The Impacts of Risk Management on Investment and Stock Returns

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 279 The Impacts of Risk Management on Investment and Stock Returns Hangyong Lee 1 Korea Development Institute Received 31 January 2006 ; Accepted 30 March 2006 Abstract This paper investigate the impacts of the use of interest rate swaps to assess two competing yet closely related theories on risk management: capital structure and financial market imperfections. Empirical results on investment suggest that the use of interest rate swaps allows firms to substitute debt for equity in financing investment as well as to reduce the dependence of internal funds. The volatility of stock returns and the risk exposures to changes in interest rate changes are lower for swap users, consistent with hedging. However, the risk exposures to debt or default risk increases as firms initiate interest rate swaps program, suggesting that hedging is not only a risk reduction tool but also a risk reallocation technique. Keywords : Interest Rate Swaps; Investment; Hedging. JEL classification : G10, G30, E22 1 Correspondence : Korea Development Institute (Phone) +82-2-958-4079 (fax) +82-2-958-4088 (E-mail) hlee@kdi.re.kr. I thank Andrew Ang, John Donaldson, Jaehoon Hahn, Rober Hodrick, and seminar participants at Columbia university, Ewha women s university, KAIST, the Bank of Korea, and Korea Development Institute for valuable comments and suggestions. The Author is grateful to two anonymous JER referees for their helpful comments. All remaining errors are mine.

280 The Impacts of Risk Management on Investment and Stock Returns 1 Introduction The use of financial derivatives such as forwards, futures, swaps, and options has been increasingly common in corporate risk management. Despite several theoretical justifications and empirical evidence on rationales for risk management, it is safe to say that there is no single principle that underlies hedging program with derivatives. Froot, Scharfstein and Stein (1993) argue that volatile cash flows disturbs both investment and financing plans in a way that is costly to the firm. Therefore, risk management can increase the value of the firm by reducing the variability in cash flows. Geczy, Minton, and Schrand (1997) and Allaynnis andweston (2001) provide empirical evidence. On the other hand, Ross (1996) and Leland (1998) suggest that firms use financial derivatives to increase leverage and the tax benefits of debt since the primary benefit of debt financing is the tax deductibility of interest. Graham and Rogers (2002) offer strong support for this argument. 2 The purpose of this paper is to investigate the impacts of risk management and to assess these two competing yet closely related theories from several perspectives. First, I estimate investment equation to examine how risk management is related to financing investment: the capital structure choice and the dependence on internal funds. This is an appropriate direction of research since making good investment is the key to enhancing corporate value and thus risk management should accord with investment strategy. Second, I investigate how the stock market reacts to risk management and the associated changes in financing strategies. To explore whether and how risk management affects the volatility of stock returns and the risk exposures of portfolio returns is important in order to identify the role of the derivatives use. I examine the use of interest rate swaps from a sample of non- 2 Other rationales for risk management include managerial motives and tax convexity. Stulz (1984) argues that managers are better off by reducing the fluctuation of firm value since they may hold a relatively large portion of their wealth in the firm s stock. Tufano (1996) provides empirical evidence using the data of gold mining firms. Smith and Stulz (1985) argue that hedging is beneficial if taxes are a convex function of earnings because more volatile earnings leads to a higher expected taxes. However, Graham and Rogers (2002) find no evidence that firms use derivatives in response to tax convexity.

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 281 financial firms listed in S&P 500 for the period from 1992 to 1999. With relatively large sample of firms in both cross-section and time-series dimensions, empirical results in panel data analysis are expected to havemore statistical power. Large number of observations in time-series also makes it possible to construct monthly portfolios and to obtain robust estimates of risk exposures of stock returns. To my knowledge, no study attempt to form monthly portfolios for derivatives user stocks and nonuser stocks. A crosssection or panel data analysis is useful to compare the derivatives users with non-users. However, non-users may not be a good control group due to different firm characteristics. Therefore the empirical results in panel data analysis do not necessariliy reflect the impacts of risk management. To mitigate this problem, I examine the changes in the coefficient estimates in investment equation and the changes in risk exposures between before and after the initiation of risk management program for the same firms. Empirical findings in this paper suggest that risk management is closely related to capital structure in financing investment. I find that investment-q sensitivity is lower for interest rate swap users, consistent with the notion that risk management using interest rate swaps leads firms to substitute debt for equity in financing investment. I also find that the estimate of investment-cash flow sensitivity is statistically significant before the use of interest rate swaps, but economically and statistically insignificant after the swap use. This result suggests that risk management also contributes to decreasing the dependence of investment on internally generated funds. Indeed, the two theories share common predictions. Suppose that firms use interest rate swaps to reduce the risk associated with changes in interest rates and thereby smooth cash flows over time. The expected decrease in cash flow variablity, in turn, reduces the probability of financial distress and at the same time may reduce expected external finance premium. Then the trade-off theory of capital structure predicts that firms can increase debt capacity since marginal tax benefit of debt financing is higher relative to marginal cost of potential financial distress. Similarly, theories on capital market imperfection also suggest that firms can issue more debt due to decreased external financing costs. Ross (1996) argues that the costs of financial distress do not necessarily decrease because of increased leverage. Despite the leverage effect,

