedging) exposures andalsoshow significantly lowerstock returnvolatilitiescompared to non-users. Along thesamelines, evidence in Brown et al., (2003) suggests that the economic significance of speculative componentsof selectivehedging is small.

Provided that nonfinancial firms generally appear to use derivatives with theoverall intention to reduce their exposures, financial theory seems on first sight toprovide clear guidance regarding the choice of instrument. On a basic level, riskmanagement theory suggests the nature of the exposure to determine the appropriaterisk management instrument. In particular, derivatives that have a linear payoff profile (forwards, futures, swaps, etc.) would seem suitable to hedge a linear exposure,while nonlinear exposures would call for the use of instruments with nonlinear payoff profiles (such as options and portfolios of options) related to the very same underlyingrisk factor in order to achieve variance minimization (see e.g. Stulz, 2003; Smithson,1998). Exposures are linear as opposed to nonlinear if they do not change for variationsin the risk factors, i.e. if they are independent of them. The classic example of a linearexposure is a foreign currency receivable (without default risk), as the amount at risk inforeign currency is independent of the exchange rate.

While nonlinear exposures have generally received relatively little attention in theliterature, financial theory suggests several situations that give rise to a nonlinear orasymmetric effect of financial risks on firm value (Bartram, 2004). In particular,nonlinear exposures exist if corporate cash flows (and thus firm value) are a nonlinearfunction of the considered risk factor(s). As a result, the exposure itself is a function of the risk factors and thus random/uncertain, e.g. when a firm faces price as well asquantity risk that are not perfectly correlated, so that the exposure is contingent on therisk factor. For example, the cash flows of nonfinancial firms can depend on foreignexchange rates in a nonlinear fashion, because foreign currency appreciations lead toboth a higher number of units sold abroad and to higher home currency cash flows perunit sold, rendering the exposure a function of the exchange rate (Stulz, 2003; Sercuand Uppal, 1995). While these arguments have been mostly made with regard toexchange rate risk, they extend in principle to other sources of risk (such as changes ininterest rates and commodity prices) as well. To illustrate, the interest rate exposure of a fixed-income security changes with the level of interest rates, i.e. the convexity of duration.

Exchange rate movements often also prompt firms to react with operative decisions,such as shifting sourcing and production between countries, if import, export andproduction decisions are flexible (Adam-Mu ller and Wong, 2002; Kogut and Kulatilaka,1994; Ware and Winter, 1988). In general, operative flexibility represents a real optionto the firm that has by definition a nonlinear payoff. The exposure is also asymmetric if exporting firms use greater pricing-to-market during periods of foreign currencyappreciations in order to build market share (subject to the threat of trade restrictions).Alternatively, capacity constraints and quantitative trade restrictions can causeexporting firms to apply greater pricing-to-market during periods of foreign currencydepreciations (Knetter, 1994). As a result of export price adjustments, the cash flow and


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value of an exporting firm is a convex function of the exchange rate (Sercu and Uppal,1995). If firms use multiple currency price lists, they effectively grant an option, whichhas a nonlinear payoff profile, to their customers (Kanas, 1996a; Kanas, 1996b; Giddyand Dufey, 1995). The effect of currency movements is also one-sided with regard to

default risk, thus inducing a nonlinear exposure.While linear derivative instruments are suitable to hedge linear exposures as astatic hedge (i.e. without changing the hedge until its maturity), they can also be usedfor a delta hedge of a nonlinear exposure. Nevertheless, this entails the rapid andcontinuous adjustment of the derivatives hedge position as the risk factor changes(dynamic hedge), and it requires subsequent changes in the risk factor to be small, asthe hedge only works well for small risk changes. For a static linear hedge of anonlinear exposure, the effectiveness of the hedge depends significantly on thecorrelation between price and quantity risk (Stulz, 2003). As a result, forwards andfutures are often not the best choice of derivative instrument to hedge nonlinearexposures with regard to variance minimization.

Options, in contrast, are very versatile risk management instruments that can beused well to hedge various types of exposure. They can not only be combined into astatic portfolio to replicate linear derivative instruments in order to hedge linearexposures, but options and portfolios of options can be used effectively to hedge(complex) nonlinear exposures as well. In particular, static option positions can becreated that hedge nonlinear exposures significantly better than static positions of linear derivatives such as forwards and futures (Stulz, 2003). This makes them veryflexible and valuable risk management tools. In fact, almost any arbitrary payoff function can be hedged with a piecewise linear approximation using a tailored portfolioof options. While short-term corporate cash flows may have little uncertainty and canbe hedged effectively with linear derivatives, most future corporate cash flows bearprice and quantity risk, resulting in nonlinear exposures that make a case for the use of options in corporate risk management.

