MSc Investment Management Dissertation: Derivatives and Firm Value

This dissertation, submitted by Rohan Aji Kumar for an MSc in Investment Management, investigates the use of derivatives for hedging and enhancing firm value. The study analyzes non-financial corporations in developed countries from 2011 to 2020, using fixed outcomes regression analysis, propensity score matching, and difference-in-difference models. The research explores the effectiveness of different derivative types on firm value, considering interest rate and foreign exchange derivatives. The dissertation includes an introduction to derivatives, risk management strategies, a literature review, research methodology, data analysis, and findings. The work highlights the importance of understanding derivatives and their potential impact on financial risk and firm performance, concluding with insights into the relationship between derivatives usage and company value. The study also discusses the rationale for the study, empirical testing, determinants for the use of derivatives, classification of derivative markets, option hedging, and the benefits and regulation of hedging.

SCHOOL OF SOCIAL SCIENCES
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STUDENT ID NUMBER: H 0 0 3 6 4 1 4 2
STUDENT NAME: Rohan Aji Kumar
PROGRAMME:(e.g. MA Accountancy and
Finance; MSc International Business Management) MSc Investment Management
DISSERTATION TITLE: Using Derivatives for Hedging and increasing
firm’s value
DISSERTATION SUPERVISOR: Dr. Ullas Rao
Dissertation hand-in deadline
(date specified for hand-in) 10/12/2021
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DATE: 9/12/2021
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Masters Dissertation
Using Derivatives for hedging and increasing firm’s value
Submitted by
Rohan Aji Kumar
H00364142
Under the guidance of
Supervisor: Dr. Ullas Rao
Word count:
Dubai, December 10th 2021
Table of Content
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Declaration 4
Acknowledgment 5
Abstract 6
Chapter 1: Introduction 7
1.1 The rationale of study 7
1.2 Empirical Testing 7
1.3 Determinants for the use of derivatives 8
1.4 Classification of Derivative markets 8
1.5 Option Hedging 9
1.6 Hedge and its benefits 10
1.7 Objectives of the study 12
Chapter Scheme 14
Chapter 2: Risk management by using Derivatives 15
Chapter 3: Literature Review 17
3.1 Theory of Hedging and it’s determinants 17
Chapter 4: Research Methodology 26
4.1 Sample Selection 26
4.2 Dependent Variable 26
4.3 Control Variable 26
4.4 Propensity matching methodology 27
4.5 Hypothesis 28
Chapter 5: Data Analysis 29
Chapter 6: Findings and Conclusions 31
6.1 Findings 31
6.2 Conclusions 31
Reference 32
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Declaration
I declare that the research work undertaken for this Master dissertation has been
undertaken by myself and the final dissertation produced by me. The work has not
been submitted in part or in whole in regard to any other academic qualification.
Title: Using Derivatives for hedging and increasing firm’s value
Name: Rohan Aji Kumar
Date: 10/12/2021
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Acknowledgement
I would like to thank all the people who. Helped and supported me through the
process of writing dissertation. Firstly, I would like to thank my parents who were
there for me the whole time supporting and motivating me in my good and bad day.
After them, I would like to thank Dr. Ullas Rao who I was very lucky to have him as
my supervisor for the advices and corrections that I got from him. At the end I want to
focus on my friends who were a great source of motivation that helped me to write the
masters dissertation on time.
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Abstract:
Contemporary commercial enterprise contraptions to hedge financial dangers include rate of
interest , rate of exchange , and price risk associated with commodity . Such hedging things add
to firm fees by assuaging market imperfections, which affords an incentive to hedge. However,
derivative contraptions can also be used for speculation and hedging, magnifying risk and
probably decreasing company value. The attention of derivatives' effectiveness at various
financial intervals or in several industries is also of value, and it can ultimately result in better
hedging and even hypothesis strategies. In this dissertation, we inspect non-financial
corporations in India developed countries from 2011 to 2020 and apply fixed outcomes
regression analysis, propensity score matching and difference-in-difference models to examine
the relationship between derivatives usage and company value. The effect of unique categories of
derivatives usage on firm value varies with the aid of the country. In particular, even though
interest derivatives damage association cost worldwide, forex derivative utilization seems to
enlarge company value.