282 The Impacts of Risk Management on Investment and Stock Returns controlling for firm characteristics, I find that average stock return and return volatility are lower for swap users. Furthermore, I construct the portfolios according to the debt-asset ratio and swap use to estimate the risk exposures to interest rate changes as well as other risk factors. The estimation results show that the interest rate risk exposure is statistically significant only for high debt-asset ratio/non-user portfolio returns suggesting that the use of interest rate swaps is consistent with hedging. In contrast, I also find that the risk exposures to the factors that are believed to proxy for investment or default risk increase as firms initiate interest rate swaps program. As noted in Schrand and Unal (1998), the results imply that risk management is not only risk reduction tool but also risk reallocation technique. Lower interest rate risk and higher default risk imply that the role of derivatives is to alter the nature of risk from price risk to quantity risk. The risks that firms hedge with financial derivatives are the risks associated with changes in asset prices. On the other hand, higher leverage or debt may increase the risks associated with quantities. Higher level of debt leads firms to be more vulerable to an adverse demand shock in the product market that substantially decreases sales and cash flows. In this case, firms may not meet the debt obligation and thus they are more exposed to default risk. This paper is organized as follows. Section 2 reviews the rationales for risk management. Section 3 describes the characteristics of interest rate swap users and examines the relation between the use of interest rate swaps and debt-asset ratio. Section 4 investigates the effects of the swap use on fixed investment decisions using firm-level panel data. Section 5 examines the impacts of risk management on stock market. Section 6 discusses the macroeconomic implications of financial derivatives and offers concluding remarks. 2 Motivation for Risk Management In the presence of financial market imperfections where asymmetric information matters in the external financing contracts, firms must pay an external finance premium over the market interest rate when exter-

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 283 nal finance is required. Given the same investment opportunities, the wedge between the marginal cost of external financing and the opportunity cost of internal funds causes financially constrained firms to invest below the efficient level. Froot, Scharfstein and Stein (1993) show that a firm s expected profit is a concave function of internal funds if the firm is financially constrained. An increase in the internal funds leads to an increase in the expected profit more than proportionally since it lowers the marginal cost of external financing. Therefore, if firms face positive probabilities of being financially constrained, they act in a risk-averse manner and the degree of risk aversion depends on the amount of internal funds. 3 As a result, firms are willing to smooth fluctuations of their internal funds. If internal funds are affected by changes in interest rates, interest rate swaps provide an opportunity to manage fluctuations of internal funds, thereby to increase expected profits. 4 Empirical studies show that the use of financial derivatives is broadly consistent with theory. For example, Geczy, Minton, and Schrand (1997) examine the determinants of the use of currency derivatives in a sample of Fortune 500 firms that have ex ante foreign exchange rate risk. They find that firms with greater growth opportunities and tighter financial constraints are more likely to use currency derivatives. Gay and Nam (1998) also find that firm with enhanced investment opportunities use financial derivatives more when they have relatively low cash flows. 3 Note that the model does not necessarily imply that only the firms that are currently financially constrained would use financial derivatives. Instead, the model predicts that firms that are likely to require costly external finance in the future have an incentive to use financial derivatives. The motivation for risk management stems from ex ante financial constraints rather than ex post financial constraints. 4 In addition to the theories that motivate risk management in general, several theories provide explanations for why firms use interest rate swaps in particular. For example, Titman (1992) develops a model of asymmetric information, in which one firm believes that it will have lower borrowing cost in the future but it cannot convince the lender. In this case the firm has an incentive to borrow short and then swap floating for fixed to reduce the interest rate expense under the assumption that the counterparty is indifferent between borrowing long or short. Bicksler and Chen (1986) explain swap use in terms of comparative advantage in borrowing between firms. They argue that swap allows both firms to arbitrage the quality spread differential and lower the borrowing costs. However, along with the growing use of interest rate swaps, it is expected that these types of differences to be arbitraged away.

284 The Impacts of Risk Management on Investment and Stock Returns Several studies on investment also present empirical evidence consistent with Froot, Scharfstein and Stein. Minton and Schrand (1999) report that higher cash flow volatility is associated with lower level of investment. Adam (2002) documents that hedging increases the likelihood that investments can be financed internally. Their findings provide indirect evidence that capital market imperfection is an important motivation for risk management. Allayannis and Mozumdar (2000), on the other hand, directly estimate an investment equation for currency derivative users and nonusers, and find that the sensitivity to unhedged cash flow is significantly lower for derivatives users. 5 They argue that the use of derivatives stabilizes investment since hedgers are better able to reduce net cash flow volatility. In contrast, the trade-off theory of capital structure states that the trade-off between tax benefits and the cost of financial distress determines optimal leverage. The present value of tax shield rises as a firm borrows more, while the probability of financial distress increases with additional borrowing. The theoretical optimum is reached when the present value of tax savings due to additional debt is offset by marginal increase in the present value of the costs of financial distress. Ross (1996) and Leland (1998) show that risk management provides an opportunity to increase leverage and the associated tax benefits. Stulz (1996) also argues that the role of financial derivatives is to eliminate costly lower-tail outcomes by reducing various costs associated with financial distress and thereby to increase leverage. Graham and Rogers (2002) present direct and strong empirical evidence that risk management enables firms to increase debt capacity and tax benefits. Hentschel and Kothari (2001) show that there is no economically significant relation between the amount of derivatives hoding and stock return volatility. Ross argues that the findings in Hentschel and Kothari are consistent with his view since much of the volatility reduction by risk management is likely to be offset by increased leverage. 5 They select firms that include all cash flow from hedges in nonoperating income (e.g. other income or interest income) or in both operating and nonoperating income, and use operating cash flow as a proxy for unhedged cash flow.

