The Effect of Hedging on the Value of Listed Banks in Nigeria

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The Effect of Hedging on the Value of Listed Banks in Nigeria

THE EFFECT OF HEDGING ON THE VALUE OF LISTED BANKS IN NIGERIA

Essien, Esitime Okon

Department of Accountancy

Trinity Polytechnic, Uyo

essienesitime@gmail.com

+2348063921032

&

Dorathy Christopher Akpan (PhD, ACA)

Department of Accounting

Akwa Ibom State University Obio Akpa Campus

dorathyakpan@aksu.edu.ng

+2348036056169

ABSTRACT

The study investigates the effect of hedging on firm value in Nigeria drawing samples from listed banks on the floor of the Nigerian Exchange Group market. The study was based on an ex-post facto research design with a sample size of 12 listed banks in Nigeria. While firm value proxied by Tobin Q was the dependent variable, the independent variables adopted for this study include foreign currency hedging and interest rate hedging. Furthermore, in line with related extant literature, we employed the variable of firm size to control our model. Data set employed in this study spans through the periods between 2011 and 2020. The econometric techniques adopted in this study are the panel fixed and Random effect regression techniques. The findings showed that interest rate hedging has a positive and significant influence on firm value. The study also shows that foreign exchange hedging has a negative and insignificant influence on firm value. In the light of this, the empirical result of this study leads to the conclusion that while interest rate risk significantly improves the value of listed banks in Nigeria, foreign currency risk insignificantly improves the value of listed banks in Nigeria. The study recommends that to improve firm value, management should cautiously consider interest rate hedging policy since the result indicates it significantly improves firm value.

KEYWORDS: Hedging, Interest rate, foreign currency, Firm Value, Tobin Q

1.0       Introduction

Although multinational corporations have reaped the benefits of internationalization by exploiting the use of derivatives to lower their systematic risk, idiosyncratic risk, and total risk (Trang, 2018), the legislators, policymakers, and regulators failed to identify and manage the systemic risk (Campbell, D’Adduzio, Downes, & Utke 2021) linked with the use of derivatives. Financial hedging plays a central role in risk management. The use of hedges by firms is consistent with the positive valuation effects found in the literature (Khan, Rajgopal, & Venkatachalam, 2018). Risk management plays an important role in corporate financial strategy. Assuming Modigliani and Miller’s (1958) hypotheses are valid, companies’ financial policies do not have any impact on firm value in a perfect capital market.

However, if financial markets are efficient, hedging activities by a firm does not add any value because the investor would then be able to build such a diversified portfolio that would allow them to eliminate the risks and would make the payment of a premium for the firm adopting a hedging policy unnecessary. However, when some of the assumptions made by Modigliani and Miller (1958) are relaxed, it is possible to show that a company’s hedging policy would add value to the firm. Breslin, Basu, and Ziel (2019) show that tax reasons and the possibility of incurring costs of financial distress could lead hedging to add value to the firm. Firms especially commercial banks operate in a constantly changing and risky environment, which causes unpredictability, volatility, and complexity. Risk management strategies that are effective in terms of costs and resources are becoming increasingly important to the success of any business both domestic and international (Campbell, D’Adduzio, Downes, and Utke 2021).

Although hedging is generally considered a value-enhancing activity by reducing financial distress cost (Chen, Liu, Seow, and Xie 2020; Breslin, Basu, and Ziel 2019), increasing debt capacity and tax shield (Mota, 2021), reducing under-investment problems (Frensidy and Mardhaniaty, 2019), empirical evidence shows mixed results (Bessler et al., 2019). While several studies found a positive relation between hedging and firm value (Chen, Liu, Seow, and Xie 2020; Allayannis et al., 2012; Campbell, D’Adduzio, Downes, and Utke 2021), their average effect is weak with only 0.02. On the other hand, other studies found a negative relation, especially in the oil and gas industry (Khan, Rajgopal, and Venkatachalam (2018); Mota (2021); Frensidy and Mardhaniaty (2019). Although a negative effect is possible due to the manager’s incentive to maximize their utility through corporate hedging (Liao and Zhang, 2020), only a few studies examined this theory, including Breslin, Basu, and Ziel (2019) who find the impact of agency cost and hedging on firm value. In the light of the above, this study examines the effect of hedging on firm value drawing samples from listed banks in Nigeria from 2011-2020.

