The literature on corporate risk management has traditionally assumed that derivative securities are fairly priced on average, so that firms could not systematically exploit unusual market conditions and earn positive returns from their hedging transactions. Here, Associate Professor Tim Adam questions this basic premise on which corporate risk management literature is founded and reveals two key findings.

Incorporating a market view into a corporate risk management strategy appears to be a widespread phenomenon.

In a survey of 244 Fortune 500 firms, almost 90% of the firms based the size of their hedges on their market views. In another separate survey on derivatives usage by 399 US non-financial firms about 50% of firms admit to sometimes altering the size and/or the timing of a hedge due to managers' market views.

The gold mining industry appears to be no exception in this regard.

Recognizing this, Professor Adam asked: can managers create value by hedging selectively, i.e., varying the size and timing of their hedging transactions based on their market views, perhaps shaped by private information? Can managers create value by exploiting systematic patterns and anomalies in derivatives markets?

To answer these questions Prof Adam analyzed the quarterly gold derivatives positions of a sample of 92 North American gold mining firms from 1989 to1999. This data, together with market data on average gold spot and futures prices, interest rate, and the gold lease rate, permitted the calculation of the quarterly net cash flows associated with each derivatives transaction for each firm.

These derivatives cash flows were then compared with several benchmarks to determine whether firms are making or losing money using derivatives, and what the sources of these gains or losses were.

Study Findings

During the sample period, there were two major gold price trend reversals: Gold prices generally fell from 1989 to 1993, then increased until 1996, and continued to decline until 2000.

Prof Adam found that firms that hedged their gold production during this period generated large positive cash flows. These firms realized an average total cash flow gain of $11 million or $24 per ounce of gold hedged per year, while firms' average annual net income was only $3.5 million per year.

The source of most of this gain was a positive realized risk premium, i.e., a persistent positive spread between the contracted forward price and realized spot price. The positive realized risk premium was not special to the particular sample period, but had existed in the gold market since the late 1970s.

Thus, this finding highlighted a new motive for corporate hedging, which the literature had previously ignored.

There was considerable evidence that managers were incorporating their market views into their risk management programs. This caused excess variation in firms' hedge positions that cannot be explained by changes in firms' fundamentals.

In contrast to the first finding, however, firms did not realize economically significant cash flows by hedging selectively. The additional cash flows generated by deviating from a benchmark hedging strategy were either zero of economically insignificant. <

Consistent with this result, firms were unsuccessful on average in predicting the gold price trend reversals and adjust their hedge ratios accordingly.

Prof Adam thus concluded that managers had no market timing ability and attempting to speculate in this way created no value (and probably destroyed value) for shareholders.

This finding was in stark contrast to the widely held view among corporate executives that market timing was an integral part of a hedging program.

Even though gold mining firms as a group did not outperform the market, it could be that there were persistent winners and losers within the group.

However, no evidence of persistence was found.

In most cases, a positive selective hedge cash flow in one quarter was generally not followed by another positive selective hedge cash flow in the next quarter.

Furthermore, the selective hedge cash flows were not correlated with firm size, with how much firms hedge or the frequency with which firms adjust their hedge ratios.

Thus, consistent with the efficient markets hypothesis, managers were not able to outperform the market.

Can Managers Create Value?

Between 1989 and 1999, gold mining firms were able to benefit from a persistent positive risk premium in the gold market.

During this time firms' derivatives positions generated significant value of shareholders.

This finding is important for future empirical studies that aim at measuring the benefits of corporate derivatives use.

These benefits may not only arise from the alleviation of certain financial frictions and market imperfections that individual firms face but also stem from the presence of unusual market conditions.

Since risk premia have been documented in a wide range of currency and commodity markets, there is no ex ante reason to believe that the results in this study are unique to the gold market.

There was no convincing evidence that firms consistently outperform the market by hedging selectively.

Firms' selective hedge cash flows are zero on average. Furthermore, there were no persistent winners and losers, and there were no significant cross-sectional differences between winners and losers.

These results indicate that although gold mining firms appear to speculate a lot, this does not translate into economically significant derivatives cash flows that could be attributed to successful market timing.

So, can managers create value by exploiting systematic patterns and anomalies in derivatives markets? Can they create value by hedging selectively?

The answer to the first question is "yes" and to the second is "no".

Associate Professor Tim Adam is currently with NUS Business School, Department of Finance and Accounting. He obtained his PhD in Economics at the University of Virginia and received several teaching awards, including twice the Franklin Prize of Teaching Excellence. His areas of interest include corporate risk management, corporate restructurings, corporate finance, and derivatives, and he has published several papers on these topics. The above article is an excerpt from his paper, "Hedging, Speculation, and Shareholder Value" co-authored with Chitru Fernando and published in the Journal of Financial Economics in 2006.

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