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 285 3 Characteristics of Swap Users 3.1 Data Interest rate swaps is an agreement on exchange of cash flows between two parties. It states that one party (Firm A) agrees to pay the other party (Firm B) cash flows equal to a predetermined fixed rate on a notional principal for a certain number of periods. At the same time, Firm B agrees to pay Firm A cash flows equal to interest at a floating rate on the same notional principal. Since the first interest rate swap contracts were negotiated in 1981, the market for interest rate swaps has grown rapidly. For empirical analysis, I select non-financial firms listed in the S&P 500 index and then search the annual Securities and Exchange Commission (SEC) filings in Lexis-Nexis for the sample period from 1992 to 1999. I choose the sample period from 1992 to 1999 because SFAS no.105 published by the Financial Accounting Standard Board has required the disclosure of interest rate swap use in the financial statements since June 1990. I exclude firms whose financial data and stock return data are not available in the COMPUSTAT and the Center for Research in Security Prices (CRSP) during the sample period. The final number of firms that meet these restrictions is 348. In 1993, only 53 firms used interest rate swaps, while 195 firms had outstanding interest swap contracts in 1999. This paper does not distinguish whether an interest rate swap user is a fixed rate payer or a floating rate payer. In many cases, firms do not report their swap positions, making it impossible to determine the type of swap contracts. Furthermore, many firms use both types of swaps simultaneously, and both types of swap use are consistent with hedging. 6 The data of the use of interest rate swaps have some advantages. First, interest rate swaps is the most popular instrument among financial derivatives. For example, Swaps Monitor reports that the notional size of global interest rate swaps grew from 0.3 trillion dollars at the end of 1985 to 52 trillion dollars in 1999. By contrast, total size of currency 6 Saunders (1999) and Balsam and Kim (2001) report that most non-financial firms use interest rate swaps as fixed rate payers.

286 The Impacts of Risk Management on Investment and Stock Returns derivatives at the end of 1999 was only 17.7 trillion dollars. Second, empirical study on interest rate swaps allows to focus on a single risk that is associated with changes in interest rates. For currency derivatives, on the contrary, it is hard to identify the underlying risk because many different foreign currency risks are involved across firms. The other advantage of the data is that the number of observations in the sample period is relatively large and thus a time series or panel data analysis can be conducted with more statistical power. This was impossible for most of previous research. 7 3.2 Firm Characteristics of Swap Users To compare swap users and non-users, Table 1 reports the averages of the financial variables that may proxy for the degree of financial constraints, including market capitalization, book-to-market equity, debtasset ratio, dividend payout ratio, and cash flow-capital stock ratio. Market capitalization has been proposed as a proxy for financial constraints because, as Gertler and Gilchrist (1994) argue, small firms are more likely to face larger barriers to external finance than large firms. Book-to-market equity is known to be a proxy for growth potential, and debt-asset ratio represents the relative debt burden and thus may signal potential financial distress. The dividend payout ratio is used in Fazzari, Hubbard, and Petersen (1988) to examine the difference in the cash flow-investment relationship. Firms that pay high dividends can finance additional investments by reducing the dividend payments while low dividend firms must rely on external finance. Cash flows represent internally generated funds and thus high cash flow firms are less likely to be financially constrained. 7 Allayannis and Weston (2001) and Allayannis and Mozumdar (2000) also use panel data for currency derivatives use. Their sample periods are 1990-1995 and 1993-1995, respectively. To my knowledge, no study attempt to form monthly portfolios for derivatives user stocks and non-user stocks.