2.0       Literature Review

Firm Value

Firm value represents the assets owned by a company. It is crucial because it describes the prosperity of the business owners. The manager being the representative of the owners of the business is responsible for optimal maximization of the value of the firm which forms the fundamental objective of any organization (Bhabra, 2007). A high firm value indicates that the company is prosperous and hence the shareholders’ wealth is maximized. The prosperity level of the shareholders and investors are reflected in the firm value. Firm value is an indicator used to assess the performance of a company. Investors also perceive the company through its firm value, and this is related to the stock price. According to Ftouhi, Ayed and Zemzem (2010), high stock price will make a higher firm value.  Bhabra (2007) opined that firm value is the price paid by the wealthy buyer when a company is sold, and he also sees firm value as the objective value from the public and the orientation of company’s survival. From the preceding, it is clear that firm value is the investors’ perception towards a company’s success level, and this is usually associated with stock price (Bhabra, 2007).  Firm value is typically indicated by price to book value (PBV). When the PBV is high, it, therefore, means that the principle of going concern is operational which translates into shareholders’ wealth. Modigliani and Miller (1961) opined that firm value is determined by company’s asset earnings power. It implies therefore that, when the impact of asset earnings power is positive, the company is doing well, and its asset turnover will be more efficient, and this results in high profit.  Firm value may be measured from two perspectives: from the point of view of accounting measure of profitability: return on assets (ROA), return on equity (ROE), Tobin’s Q, Net Profit Margin; and from the stock market perspective, using the share prices from the stock exchange market.

Most empirical studies measure firm value using Tobin’s Q. Desai and Dharmapala (2009) used Tobin’s q as a proxy for firm value. Tobin’s Q is the ratio of the market value of a firm to the replacement cost or book value of assets (Allayannis & Weston, 2001). Tobin’s Q measures a firm value by scaling the market value of a company’s assets with the costs that would be incurred to replace the asset at the current market value (Lewellen & Badrinath, 2007). Tobin’s Q is utilized as the market value of a firm in most studies (Desai & Dharmapala, 2009; Bhabra, 2007; Allayannis & Weston, 2001). The popularity of the index is based on its ability to reflect the performance of management. According to Bhagat and Black (2002), high Tobin’s Q means that the managers of a firm have produced greater market value from the same asset. This is consistent with the position of Lewellen and Badrinath (2011) that, companies which exhibit Tobin’s Q greater than “one” means effective use of scarce resources, while Tobin’s Q less than “One,” means the inefficient or poor use of scarce resources. Tobin’s Q is also widely used as a measure of firm value because of its usefulness in studies of tax avoidance (Desai & Dharmapala, 2009).

Hedging

Hedging has become prominent, particularly in financial institutions. The creation of financial derivatives has served as a risk reduction tool for managers of financial institutions in many developed countries. Banking institutions may use derivatives as a risk management tool to hedge on-balance sheet transactions by speculating on movements in exchange rates, interest rates, and commodity prices. These advantages encourage banks to position their businesses and improve their efficiency in risk management so that efficiency in risk management should be quantified to maintain value creation and prevent the occurrence of adverse events that might not have been properly considered in the relevant business scenario (Gomes and Schmid, 2021).

Foreign Exchange Hedging

The use of foreign currency in trade and finance is prevalent in emerging markets economies (EMEs). Foreign currency dominance can be a prominent source of risk associated to currency mismatches in cash flows and statement of financial position rendering countries susceptible to changes in market sentiment, sudden stops and currency crises. Foreign exchange derivative contracts allow firms the possibility to hedge currency risk. Importantly, the FX derivative market, one of the largest markets worldwide, has seen an impressive development over the last decades surpassing spot transactions both in advanced and emerging economies.

