Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers

Abstract

The literature on corporate risk management has traditionally assumed that derivative securities are fairly priced, and thus disregarded the possibility that non-financial firms might use derivatives to generate positive returns by exploiting market conditions. This premise has led researchers to rationalize corporate risk management by its beneficial effects on bankruptcy costs and taxes, debt capacity, cost of capital, underinvestment costs, and managerial risk aversion. Our study questions this fundamental premise and thereby makes two principal contributions.

First, we show that the assumption that derivatives contracts are fairly priced on average can be violated for an extended period. By studying the hedging activities of a sample of North American gold mining companies over the 1989-1999 period, we find that these firms generated significant excess cash flows by selling gold forward. Our sample firms realized an average total cash flow gain of $11 million or $24 per ounce of gold per year, while their average annual net income was only $3.5 million. The source of these gains is a persistently positive spread between contracted forward prices and realized spot prices. This finding highlights a new motive for the corporate use of derivatives and a new potential source of value associated with risk management that the literature has previously ignored.

Second, and in contrast to our first contribution, we show that firms do not realize economically significant cash flow gains by trying to time the market in their use of derivatives. Market-timing in the context of hedging programs is a form of speculation. We find considerable evidence in our sample that managers respond to changing market prices by varying the sizes of their hedge positions, and that this variation is far in excess of what can be explained by changes in a firm's fundamentals. However, these attempts to time the market do not yield positive cash flows on average. We conclude that managers in our study have no market-timing ability and speculating in this way creates no value (and probably destroys value) for shareholders. This finding is in stark contrast to a widely-held view among many corporate executives that market timing should be an integral part of any hedging program.