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 287 Table 1. Characteristics of Interest Rate Swap Users Note: The sample consists of non-financial firms listed in S&P 500 index. Using the annual Securities and Exchange Commission (SEC) filings, swap users and nonusers are identified in each year. Numbers are average of financial variables for swap users and non-users. ME is market equity. BM is book-to-market equity. DA is debt-asset ratio. DO is dividend payout ratio, CK is cash flow-capital stock ratio, I/K is investment nomalized by capital stock, R R m is the difference between the individual firm s stock return and CRSP value-weighted market return, and σ/σ m is the ratio of standard deviation of daily stock return and the standard deviation of CRSP of value-weighted market return. The sample period is from 1992 to 1999. The average market capitalization indicates that swap users tend to be large firms. Table 1 also shows that swap users are, on average, low book-to-market firms, high debt to asset ratio firms, low dividend payout firms, and low cash flow firms. These average firm characteristics, except for firm size, suggest that swap users are likely to face higher probabilities of being financially constrained. To examine how the firm characteristics are changed due to interest rate swaps, I collect the sample of firms that initiated risk management program during the sample period and calculate the average firm characteristics for the years before and after the use of interest rate swaps. Notably, debtasset ratio increases while cash flow capital ratio remains the same after firms use interest rate swaps. Average stock return in excess of CRSP market portfolio return and standard deviation of daily stock return normalized by standard deviation of market return are also calculated for swap users and non-users. After initiating interest rate swaps program, average return falls along with decreased return volatility

288 The Impacts of Risk Management on Investment and Stock Returns 3.3 Risk Management and Debt-Asset Ratio This subsection examines the relation between the use of interest rate swaps and the debt-asset ratio. First, a probit model is estimated to test whether the debt-asset ratio is an important determinant for hedging decision. I implement probit model estimation for two samples. The dependent variable for the first sample is a binary choice variable that takes on one for the firms that have some outstanding swap contracts and takes on zero for the firms that have no swap contract in the year t. The second sample includes only the firm years of swap initiation. 8 In this sample, the dependent variable is a binary choice variable that takes on one for the firms that first initiate a swap contract and takes on zero for the firms that have no swap contract. The right hand side variables are one period lagged financial variables to avoid potential simulaneous equation bias. Panel A of Table 2 reports the estimation results. The empirical findings for the two samples are qualitatively similar. The estimation results suggest that the firm size, the debt-asset ratio, and the cash flows are important determinants for the use of interest rate swaps. The coefficients on the book-to-market and the dividend payout ratio are not significant in both samples. The empirical findings in probit model estimation are broadly consistent with the predictions of the theories on capital market imperfections in that the firms that are more likely to be financially constrained use interest rate swaps. High debt-asset ratio firms are more likely to use interest rate swaps. Since they are more likely to be exposed to risks of interest rate changes, an adverse shock may lead the firms to be severely financially constrained. Locking in interest payment on the debt by interest rate swaps contributes to stabilizing the net worth and thus prevents firms from being severely financially constrained. Haushalter (2000), Balsam and Kim (2001), and Graham and Rogers (2002) also find a significant role of debt on hedging decisions. 8 Saunders (1999) finds that total asset and sales growth are important factors for the swap initiation. Balsam and Kim (2001) also investigate the earlier sample period when disclosure was not mandatory. They obtain significantly estimated coefficients on sales, long-term debt to asset ratio, and book to market.

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 289.

290 The Impacts of Risk Management on Investment and Stock Returns Note: The sample consists of non-financial firms listed in S&P 500 index. Numbers in Panel A are coefficient estimates with standard errors in parentheses from the probit model estimation. The dependent variable, D it, is a binary choice variable that takes on one (zero) if firm i has some (no) outstanding interest rate swaps contracts in the year t. ME is market equity. BMis book-to-market equity. DA is debt-asset ratio. DO is dividend payout ratio, and CK is cash flowcapital stock ratio. The explanatory variables are one period lagged variables. The probit regressions are performed for two samples: the whole sample (swaps outstanding) and the sample of the periods that firms initiated swaps trading (swaps initiation). Numbers in Panel B are coefficient estimates with standard errors in parentheses from debt-asset ratio equation. The dependent variable, DA it, is the debt-asset ratio for firm i in year t. D it 1 is the lagged indicator variable for swap use. The control variables, X it 1 include market equity (ME), book-to-market equity (BM), cash flow-capital stock ratio (CK), and dividend payout ratio (DO). The equations are estimated with fixed effects. The sample period is from 1992 to 1999. The significantly estimated coefficient on firm size suggests that there may exist fixed costs in swap contracts so that small firms cannot use interest rate swaps. It also suggests that firms face economies of scale in initiating risk management programs. 9 In addition, Saunders (1999) points out that in the early 1990s, swap intermediaries did not issue a swap contract for a notional amount less than 5 million US dollars. High cash flows, on the other hand, reduce the likelihood of using interest rate swaps. Higher cash flows lower the degree of financial constraints thereby reduce the incentives to use derivatives. The probit model estimation results show that debt-asset ratio is crucial for the decision to use interest rate swaps. However, the relation between the debt-asset ratio and hedging decision also runs the other way because reduced costs of financial distress and potential tax benefits leads firms to increase leverage. To examine the effects of risk management on leverage, the debt-asset ratio is regressed on lagged swap dummy variable controlling for other firm characteristics with fixed firm and year effects. The results in Panel B show that the debt-asset ratio of swap users is about 1.1% higher than the debt-asset ratio of non-users, indicating that the use of interest rate swaps predicts systematically higher debt-asset ratio. Graham and Rogers (2002) first present empirical evidence that the relation runs both directions. In a simultaneous equation system, they 9 Haushalter (2000) also notes that the positive correlation between the decision to hedge and total assets implies economies of scale in hedging activities.