Interest Rate Hedging

Investment in fixed assets, such as bonds, is risky because the volatility of their prices can lead to unexpected capital gain and losses. The risk of an asset can be measured by the volatility of its return, which is the sum of the income flows from the assets plus any changes in its price. Since the income flows from a fixed income asset, such as the coupon payments and maturity value of a coupon bond, are fixed, the riskiness of the asset depends only on its price volatility. For example, as the volatility of a bond‘s price rises, the bond‘s riskiness rises because unexpected capital gain or losses are more likely. Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decrease since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Theoretical Framework

Modigliani and Miller (1958)’s irrelevance theorem implies that under the assumption of a perfect capital market, corporate hedging is irrelevant for firm value. In a frictionless market, individual investors can hedge on their own (instead of the company hedging on their behalf), because they have access to the same information and the same hedging instruments. If the assumptions of a perfect capital market are violated, there are several channels through which hedging at the firm-level may affect shareholder value and create a hedging premium. In such an imperfect market, cash flow volatility is costly due to financial distress (Smith and Stulz, 1985), convex tax functions (Smith and Stulz, 1985), external financing (Froot et al., 1993), or information asymmetry between the firm and its shareholders (DeMarzo and Duffie, 1991). As hedging is an instrument to improve cash flow stability, it may reduce the costs of market friction and thereby positively affect shareholder value. In contrast to the various theoretical arguments on how the relaxation of the assumptions of a perfect capital market creates opportunities for corporate hedging to be beneficial for shareholders, other arguments suggest that hedging might also be associated with a discount in firm value. For example, MacKay and Moeller (2007) highlight that hedging is not costless and if hedging costs outweigh benefits, it might not be valuable. In a similar vein, hedging can be associated with agency costs and monitoring problems for shareholders if managers make selective hedging decisions to protect their individual interests or to increase risk exposures for speculative purposes (Chen, Liu, Seow, and Xie 2020; Smith and Stulz, 1985; Tufano, 1996).

Empirical Review and Hypotheses Development

Interest Rate Hedging and Firm Value

Many studies have been conducted on the effect of interest risk hedging and firm value (Nova et al. (2015), Frensidy and Mardhaniaty (2019), Ayturk et al. (2016). Particularly, Nova et al. (2015) used hedging variables on derivative instruments, where only exchange rate and interest rate risks were hedged. Frensidy and Mardhaniaty (2019) examined hedging variables such as exchange rate derivative instruments, interest rates, commodity prices and the extent of firms’ hedging. Ayturk et al. (2016) employed different variables, namely the use of derivatives, the extent of hedging, and hedging accounting based on the use of derivatives. In comparison, Monalusi (2015) assessed hedging variables for foreign exchange. Ayturk et al. (2016) and Frensidy and Mardhaniaty (2019), who found no significant effect between the hedging of interest rate risk on firm value. Research by Ayturk et al. (2016) conducted on non-financial companies listed on the Turkish Stock Exchange 2005–2013 argued that investors prefer companies that do not conduct derivative instrument transactions because the derivative market is unstable. Meanwhile, Frensidy and Mardhaniaty (2019) who conducted research on companies’ non-financial companies listed on the Indonesia Stock Exchange in 2012–2015, are of the opinion that Bank of Indonesia exercises strict supervision of interest rate stability. Banks in Indonesia tend to supervise their customers on financial ratios. In addition, companies in Indonesia monitor interest rates by communicating with banks about interest costs and implementing cash management to minimise interest costs. This method is usually done with the aim of overcoming the interest rate risk so that the average sample company does not require hedging. Based on the foregoing, the first hypothesis of the study is stated as follows:

H01: Interest rate hedging has no significant effect on the value of listed banks in Nigeria

