Risk Management and Derivatives

Abstract

This chapter reviews both the theory behind derivatives as a form of risk management and selected surveys that shed light on why and how firms use derivatives. Hedging is designed to reduce volatility and avoid downside risk. Under the perfect market and complete information assumptions, investors will costlessly diversify or use homemade hedging so firms cannot use either natural or derivative hedges to enhance their value. Researchers, therefore, identify the following six exceptions that enable hedging to reduce the volatility of the firm and add value: taxes, bankruptcy, agency costs, costs of external funds, economies of scale, and information advantage. In addition to addressing survey research of country-regionU.S. firms, this chapter also reviews survey research of non-U.S. firms and compares the findings to the results from U.S. firms.

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