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 291 find that high debt-asset ratio contributes to using derivatives and also the predicted extent of hedging is positively correlated with debt-asset ratio. 10 Unlike the results in this paper, Geczy, Minton, and Schrand (1997) report that the predicted probability of derivatives use does not affect the debt-asset ratio in simultaneous equation system. The different results may stem from the different data set: Geczy, Minton, and Schrand use the data of the foreign exchange rate derivatives use. As noted in Garham and Rogers, if foreign debt substitutes foreign currency derivatives, the powe of the test would be decreased. In addition, firms may use foreign exchange rate derivatives to increase foreign operations rather than to increse debt-asset ratio. 4 Investments and Interest Rate Swaps 4.1 Sensitivities of Investment to q and Cash Flows Using firm-level panel data, I estimate the investment equation for swap users and non-users in which a firm s investment spending is a function of Tobin s q and cash flows. 11 Specifically, I estimate the following equation with fixed firm and year effects: (I/K) it = µ i + µ t + µd it 1 + α 0 Q it + α 1 D it 1 Q it + β 0 CK it 1 + β 1 D it 1 CK it 1 + u it, where (I/K) it is the firm i s investment spending in year t scaled by the capital stock of the previous year. Q it is the Tobin s q at the beginning of year t and CK it 1 is the cash flows normalized by capital stock at t 1. D it 1 is the dummy variable that takes on one if firm i has some outstanding interest rate swap contracts in year t 1 and takes zero otherwise. Since the decisions on investment and the decisions to use interest rate swaps are likely to be correlated with each other, I use one-period lagged dummy variable to avoid the potential simultaneity 10 I also perform the test in simultaneous equation system and find highly significant coefficient estimate on the predicted probability of swap use in the debt-asset ratio equation. 11 Fazzari, Hubbard and Petersen (1988), Gilchrist and Himmelberg (1995), Hoshi, Kashyap and Scharfstein (1991) among others.

292 The Impacts of Risk Management on Investment and Stock Returns bias. I also use the lagged cash flow term because lagged cash flows do not include cash transfers from interest rate swaps transactions and thus may proxy for unhedged cash flows. In addition, lagged cash flows do not lead to a simultaneity bias in coefficient estimates while current cash flows can be influenced by current investment. The differerences in the sensitivities of investment are captured by the coefficients on the interaction terms of q or cash flows and the dummy variable, D it 1. Table 3 presents the estimation results. Without the cash flow term, the coefficient estimate on the interaction term D it 1 Q it 1 is -0.0137 and statistically significant, implying that investment of swap users respond less strongly to q. When the cash flow term is included as a regressor, the estimated investment-q sensitivity of non-users is also almost twice as large as that of swap users. The coefficient on the interaction term D it 1 Q it 1 is also negative and significantly estimated when the coefficient on cash flows are restricted to be the same for both groups. Why does the investment of swap users respond less strongly to q? Since most of the variation in q can be explained by the fluctuations of stock prices, low investment-q sensitivity implies low investment-stock price sensitivity. If a firm is equity-dependent in financing investment, it can raise more capital with the same number of equity issues when stock price is high. Therefore, different investment-q sensitivity may reflect the degree of equity dependence in financing investment. Baker, Stein, and Wurgler (2002) document that stock prices have a stronger impact on the investment of equity-dependent firms that need external equity to finance their marginal investment. They argue that investments of equity-dependent firms may be more sensitive to the non-fundamental component rather than the information on future profitability in stock prices. This explanation is consistent with higher debt-asset ratio of swap users documented in the previous section and the theoretical prediction that risk management increases leverage. If the use of interest rate swaps is associated with more debt-dependent capital structure, the investment of swap users may respond less strongly to stock prices than the investment of non-users. This suggest that firms use interest rate swaps to substitute debt for equity in financing investment. On the other hand, since non-users are, on average, small and young firms, they may not easily access to debt markets. Thus, non-users are more likely to be equity-dependent firms, leading the investment more

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 293 strongly sensitive to market price of equity. Although the above argument is consistent with the empirical observations of different investment-q sensitivities, alternative explanations can also be addressed. If q measures the future profitablity of investment perfectly, low investment-q sensitivity simply reflects low responsiveness of investment to the future profitability. 12 Therefore, it is also possible that low investment-q sensitivity of swap users results from other motivations for risk management. In particular, Tufano (1998) observes a potential cost of risk management in exacerbating agency problems, leading firms to poor investment decision. He argues that if projects are negative NPV investments to shareholders, but managers support them nevertheless because of some private benefits they will enjoy, eliminating the discipline that the capital markets would impose on firms can lead to improper resource allocation and destruction of shareholder value. In that case, investment of swap users responds less strongly to future profitability measured in q. The coefficient estimate on the dummy variable for swap use is significantly positive, suggesting that the use of interest rate swaps is correlated with a systematically high investment spending. This is consistent with the notion that firms reduce the under-investment problem by managing interest rate risks. Taken together with the debt-dependency of the swap-users, interest rate swaps may provide firms with an opportunity to increase debt capacity to finance additional investment spending. 12 The q theory of investment states that q is a sufficient statistic for summarizing all the information relevant to a firm s investment decision. Empirical research typically rearranges the theoretical first order condition as a linear regression under the assumption of quadratic adjustment costs, and then uses the observable Tobin s q as a proxy for marginal q. Hayashi (1982) shows that, under the assumptions of constant returns to scale and perfect competition, marginal q is equal to average q, which is the ratio of manager s valuation of the firm s existing capital stock and its replacement cost. If the financial market is efficient, average q should be equal to the ratio of market valuation to replacement cost, which is Tobin s q.