Options are often also used as insurance against unfavorable market movements,i.e. to eliminate downside risk while keeping the upside potential. For example, firmswith floating rate debt buy interest rate caps when they expect interest rates to rise inorder to limit the cost of borrowing, while allowing them to benefit from lower fundingcost when interest rates decrease. Similarly, firms can enter into floors to protect theincome from variable-rate investments. The choice of using swaps or caps/floors isoften based on the firms view of future interest rates. However, the use of options inthis case, while protecting the position against losses, is not a hedge in a varianceminimizing sense. In fact, options are suitable instruments to create a speculativeposition in the guise of hedging, e.g. when options are used to hedge linear exposures(Giddy and Dufey, 1995)[3]. Finally, it can also be sensible for firms to buy put options

on their own stocks in order to reduce financial constraints in bad states of theworld[4].Recent research directly models the choice of a value-maximizing firm to use linear

(forwards) and nonlinear (options and custom/exotic) derivative contracts in thepresence of price and quantity risk (Brown and Toft, 2002). The use of a variety of derivatives appears consistent with the objective of value maximization when the firmfaces financial distress costs. The optimal hedge is dependent on the correlationbetween price and quantity risk, price and quantity volatilities, and the profit margin.To illustrate, linear derivatives are efficient risk management tools if quantity andprice risk are uncorrelated, which possibly explains the popular use of forwards,


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futures and swaps. In contrast, firms with negative correlation between price andquantity risk are more likely to benefit from options (and exotic derivatives). Moreover,firms should use more options if they face large quantity risk or small price risk andlarge positive or negative price-quantity correlation. Also, consistent with observations

about risk management practices, the model predicts that firms often hedge less withforwards when cash flows are in the more distant future.When examining the optimal mix of linear and nonlinear hedging instruments, the

optimal hedge portfolio consists largely of linear instruments for firms with little or noquantity risk (Gay et al., 2001). In contrast, higher levels of quantity and price risksgive rise to using fewer linear contracts and more nonlinear instruments (long putoptions) in order to avoid overhedging. This substitution effect between linear andnonlinear instruments is a function of the price-quantity correlation. If the correlationis negative, there is a natural hedging effect reducing the overall demand for hedginginstruments and leading to more substitution into nonlinear contracts as theoverhedging problem is aggravated. In contrast, in the case of positive price-quantitycorrelation, higher demand for derivatives results, as they can reduce some of thequantity risk as well, and more (less) linear (nonlinear) derivatives are used.

Besides rationales for the use of options in corporate financial management basedon risk management considerations, the accounting treatment of derivatives may havean impact on the choice of instrument as well. According to the 1998 Wharton surveyon financial risk management, the accounting treatment is the issue of highest concernregarding the use of derivatives (Bodnar et al., 1998). When a company uses derivativeswith linear payoff profile such as forwards, futures and swaps to hedge an underlyingposition, the derivatives position can result in an accounting loss (hedge accountingwould solve this problem, but may be difficult to apply for anticipated exposures). Toillustrate, when a firm uses a forward contract to hedge a receivable in foreigncurrency, the forward contract will show a loss if the domestic currency depreciates. Atthe same time, the value of the underlying asset (the receivable) increases in value inreturn, so that the combined position of the underlying asset and the derivativeremains constant and independent of exchange rate movements. The elimination of the upside potential on the underlying asset is the price for the protection the derivativeoffers for situations where the underlying asset looses value.

If these principles of hedging are not well understood, CFOs may find themselves indifficulties explaining to management and shareholders losses on their derivativesposition and concomitant negative effects on earnings, especially since they occur attimes where the hedged asset would have made a big gain without the derivativehedge. These accounting effects can make the use of financial options preferable. Whencompanies take long positions in options, these will never cause negative cash flows,except for the option premia, which can be amortized over time. In contrast, options

provide welcome gains in situations where the underlying asset loses value. Theseeffects can render the use of options preferable, even if the exposure to be hedgedwould require a linear hedging instrument. At the same time, there may be agency-related incentives to use options because of their role to present dual bets on bothdirection as well as future volatility of the underlying.

A related argument pertains to potential liquidity effects of the hedge. These resultfrom the fact that exchange-traded derivatives are marked to market. If a companyuses futures for hedging purposes, the firm will have to meet margin calls in situationswhere the value of the underlying asset appreciates. These margin payments put adrain on the firms liquidity before the value gain on the underlying is realized. The


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About the authorSohnke M. Bartram obtained his Ph.D. in Finance from WHU Koblenz. Gunter Dufey (Universityof Michigan) chaired his dissertation committee. Thereafter, Rene M. Stulz, Everett D. ReeseChair of Banking and Monetary Economics, invited him as a Visiting Scholar to the Charles A.Dice Center for Research of Financial Economics at the Fisher College of Business/Ohio StateUniversity (Columbus, OH). This postdoctoral year was supported by the German National MeritFoundation, the German Academic Exchange Service, the German Federal Department of Commerce and Technology, and the Charles A. Dice Center for Research in Financial Economics.Subsequently, he held a faculty position at the University of Maastricht and currently atLancaster University Management School. In 2005, he was invited by Gregory W. Brown as aVisiting Scholar to the Department of Finance at the Kenan-Flagler Business School/Universityof North Carolina (Chapel Hill, NC). His immediate research activities center around issues ininternational finance, corporate finance and financial markets, especially financial riskmanagement. The U.S. Federal Deposit Insurance Corporation, the PricewaterhouseCoopersGlobal Competency Centre, the Leverhulme Trust, the Institute for Quantitative InvestmentResearch, Lancaster University, Lancaster University Management School, as well as theMaastricht Research School of Economics of Technology and Organizations granted financialsupport for his research activities in the area of international and corporate finance. In 2003, theFederation of European Securities Exchanges awarded the Josseph de la Vega Prize for his workon derivatives market microstructure. His work has been presented at conferences organized bythe American Finance Association, the NBER and CEPR, and published among others in the Journal of International Money and Finance, Journal of Empirical Finance, and European Finance Review. Sohnke M. Bartram can be contacted at: [email protected]

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