Foreign Currency Hedging and Firm Value

The empirical literature has focused on understanding the use of currency derivatives. Most papers have relied on information of net positions of listed or multinational firms, or survey data for mostly developed economies. Notably, the role of financial intermediaries in crisis periods has been recently put forward by Correa et al. (2020) who studied the US bank stress test and the supply of mortgage credit, and Liao and Zhang (2020) who studied institutional investors’ hedging choices and how they affect spot and forward exchange rates. By exploiting a regulation change to Pension Funds hedging requirements which resulted in a supply shock to the short side of FX-derivatives market, they show that firms hedging decisions were affected, and their exchange rate exposure was temporarily increased. This refers not only to foreign currency cash-flows but also domestic currency obligations. Furthermore, several authors have concluded that the use of FX derivatives is more prevalent in firms with exchange rate exposure (Korea, Bae et al. (2018); Euro countries, Lyonnet et al. (2016), Germany, Kuzmina and Kuznetsova (2018) in Germany; Brazil, Rossi-J´unior (2012); Chile, Miguel (2016), Colombia, Alfonso-Corredor (2018)), and Mexico, Stein et al. (2021)). Longer deliveries and transportation times in international transactions exacerbate these differences increasing the need for working capital (Antr`as and Foley (2015). Moreover, important costs remain in local currency (wages, taxes, others), and they matter for cash flow management. Thus, natural hedging may still render firms vulnerable to currency fluctuations associated, for example, to working capital obligations. Based on the foregoing, the second hypothesis of the study is stated as follows:

H02: Foreign exchange hedging has no significant effect on the value of listed banks in Nigeria

3.0       Methodology

In relation with extant literature, this study employed the expo-facto and non-experimental research design. The study is longitudinal covering a period of ten (10) years. That is, from 2011 to 2020 employing listed banks on the floor of the Nigerian Exchange Group (NGX). The sampling technique employed is purposive since banks were included in the sample on certain selection criteria. These criteria were based on the view that the banks are listed on the Nigerian Exchange Group (NGX) market from 2011-2020; there were access to their annual financial reports within the period and they were not firms operating subsidiaries in Nigeria that are not listed in the Nigerian Exchange Group (NGX). Newly listed banks and delisted banks were excluded from the study. Thus, only banks that had all relevant data due to continuous existence were included in the sample. Our final sample size consists of 12 banks that was arrived at based on the availability of data for ten years for all the research variables. Hence, the study expresses the econometric model as

Where:

TOBQ             =          Tobin Q measure of Firm Value

FCHG             =          Foreign currency hedging

INHG              =          Interest rate hedging

FSIZ                =          Firm Size

β0                            =          Constant

β1– β3               =          Slope Coefficient

                      =          Stochastic disturbance

i                       =          ithbank

t                       =          time-period

Thus, our apriori expectations are stated as; Х1-X3>0: which means that a rise in the determinant variables of hedgingwill lead to a rise in firm value of listed banks in Nigeria. The econometric techniques adopted in this study are the panel fixed and Random effect regression techniques. The rationale for its usage is based on the following justifications: the data that will be collected may have time and cross-sectional attributes as well as across the sampled firms (cross-section); panel data regression provides better results since it uses large observation and reduces the problem of degree of freedom (Muhammad, 2012); it avoids the problem of multicollinearity and help to capture the individual cross-sectional (or firm-specific) effects that the various pools may exhibit with respect to the dependent variable in the model.

The dependent variable in this study is firm value which is measured in terms of Tobin Q. The study used Tobin’s Q ratio to measure firm value as it is the most widely used measure of firm value in the literature (Bessler et al., 2019). Tobin’s Q ratio compares the market’s valuation of the firm with the replacement cost of the firm’s assets. In terms of the independent variable, hedging is measured by foreign currency hedging and interest rate hedging. Due to the information limitation on the hedging amount in annual reports, the study measured both hedging variables as binary variables, which equal 1 if a company uses the relevant hedging, and 0 otherwise. Furthermore, to control the model’s goodness of fits, the study employed the variable of firm size which is measured as the natural logarithm of total asset.

4.0       Empirical Results and Discussion

The study investigates the impact of hedging on firm value in Nigeria drawing samples from listed banks on the floor of the Nigerian Exchange Group market. While firm value proxied by Tobin Q is the dependent variable, the independent variables adopted for this study include foreign currency hedging and interest rate hedging. Furthermore, in line with related extant literature, we employed the variable of firm size to control our model. Data set employed in this study spans through the periods between 2011 and 2020. Table 4.1 below describes the data in terms of the banks which they belong. Overall, the descriptive statistics provides some insight into the nature of the selected Nigerian listed banks that were employed in this study. 