294 The Impacts of Risk Management on Investment and Stock Returns Table 3. Risk Management and Investment Note: The estimation results of the following regression model for the sample of non-financial firms listed in S&P 500 index. (I/K) it = µ i + µ t + µ 1D it 1 + α 0Q it + α 1D it 1Q it + β 0CK it 1 + β 1D it 1CK it 1 + u it, The dependent variable, (I/K) it, the investment normalized by the beginning of the year capital stock for firm i in year t. Q it 1 is the beginning of the year Tobin s q and CK it 1 is the lagged cash flow-capital ratio in year t 1. D it 1 is a dummy variable that takes on one (zero) if firm i has some (no) outstanding interest rate swaps contract in year t 1. The equation is estimated with fixed effects. The sample period is from 1992 to 1999. Numbers are coefficient estimates with standard errors in parentheses. In contrast, I find no evidence that the investment-cash flow sensitivity is different between swap users and non-users. The coefficient estimate on D it 1 CK it 1 is not different from zero except for the case that the coefficient on q is assumed to be the same. Allayannis and Mozumdar (2000) report that the investment-cash flow sensitivity is lower for hedgers under the restriction of the same investment-q sensitivities. However, their results may change if the investment-q sensitivities are allowed to differ between two groups. A potential problem has been addressed in the economic interpretation for investment-cash flow sensitivity. Given the debate between Fazzari, Hubbard, and Petersen (2000) and Kaplan and Zingales (1997, 2000), it is not clear whether investment-cash flow reflects the degree of

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 295 financial constraint and thus hedging effects of interest rate swaps. Fazzari, Hubbard, and Petersen (1988, 2000) contend that firms with larger coefficient estimates on cash flows are likely to be more financially constrained. On the other hand, Kaplan and Zingales (1997, 2000) argue that investment-cash flow sensitivities are not good measures of financial constraints. If the sensitivities do not increase monotonically with the degree of financial constraint, lower sensitivity does not necessarily imply low degree of financial constraints. 13 I find that invetment-q sensitivity is lower for swap users while investment-cash flow sensitivities are not different between two groups. Nevertheless, it is safe to say that the empirical results in panel data analysis do not necessarily imply the effects of risk management on investment. The results in the panel data analysis simply describes the different investment behaviors of two groups that may also be affected by different firm characteristics. In particular, no difference in investment-cash flow sensitivities between swap-users and non-users does not necessarily imply that risk management does not reduce the degree of financial constraints. Table 1 indicates that non-users are generally low debt and high cash flow firms, implying that investment-cash flow sensitivity is likely to be lower. Therefore, althogh the use of interest rate swaps could reduce the investment-cash flow sensitivity, it is possible that the resulting sensitivity of swap users is not different from the sensitivity of non-users. To examine the effects of risk management, it is more desirable to estimate the changes in sensitivities of the same firms after they use interest rate swaps. 4.2 Robustness Tests: Alternative Specifications Before estimating the changes in sensitivities of investment, I examine whether the empirical results in Table 3 are robust to alternative specifications. First, since investment spending is likely to be serially correlated, I include lagged investment in the regression and examine how the inclusion of lagged investment affects other coefficient estimates. Panel A reports the estimation results. Controlling for lagged in- 13 Furthermore, Erickson and Whited (1999) argue that the OLS coefficient on cash flow can appear significant due to the measurement errors in q.

296 The Impacts of Risk Management on Investment and Stock Returns vestment leaves most of the estimation results qualitatively unchanged. The estimated investment-q sensitivity is higher for non-users and the investment-cash flow sensitivities are the same for both groups. On the contrary, the coefficient on swap dummy variable is estimated insignificantly, which is not the case in Table 3. One potential explanation for the insignificant coefficient on swap dummy variable is that since the decision on investment and the decision on the use of interest rate swaps are simultaneously made, leading to a correlation between swap dummy and lagged investment. Second, if investment is a concave function of Tobin s q, lower investment-q sensitivity for swap users simply reflects the lower level of q. A simple way to consider the potential non-linearity is to include q 2 in the regression (Baker, Stein, and Wurgler (2002)). However, including q 2 does not affect the estimation results qualitatively as documented in Panel B. Even though larger coefficients on q are estimated for both swap users and non-users, all the results in Table 3 remain unchanged qualitatively. Third, different investment-q sensitivities can result from different sensitivities to debt-asset ratio rather than different sensitivities to stock price since debt-asset ratio is a component of q. In addition, theories on capital market imperfections predict that higher level of debt is likely to have negaive effect on investment since higher leverage may impair access to credit to finance investment. Therefore, investment-cash flow sensitivities may be affected by investment-debt sensitivities. The estimation results in Panel C, however, show that debt-asset ratio does not affect the main results on investment-q sensitivities and investmentcash flows sensitivities. Despite controlling for the debt-asset ratio, the estimation results are similar to the one from controlling for lagged investment. Since the debt-asset ratio is a strong determinant of the use of interest rate swaps, the swap dummy variable is also expected to be correlated with debt-asset ratio as is the case with lagged investment.

