Corporate derivatives use and the cost of equity

• Published in: Journal of banking & finance Vol. 35; no. 6; pp. 1491 - 1506
• Main Authors: Gay, Gerald D., Lin, Chen-Miao, Smith, Stephen D.
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.06.2011; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Banking & Finance
• Subjects: Asset pricing; Beta; Capital costs; Capital structure; Cost of capital; Derivatives; Derivatives Risk management Asset pricing Financial distress risk; Equity; Financial distress risk; Financial management; Interest rates; Risk management; Studies; G32; G13; G12; Derivatives; Risk management; Financial distress risk; Asset pricing
• ISSN: 0378-4266; 1872-6372
• DOI: 10.1016/j.jbankfin.2010.10.033

We investigate the relation between derivatives use and corporations’ cost of equity capital. Using a large sample of non-financial firms, we compute and analyze (i) the relative cost of equity of firms that use derivatives and those that do not; and (ii) the change in cost of equity experienced by firms initiating derivatives programs. We find that the cost of equity of derivatives users is lower than non-users by 24–78 basis points. Our results are robust to specifications that account for potential endogeneity related to a firm’s derivatives use and capital structure decisions. We further find that the reduction in the cost of equity is attributable to both lower market beta and SMB beta, suggesting that firms use derivatives to reduce their financial distress risk and that this distress risk has a systematic component that is priced in the market. Finally, the observed reductions in the cost of equity tend to be largest for smaller firms and for firms utilizing currency and interest rate derivatives.