Descriptive Analysis

In this section, we examine the descriptive statistics for both the explanatory and dependent variables of interest. Each variable is examined based on the mean, standard deviation, maximum and minimum. Table 1 below displays the descriptive statistics for the study.

Table 1: Descriptive Statistics

VARIABLES MEAN SD MIN MAX NO OBS
TOBQ 0.86 0.25 0.63 2.55 120
INHG 0.89 0.31 0 1 120
FCHG 0.87 0.34 0 1 120
FSIZ 9.18 0.40 8.19 9.94 120

Source: Author (2023)

The table above shows the summary of the descriptive statistics of the study. From the table it is observed that firm value (TOBIN Q) had a mean of 0.86 with a standard deviation of 0.25. The table also shows that about 89% of the banks in the sample used interest rate hedging while 87% of the banks in the samples used foreign currency hedging during the period under study. In the case of the control variable, the table shows that firm size has a mean of 9.18 with a standard deviation of 0.40.

Correlation Analysis

In examining the association among the variables, we employed the Pearson correlation coefficient (correlation matrix), and the results are presented in the table below. 

Table 2: Correlation analysis

TOBQ INHG FCHG FSIZ
TOBQ 1.00
INHG 0.23 1.00
FCHG 0.38 0.49 1.00
FSIZ -0.27 0.06 -0.14 1.00

Source: Author’s computation (2023)

In the case of the correlation between the variables of interest, the above results show that there exists a positive and moderate association between interest rate hedging and firm value measured in terms of Tobin Q (0.23). There exists a positive and moderate association between foreign currency hedging and firm value measured in terms of Tobin Q (0.38). The control variable of firm size has a negative and moderate association between interest rate hedging and firm value measured in terms of Tobin Q (-0.27). To test our hypotheses a regression results will be needed since correlation test does not capture cause-effect relationship.

Regression Results

Specifically, to examine the cause-effect relationships between the dependent variables and independent variables as well as to test the formulated hypotheses, we present a panel data regression and an OLS pooled results in the table below.

Table 3: Regression Result

TOBQ Model (Pooled OLS) TOBQ Model (FIXED Effect) TOBQ Model (RANDOM Effect)
CONS 3.05 {0.000} ***   4.82 {0.000} ***    4.05 {0.000} ***   
INHG 0.11 {0.175}    0.22 {0.006} ** 0.18 {0.015} **   
FCHG  0.07 {0.353}  -0.11 {0.330}   -0.05 {0.578}     
FSIZ -0.25 {0.000} ***  -0.44 {0.000} ***  -0.36 {0.000} ***    
F-statistics/Wald Statistics 9.92  (0.00) *** 6.78 (0.01) ** 21.71 (0.01) **
R- Squared 0.20 0.16 0.16
VIF Test 1.25  
Heteroscedasticity Test 133.59 (0.0000) ***   
Hausman Test   2.76 (0.4295)  

Note:      (1) bracket {} are p-values 

(2) **, ***, implies statistical significance at 5% and 1% levels respectively

In the table above, it is observed from the OLS pooled regression that the R-squared value of 0.20 shows that about 20% of the systematic variations in firm value proxied by Tobin Q in the pooled banks over the period of interest was jointly explained by the independent and control variables in the models. The unexplained part of firm value can be attributed to exclusion of other independent variables that can impact on firm value but were captured in the error term.  The F-statistic value of 9.92 and the associated P-value of 0.00 shows that the OLS regression of the model on the overall is statistically significant at 1% level, this means that the regression models is valid and can be used for statistical inference.  The table above also shows a mean VIF value of 1.25 which is within the benchmark value of 10, this indicates the absence of multicollinearity in the models, and this means no independent variable should be dropped from the models. Also, from the table above, it can be observed that the OLS results had heteroscedasticity problems in the model since its probability value was significant at 1% [133.59 (0.0000)]. The presence of heteroscedasticity in the models clearly shows that the sampled banks are not homogeneous. This therefore means that a robust or panel regression approach will be needed to capture the impact of each firm heteroscedasticity on the results. In this study, the panel regression method using both fixed and random effect models will be employed.