Keywords: derivatives, hedging, risk management, association value.
Chapter 1: Introduction
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Due to the growing lookup attention, an awful lot of interest is paid to the monetary instrument
or use of derivative because of their growing recognition in the companies. The Derivatives are
monetary investments such as preferences and futures, which helps hedge the financial chance
from surprising adjustments in hobby rates, alternate charges and prices of the commodity. Firms
are using economic instruments for hedging the exposure to different hazards towards amplifies
their value. Much debate is going on the effectiveness of derivatives on threat management and
cost creation.
1.1 The rationale of a Study:
The spinoff market as a counterpart of the safety market has been popular worldwide, and even
there is a cognizance amongst creating nations about derivatives markets. The introduction of
Derivatives additionally generated worries for policymakers, practitioners and regulators
concerning its impact. Financial instruments are urbanized as extra classy and advanced tools for
managing risk. However, still today, market funders now are so acquainted with derivatives
usage. Lack of grasp of markets and of a handy relation to those doing the daily trading have also
stalled the boom of these financial markets.
Absence of perception of in what way the derivatives in trading markets are operating is an
important barrier in the forthcoming & preferences marketplace in United States as trading of
derivative is a great-risk trading tool and it’s a new area in the capital market scenario of India.
This one is fundamental to comprehend unique feature of the derivative goals and possibility, the
types of dangers related, and the approaches and potential of minimizing these risks. Even after a
time after more than 10 years from familiarizing derivatives, marketplace partakers, particularly
merchandising single financiers, are no longer acquainted with derivatives principles. Due to the
absence of such focus and insufficient obligation, derivatives may result in various particpants
who burn their fingers.
However, they take leveraged positions for speculation and abuse derivatives by incurring
significant losses. For this reason, investors need clear guidance on risk management practices.
Therefore, it is necessary to investigate investor perceptions, perceptions and attitudes towards
hedging and speculation and identify knowledge gaps between investors in derivatives. We also
need to understand investor guidance on derivative trading and suggest avoiding high losses
from speculative trading.
1.2 Empirical Testing of the Relationship between Derivative Hedges and firm value:
As validity of hedging theory has already been tested and confirmed in previous studies. The
results of previous studies show that corporate risk management is well suited to increasing
corporate value. In addition, if there are market flaws such as bankruptcy costs, convex taxation,
and underinvestment issues, hedging is rational, such as various types of research so far. These
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topics are popular among researchers and practitioners. We have been working on achieving
various economic goals, and previous literature has provided inconsistent results on this topic.
1.3 Determinants for the use of derivatives:
In reality, businesses had to face taxes, various cost of agency, difficulties associated with
finance, and asymmetry of information that interrupt the Modigliani Miller theory of hypothesis.
In such an imperfect market, individual investors struggle to recreate risk management strategies
in their accounts. Therefore, many researchers suggest that imperfect markets create solid
exposure to hedging activity. There are five main classes of market flaws.
1. Information asymmetry and agency costs.
2. Raise funds for emergency costs.
3. Management risk aversion.
4. Corporate tax
5. Sub-investment
The above five criteria contribute to broader risk exposure and management outlook than
individual investors. Hedges mitigate information asymmetry in two ways by smoothing cash
flow volatility and fairly assessing the quality of management. First, goodwill is the expected
value of future cash flow. As a result, information asymmetry can affect an investor's view of
future cash flow and negatively impact corporate value. Since Dart et al. (2002), The use and
scope of derivatives suggest reducing cash flow variability and, as a result, reducing information
asymmetry by making future cash flows more predictable.
Therefore, small businesses are likely to be incentivized to use hedging to reduce information
asymmetry. Alternatively, many studies suggest that large companies are more likely to use
derivatives. This is probably due to the more resources of large companies and the subsequent
use of specialists who can apply stronger hedging strategies, Adam etc.
1.4 Classification of Derivative markets
Derivatives Markets Financial markets can be divided into specialized stock exchange markets
and counter markets.
