Asymmetric information and corporate derivatives use

Abstract

We investigate the relationship between derivatives use and the extent of asymmetric information faced by the firm. Using alternative analyst forecast proxies for asymmetric information, we find evidence that both the use of derivatives and the extent of derivatives usage is associated with lower asymmetric information. Specifically, for firms using derivatives (notably currency derivatives) we find that analysts' earnings forecasts have significantly greater accuracy and lower dispersion. These findings support the conjectures of DeMarzo and Duffie (1995) and Breeden and Viswanathan (1998) who argue that hedging reduces noise related to exogenous factors and hence decreases the level of asymmetric information regarding a firm's earnings.

Corporate use of derivatives and excess value of diversification

“…Users have lower residual volatility of stock returns, higher institutional and lower insider shareholdings than non-users. This evidence is also in line with the findings of DaDalt et al (2002) and in support of the notion that derivatives use is associated with greater firm transparency. In addition to lower informational asymmetry, on average, users of derivatives have a significantly higher excess value index than firms that do not use derivatives, which is consistent with prior evidence that the use of derivatives is associated with higher market valuation (Allayannis and Weston, 2001).…”

“…Dolde and Mishra (2002) show that more complex firms (i.e., geographically diversified firms) use substantially greater amounts of foreign exchange derivatives than purely domestic firms. DaDalt et al (2002) present evidence in line with the view that the use of derivatives is associated with lower asymmetric information.…”

“…Thus, our findings are in line with the argument that hedging can reduce informational asymmetry between insiders and shareholders (see DeMarzo and Duffie, 1995;Breeden and Viswanathan (1998)). Our results also complement the empirical evidence in DaDalt et al (2002) by providing evidence that the reduction of informational asymmetries associated with the use of derivatives can result in a positive valuation effect.…”

“…Froot et al (1993) show that firms, that might otherwise fail to invest in valuable growth opportunities, have an incentive to hedge so as to ensure enough internal funds to undertake attractive investment opportunities. In addition, as argued in Geczy et al (1997) and DaDalt et al (2002), in cases where there are insufficient internal funds to take on all positive-NPV projects, hedging can provide the additional benefit of lowering external financing costs because by increasing the informativeness of earnings it alleviates the adverse selection problem.…”

“…Graham et al's (2005) broad survey of financial executives finds that managers believe that less predictable earnings can lead to low stock prices because investors and analysts dislike uncertainty. Recent empirical evidence from several studies (see Barton, 2001;Brown, 2001;DaDalt et al, 2002;Pincus and Rajgopal, 2002, among others) shows that corporate use of derivatives is associated with lower earnings volatility, greater number of analysts following the firm, and greater accuracy of analysts forecasts.…”