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 297.

298 The Impacts of Risk Management on Investment and Stock Returns Note: The estimation results of the following regression model for the sample of non-financial firms listed in S&P 500 index. (I/K) it = µ i + µ t + µ 1D it 1 + α 0Q it 1 + α 1D it 1Q it 1 + β 0CK it 1 + β 1D it 1CK it + γ 0X it 1 + γ 1D it 1X it 1 + u it The dependent variable, (I/K) it, is the investment normalized by the beginning of the year capital stock for firm i in year t. Q it 1 is the Tobin s q and CK it 1 is the lagged cash flow-capital ratio in year t 1. The control variables, X it 1, include (I/K) it 1 Panel A, Q 2 it 1 Panle B, or the debt-asset ratio, DA it 1 Panel C. D it 1 is a dummy variable that takes on one (zero) if firm i has some (no) outstanding interest rate swaps contract in year t 1. The equation is estimated with fixed effects. The sample period is from 1992 to 1999. Numbers are coefficient estimates with standard errors in parentheses. 4.3 Investment of New Swap Users One may argue that the different investment behaviors between swap users and non-users stem from other firm characteristics rather than risk management using interest rate swaps. This concern is particularly relevant if non-users are not an appropriate control group. Investigating changes in the investment sensitivities between before and after the initiation of interest rate swaps for the same firms can alleviate this problem. For a sample of firms that first initiate interest rate swaps program during the sample period, I estimate the investment equation for one year prior to and one year after the initiation of interest rate swaps, separately. Then, I examine whether the direction of the changes in the estimated sensitivities are consistent with the theory s prediction. Panel A of Table 5 presents the results estimated by pooled OLS. The estimated investment-q sensitivity without cash flows decreases from 0.0438 to 0.0338 after the initiation of risk management program. Other things being equal, the responsiveness of investment (normalized by capital stock) declines by 1% point for a unit changes in Tobin s q following the risk management initiation. A decrease in the investmentq sensitivity after the initiation of interest rate swaps is consistent with the hypothesis that the use of interest rate swaps leads firms to partially substitute debt for equity in financing investments.

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 299 Table 5. Investment of New Swap Users Note: The estimation results of the following regression model for the sample of non-financial firms that start using interest rate swaps. (I/K) it = µ i + β 1Q i + β 2CK i + u i, The dependent variable, (I/K) i, is the investment normalized by the beginning of the year capital stock for firm i for the previous year (Before swap initiation) and the following year (After swap initiation) of swap initiation. Q i is the Tobin s q and CK i is the cash flow-capital ratio in year t. The equations are estimated by pooled OLS Panel A and Heckman s two-step procedure Panel B to correct for the potential sample selection bias. λ i is the inverse of Mill s ratio estimated from Probit model. The sample period is from 1992 to 1999. Numbers are coefficient estimates with standard errors in parentheses.

300 The Impacts of Risk Management on Investment and Stock Returns Interestingly, investment-cash flow sensitivities also decreases remarkably from 0.0750 to 0.0298 after firms initiate the risk management program. In particular, the estimates of investment-cash flow sensitivity is not statistically significant after firms use interest rate swaps while it is statistically significant before the use of interest rate swaps. This result suggests that the use of interest rate swaps contributes to reducing the dependence of investment on cash flows. The regression specification in Panel A is subject to endogeneity problem since it implicitly treats the decision to use interest rate swaps as exogenous. The endogeneity problem arises by way of the omitted variable problem as investment spending is only observed for a restricted, non-random sample. Investment spending after the use of swaps can be observed only if they use interest rate swaps. Conversely, investment spending before the use of swaps is observable only if they decide not to use interest rate swaps. The decision to use interest rate swaps depends on the expected gains from the use of interest rate swaps, which are not observable. Since the expected gains and other explanatory variables are correlated and unobservable expected gains are not included in the regression specification, a potential endogeneity problem arises and in that case, explanatory variables are correlated with the error term. This problem is referred to as the sample selection problem which results from using non-randomly selected samples to estimate behavioral relationships. Heckman (1979) first discusses the sample selection bias as a specification error in a cross-section model and presents a simple consistent estimation method known as a two-step regression. In the first step, a probit model of swap use is estimated and the inverse of Mill s ratio is obtained. In the second step, the equation of interest is estimated with the inverse of Mill s ratio term to correct for the bias in the regression model. Following Heckman, I employ two-step procedure to estimate the investment equation. Panel B of Table 5 presents the estimation results. The difference of the estimated investment-q sensitivities between before the swap use and after the swap use is larger than the difference reported in Panel A. Correcting the potential sample selection bias reinforces the empirical results in Panel A. The coefficient estimate on cash flows is also smaller and statistically insignificant after firms use interest rate swaps. Overall, correction for the potential sample selection bias