The F-statistic and Wald-statistic value [{6.78 (0.01)}] and [{21.71 (0.01)}]  for fixed and random effect regression respectively shows that both models are valid for drawing inference since they are both statistically significant at 5%. In the case of the coefficient of determination (R-squared), it was observed that 16%  systematic variations in firm value proxied by Tobin Q was explained jointly by the independent and control variables in both models respectively. This therefore implies that less of the variation in firm value was explained when compared to the OLS pooled regression. In selecting from the two panel regression estimation results, the Hausman test was conducted, and the test is based on the null hypothesis that the random effect model is preferred to the fixed effect model.  Specifically, a look at the p-value of the Hausman test (0.4295), implies that we should accept the null hypothesis and reject the alternative hypothesis at above 5% or 1% level of significance. This implies that we should adopt the random effect panel regression results in drawing our conclusion and recommendations. This also implies that the random effect results tend to be more appealing statistically when compared to the fixed effect. Following the above, the discussion of the random effect results became imperative in testing the hypotheses. The below is a specific analysis for each of the independent variables using the random effect regression.

Discussion of Findings

Since, the study is an extension of existing studies, only few findings in literature are not in agreement with the current positions of this study. Specifically, the study shows that interest rate hedging (Random effect regression = 0.18 (0.015)) as an independent variable to firm value appears to have a positive and significant influence on firm value. This therefore means the study should reject the null hypothesis {H01: interest rate hedging has no significant effect on the value of listed banks in Nigeria}. This suggests that an increase in interest rate hedging will significantly increasefirm value. The results of this study are in line with Ayturk et al. (2016) and Frensidy and Mardhaniaty (2019), who found no significant effect between the hedging of interest rate risk on firm value. Research by Ayturk et al. (2016) conducted on non-financial companies listed on the Turkish Stock Exchange 2005–2013 argued that investors prefer companies that do not conduct derivative instrument transactions because the derivative market is unstable. Meanwhile, Frensidy and Mardhaniaty (2019) who conducted research on companies non-financial companies listed on the Indonesia Stock Exchange in 2012–2015, are of the opinion that Bank of Indonesia exercises strict supervision of interest rate stability. Banks in Indonesia tend to supervise their customers on financial ratios. In addition, companies in Indonesia monitor interest rates by communicating with banks about interest costs and implementing cash management to minimise interest costs. This method is usually done with the aim of overcoming the interest rate risk so that the average sample company does not require hedging. The study also shows that foreign exchange hedging (Random effect regression = -0.05 (0.578)) as an independent variable to firm value appears to have a negative and insignificant influence on firm value. This therefore means the study should accept the null hypothesis {H02: foreign exchange hedging has no significant effect on the value of listed banks in Nigeria}. This suggests that an increase in foreign exchange hedging will insignificantly decrease firm value. This study contradicts the studies of Hagelin and Pramborg (2002) who investigated the effectiveness of currency derivatives and foreign denominated debt in reducing foreign exchange exposure. The results were positive. The study also contradicts those of Fok et al. (1997) who found that hedging not only reduces variability in earnings, but it also increases firm value. They found that hedging not only decreases the chances of financial distress but also the agency costs of debt and the costs of equity.

5.0       Conclusion and Recommendation

If financial markets are efficient, hedging activities by a firm does not add any value because the investor would then be able to build such a diversified portfolio that would allow them to eliminate the risks and would make the payment of a premium for the firm adopting a hedging policy unnecessary. However, when some of the assumptions made by Modigliani and Miller (1958) are relaxed, it is possible to show that a company’s hedging policy would add value to the firm. In the light of this, the empirical result of this study leads to the conclusion that while interest rate risk significantly improves the value of listed banks in Nigeria, foreign currency risk insignificantly improves the value of listed banks in Nigeria. We recommend that to improve firm value, management should cautiously consider interest rate hedging policy since the result indicates it significantly improves firm value.

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