DERIVATIVES MARKET
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Exchange Traded Market Over the Counter

Exchange-Traded Market:
Derivative exchanges are markets where individuals trade standardized contracts defined by the
exchange. The futures exchange acts as an intermediary for all related transactions and receives
initial margin payments from both sides of the transaction as a guarantee. The exchange offers a
visible and transparent market price for derivatives. They set the institutional rules for
transactions and the flow of information about transactions. These are closely related to the
clearing house that handles the post-transactional activities of listed securities and derivatives.
The exchange centralizes the transmission of bids and ask prices to all direct market participants
who can respond by selling or buying one price or responding at another price. With the advent
of e-commerce, it is no longer necessary to make an exchange a physical location. In fact, many
traditional retail floors are closed.
1.5 Option hedging:
A more expensive alternative to futures and futures contracts is currency options. They have the
advantage of protecting themselves from losses below certain unfavorable exchange rates, but at
the same time do not take advantage of the opportunity to profit from the favorable development
of the forex market.
An option is the right to buy (call option) or sell (put option) the underlying asset at a specific
price (strike price), but it is not obligatory. There are several types of options, but only plain
vanilla options are discussed here. The company has three options to protect itself. You can buy
protection at the current exchange rate, and the money option allows you to buy protection (from
money) at a lower exchange rate. Finally, he could also buy protection at a (cheaper) exchange
rate than the spot rate. Option premiums vary between these options, with out-of-the-money
options being the cheapest (because they are worthless if they expire at the current rate).
In contrast, the spot price is higher than the strike price, so the premium for in-the-money
options is the highest. Derivatives can be categorized as either trading or over-the-counter
(“OTC”). Exchange-traded derivatives are traded on regulated exchanges 57. These exchanges
act as intermediaries between the parties and guarantee the settlement of contracts through a
central payment system called the "clearinghouse". Only highly standardized, substitutable and
fluid contracts are traded on the exchange. Many of the basic conditions of exchange-traded
derivatives are not subject to negotiations between the parties.
On the other hand, bespoke, highly personalized derivatives are traded over-the-counter. OTC
derivatives are bilaterally negotiated between counterparties and tailored to the needs of the
parties. The unregulated nature of OTC derivatives contributes significantly to its popularity,
resulting in the OTC market being many times larger than the exchange-traded fund market.
Most credit derivatives are traded on OTC, with CDS being the most popular. CDS is a bilateral
contract in which the protection buyer pays a premium to the protection seller in exchange for ,
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and the protection seller compensates the protection buyer in the event that the underlying asset
is hit by a credit event. Underlying assets can range from a single corporate issuer or government
debt to an index associated with that debt.
1.6 Hedge-its benefits and regulation :
Benefits of hedging with credit derivatives:
Credit risk is one of the most common risks for businesses in their day-to-day operations.
Manufacturers who sell their products to their customers with credit bear the risk of not paying
for the goods. Similarly, banks offering millions of dollars in loans are concerned that companies
may fail to repay their loans. In both cases, manufacturers and banks are exposed to credit risk.
Credit derivatives are suitable for hedging against credit risk because they can separate credit
risk and trade it separately from the underlying asset or loan. Prior to developing credit
derivatives, banks and other financial institutions addressed these concerns about the possibility
of default by synthesizing credit, thereby minimizing exposure to a single borrower.
However, credit derivatives can allow businesses to maintain customer relationships and expose
them to credit risk. However, it protects your risk by transferring credit risk to someone who can
take the risk more efficiently. The impact of this risk transfer is significant. First, it improves the
productivity of the company. This allows companies to focus their energy on their core business
and not worry too much about the impact of credit losses on their business. Also, by offsetting
credit risk, corporate hedging with credit derivatives can reduce revenue volatility and make it
easier to plan aspects of the business. This reduces the costs associated with running your
business and allows your company to run more efficiently. Benefits of Eliminating Credit Risk
That Business Is ill
Those who are ready to process bring results that go beyond the company in question. By
focusing more on the major businesses in particular, the company can be more innovative in the
major industries and better in a better position to deliver goods and services at lower costs.