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 301 does not affect the empirical findings qualitatively. 5 Effects of Interest Rate Swaps on Risks 5.1 Stock Return and Volatility If firms use financial derivatives and successfully reduce the risk, the volatility of their stock returns would decrease. This is particularly true if firms use interest rate swaps to reduce the variablity of cash flows. In contrast, if firms increase leverage by derivatives use, higher leverage can offset the reduced volatility. This subsection examines how the use of interest rate swaps affects the average stock return and the stock return volatility. I define the volatility of stock returns for firm i in year t as the standard deviation of daily stock returns for the individual stock in year t normalized by the standard deviation of daily market return in the same year. Similarly I define the average excess return for firm i in year t as the average daily return in excess of average market return. Then I regress the individual stock return volatility and the excess return on lagged swap dummy variable and the debt-asset ratio. Table 6 shows that, without controlling for other firm charateristics, the estimated coefficients on the debt-asset ratio is positive and statistically significant for both the excess return and the return volatility. The results suggest that higher leverage increases stock return volatility consistent with Christie (1982) and Hentchel and Kothari (2001). Controlling for the market equity, the book-to-market, the cash flows, and the dividend payout ratio, however, the coefficient estimates on the debt-asset ratio are not statistically significant, implying that the debt-asset ratio may be correlated with other firm characteristics. Importantly, the coefficient estimates on the swap dummy variable is always negative and statistically significant for the excess return and the return volatility. Negative coefficients on the swap dummy variable suggest that both the average excess return and the return volatility are systematically lower for swap users consistent with hedging. The increased debt-asset ratio has only a secondary effect on the return volatility and cannot fully offset the initial effect of hedging.

302 The Impacts of Risk Management on Investment and Stock Returns Table 6. Equity Return and Volatility Note: The estimation results for the following regression model for the sample of non-financial firms listed in S&P 500 index. Y it = µ + µ sd it 1 + β k X kit 1 + u it, The dependent variable, Y it, is the difference between the individual firm s stock retun and CRSP value-weighted market return (R R m) or the ratio of standard deviation of daily stock return and the standard deviation of CRSPof value-weighted market return (σ/σ m). D it 1 is an indicator variable that takes on one (zero) if firm i has some (no) outstanding interest rate swaps contract in year t 1. The control variables, X it 1 include market equity (ME), book-to-market equity (BM), debt-asset ratio (DA), cash flow-capital stock ratio (CK), and dividend payout ratio (DO). The equations are estimated with fixed effects. The sample period is from 1992 to 1999. Numbers are coefficient estimates with standard errors in parentheses. Hentchel and Kothari (2001) find that there is no significant relation between the derivatives holdings and the return volatility. Ross (1996) argure that the findings of Hentchel and Kothari are consistent with the notion that increased leverage offset the reduced volatility by hedging. In contrast, I find that the return volatility scaled by themarket return volatility substantially decreases along with the use of

Hangyong Lee/ Journal of Economic Research 11 (2006) 279 316 303 interest rate swaps controlling for the effect of increased debt-asset ratio. In fact, Hentchel and Kothari also report that the coefficient on the dummy variable for the firms that do not use financial derivatives is much higher than the average of coefficients on the dummy variables for the firms that do use derivatives in the volatility equation. This may imply that whether firms use financial derivatives is important for the decrease in volatility, but how much to use derivatives is not monotonically related to the reduction in volatility. Indeed, If firms optimally choose the extent of hedging, there is no reason that the decrease in volatility is monotone to the derivatives holdings. 5.2 Risk Exposures of Stock Returns Another important and interesting approach to test for hedging is to estimate risk exposures of stock returns. Since I consider a single financial derivatives instrument, interest rate swaps, the risk that firms want to hedge is easily identified. Upon identifying the swap users and non-swap users in each year t 1, I form four portfolios according to the debt-asset ratio and swap use to calulate equally weighted monthly portfolio returns from July of year t to June of year t + 1 using the data from the Center for Research in Security Prices (CRSP). Since I examine the financial reports in the SEC filings from 1992 to 1999, portfolio returns are constructed for the sample period from July 1993 to June 2001. Using the portfolio returns, I examine whether the risk exposures of stock returns differ across the portfolio returns. If firms use interest rate swaps to hedge interest rate risk, other things being equal, the stock returns of swap users are expected to be less sensitive to the interest rate changes than the stock returns of non-users. On the contrary, if interest rate swaps are used for speculation, the stock returns of swap users would be more sensitive to the changes in interest rates.