Hedging Market Risk, Market Imperfections, Firm Characteristics and Firm Value: a Critical Literature Review

Abstract

There has been growing academic and industry interest in hedging market risk as a result of globalization of economic activity that has led to rapid and continuous changes in the business environment. With the collapse of the Bretton woods fixed exchange rates in 1973, increasingly volatile interest rates and wider fluctuation in oil and other commodity prices, firms are facing unprecedented uncertainty in their operations. The uncertain environment is due to presence of market imperfections of taxes, transaction costs and information asymmetry. Therefore firms have increasingly become risk focused since adverse changes in market price risk even threaten the survival of otherwise successful firms. Firms evaluate their exposures and seek to mitigate it through hedging so as to safeguard their market value. While hedging could reduce the likelihood of adverse outcome so as to ensure a firm's future existence and profitability, it leads a firm to incur additional costs involved in setting it up which may offset the hedging benefit. Firm characteristics can either strengthen or weaken the relationship between hedging and firm value. This desk review of relevant theoretical and empirical literature explores the optimality of the relationship between hedging market risk and firm value. Empirical evidence tests on the relationship between hedging market risk and firm value has been constrained heavily due to lack of available data on hedging activities. The hedging premiums with respect to empirical review findings are mainly dependent on sample size adopted, firm characteristics iincorporated and specific empirical methods used in analysis. From the review findings, a debate rages on among academics about the relationship between hedging market risk and firm value that manifests itself in the approaches adopted in addressing endogeneity problem as a result of diverse firm characteristics, operationalization of hedging and firm value concepts and multiplicity of empirical methods that consider the issues of causality. The differences in research methodology adopted explains some of the inconsistent conclusions notwithstanding that there is even lack of consensus among some studies that use identical or very similar research designs. The endogeneity potential problem due to variables such as industry, firm size, profitability and investment opportunity is admittedly a proxy that produces biased results. Research gaps emerging in the literature review include; adopting alternative proxy definition for hedging, test the possibility of a reverse causality between hedging and Tobin's Q, controlling potential endogeneity to provide robust results, employing panel data fixedeffects regression to control for any time constant unobserved firm characteristics, considering cross sectional variation to avoid any industry-specific bias factors and establishing the relationship between operational hedges and firm value. The review of literature recommend future research effort for bridging the knowledge gaps using alternative paradigms to address methodological issues of empirical studies, causality issues, fixedeffects and adopting instrumental variables to control for potential endogeneity issue. IX