There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.

Previous research offers little large-sample evidence on the magnitude of non-financial firms ' risk exposure hedged by financial derivatives. In a sample of 234 large non-financial corporations that use derivatives, we find that if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, it will collect $15 million of cash from its entire derivatives portfolio and that the entire derivatives portfolio will rise in value by $31 million. These dollar amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings raise questions about the role of derivatives securities held by non-financial firms.

would like to thank the Bank of England for providing us with the inventory positions of government bond

positions of government bond dealers. We are very grateful to Richard Brealey, Allison Holland, Francis Longstaff and John Merrick for detailed discussions. We are also grateful to an anonymous referee, Yakov

Firm value is influenced in many direct and indirect ways by financial risks, which consist of unexpected changes of foreign exchange rates, interest rates and commodity prices. The fact that a significant number of corporations are committing resources to risk management activities is, however, only an indication of the potential of corporate risk management to increase firm value. This paper presents a comprehensive review of positive theories and their empirical evidence regarding the contribution of corporate risk management to shareholder value. It is argued that because of realistic capital market imperfections, such as agency costs, transaction costs, taxes, and increasing costs of external financing, risk management at the firm level (as opposed to risk management by stock owners) represents a means to increase firm value to the benefit of the shareholders.

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In this article, the authors analyze the derivatives holdings of U.S. insurers to empirically investigate the general hypotheses developed in the financial literature to explain why widely held, value-maximizing firms engage in risk management. The authors also develop a new hypothesis suggesting that although measures of risk and illiquidity will be positively associated with an insurer's decision to engage in risk management, these same measures of risk will be negatively related to the volume of hedging for the set of firms who choose to hedge using derivatives. The authors ’ analysis provides considerable support for general hypotheses about hedging by value-maximizing firms. The authors also find support for the hypothesis that, conditional on having risk exposures large enough to warrant participation, firms with a larger appetite for risk will engage in less hedging than firms with lower risk tolerance.

This paper explores the rationale for corporate risk management. Following Smith and Stulz (1985) and Mayers and Smith (1987), the assumption is made that rms can contractually commit to bondholders to maintain a particular risk management policy, or asset volatility. With that as a starting point, the essay derives the optimal hedge portfolio, examines this portfolio's robustness to variance-covariance misestimation, and proposes a new motive for corporate risk management; a rm that hedges its risk increases its optimal amount of debt and so realizes more tax bene ts from leverage. Using the capital structure model of Leland (1994), three impacts of risk-reduction on shareholder value are measured: the increase in tax bene ts, the reduction of bankruptcy costs and the reduction in the potential cost of the underinvestment problem. The essay's motivation is to serve as a guide to chief nancial o cers regarding the bene ts of risk management and the sources of those bene ts, so that risk management can be undertaken in a way that enhances shareholder value, rather than for its own sake.

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We delineate the impact of derivatives trading on asset risk for Canadian banks over the period starting 1997 till the fallout of the bank crisis in 2007. In light of the remarkable resilience of Canadian banks in dodging the current financial turmoil, we investigate whether such bank stability is attributable to effective risk management through derivatives use. After imputing asset risk from bank stock prices based on the option-theoretic model of Merton (1974), we ascertain the links between the implied asset risk and derivatives use for trading and hedging purposes. Our findings reveal that not only bank risk increases with trading in derivatives, but increases also with derivatives reportedly used for hedging. This puzzling evidence is robust to different model specifications and alternative methods of estimations. Our new evidence is important in two ways. First, it casts doubt on the effectiveness of hedge accounting. Second, it shows that the use of derivatives by Canadian banks does not explain their envied soundness. We therefore conclude that prudent practices limiting original risk exposures remain fundamental for safeguarding a healthy financial system. This lesson from Canada is particularly relevant for China, given its developing financial infrastructure and extreme reliance on banks in providing financing to its economy.