Risk Measurement and Hedging: With and without Derivatives

This paper examines a setting in which the derivatives strategies of two firms are known, but completely different. One firm aggressively hedges its risk using derivatives. The other firm uses a combination of operating and financial decisions, but no derivatives, to manage its risk. The different choice of methods is a result of different abilities to adjust operating costs and different needs for investment capital. Managerial incentives also play a role. Although risk-averse managers have an incentive to reduce risk, how and how much they hedge depends on how they are compensated. In the corporate finance literature, research on risk management has focused on the question of why firms should hedge a given risk. The literature makes the important point that measuring risk exposures is an essential component of a firm's risk management strategy. Without knowledge of the primitive risk exposures of a firm, it is not possible to test whether firms are altering their exposures in a manner consistent with theory. However, the measurement of risk exposures for non-financial firms has received limited research attention. At one level, the measurement of risk exposure seems intuitively obvious and deceptively simple. It is the covariance of the firm's unhedged cash flows, investment opportunities, or asset values with the risk factor. In practice, the problem is more difficult, since risk exposure can only be seen through the firm's financial disclosures, which might not fully reflect the true economic exposure (Beaver and Wolfson, 1995). The measurement problem is even more complex for some variables, such as investment opportunities, where the existence of the empirical relation in the data depends on a firm's risk management strategy. Investment opportunities might truly covary with a risk factor, but such a relation will not appear in the data if market frictions prevent the firm from taking advantage of investment opportunities when they arise. In this paper, we take a new approach to measuring risk exposures and thus to testing the theory of risk management. We estimate and compare the risk exposures of two firms that are at opposite ends of the derivative-use spectrum, but are similar in that they both operate in the gold mining industry. The two firms we select are American Barrick, which The views expressed in this paper are those of the authors and do not necessarily reflect the views of the firms