Second, the transfer of credit risk increases market liquidity. Credit derivatives allow banks and
other lenders to extend low-risk loans by default. In this way, lenders are more aggressive and
can l. Borrow more money for additional business.
Basic functions and usage:
The basic purpose of these secondary products is to hedge the risk. Most derivatives are used to
exchange the underlying financial product or financial risk inherent in the product with a third
party who is willing to accept the risk. The buyer or seller of a transaction bears the risk of
ensuring speculative or opposite exposure. Few older derivative products have been rediscovered
and promoted since the early 1980s.
There are new products designed to help borrowers and investors deal with fluctuations in
interest rates, exchange rates, commodity prices and stocks. As a general rule, portfolio
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managers can take the risk of raising funds through the cash market without using financial
derivatives. For example, owners and investors can diversify their currency exposure by holding
assets and liabilities in different currencies. Companies that cannot secure attractive interest rates
to meet their future funding needs can release their debt in the cash market before they need to
raise money. However, in reality, the transaction costs of a cash market strategy can be daunting
and you need to maintain a liquidity position in the market.
The role of protection in the enterprise: Hedges play an important role in corporate value.
Goodwill is the economic value of a company. This type of economic indicator reflects the
overall value of a company in the market, including the value attributable to shareholders and
debtors. Goodwill isn't just the price you can afford for this business. This includes structure,
terminology, guidelines and more. In current financial theory, Pandyy (2009) states that the value
of a company can be calculated in a variety of ways. The most common method used is present
value (net value). But this is not the reason why the same company can have different values. It
does not depend on the evaluation method used. This is usually caused by various payment
terms, operational assumptions, transaction structures, and so on
The discount rate is usually the return of the average investment to the market with the same risk
as the investment for which the present value method is being considered. Damodaran (2006)
stated that corporate value is very important to everyone involved in the business, as it is a very
important factor in making decisions about wealth creation. The main determinants of the value
of a form are leverage, profitability, risk management, growth options, company size, and
financial constraints. Use and Growth of Financial Derivatives: Financial derivatives are
secondary products that depend on changes in the value of the underlying financial product.
Financial derivatives are usually linked to major financial products or indicators (forex,
government bonds, corporate bonds, certificates of deposit, stock indexes, interest rates, etc.) or
products. They generally do not transfer the underlying major commodities or raw materials at
the beginning of the contract. "Option like" or "forward like". The option gives the holder the
right, but not the obligation, to buy (or sell) a financial instrument or merchandise at a fixed price
specified on a future date. A forward contract is an obligation to buy (or sell) a futures financial
instrument or commodity at a specified price. Significant risks relate to the derivative risks and
potential risks to the financial system of the sole proprietor, who is a derivative dealer. At the
sole proprietorship or other user level, there are some recent cases of significant financial losses
from derivatives in complex and highly leveraged transactions. Well-known cases include
Codelco, Metalgesellschaft, Procter and Gamble, Gibson Greeting Cards, and Orange County,
California. Users of derivatives need to be more disciplined and are more aware of their
administrator's vigilance and responsibilities. Industry sources have suggested some "best
practices" for using these tools in the Group of Thirty (1993) report. It also discusses the issue of
systematic risk, the possible impact of derivatives on the financial system as a whole. Questions
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have been raised about scenarios where derivatives can cause widespread disruption to the
financial system. One of the key areas is focused on high grade.
1.7 Objectives of the study:
The study`s objective is to establish the effect of derivatives on the financial performance of
companies listed in NSE. Specific objectives: The specific objectives of this study were to:
1. To determine how the risk management in derivatives affects the financial performance of
companies
2. To examine if efficiency in trading derivatives affects the financial performance of
companies.
Conclusion:
This chapter introduces the subject and field of study. This chapter provides a basic overview of
the derivatives market and the products traded in the derivatives markets. There is also an
overview of the purpose and background of the research. It provides the historical development
of the derivatives industry at the global and domestic levels and the latest trends in the
derivatives market.
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