Derivatives not that evil, can improve firm’s value

New York, Feb 1: Remember how philanthropist Warren Buffett has termed derivatives as ‘time bombs’ – both for the parties that deal in them and the economic system.

The overuse of derivatives – which were designed to help companies hedge against risk – was widely blamed for triggering the 2008 economic meltdown but researchers have found that hedging can actually increase firm value.

Hayong Yun from Michigan State University and Francisco Perez-Gonzalez from Stanford University show that electric and gas utilities that used derivatives to hedge against unpredictable weather experienced a ‘positive and significant effect’ on the value of their firms.

“Many people have a perception that derivatives are evil, that they helped destroy the economy. Our research provides the first fundamental evidence that hedging with derivatives can improve company value,” said Yun, an assistant professor of finance.

According to Yun, he is not advocating that derivatives be completely deregulated.

At the same time, the research suggests that derivatives – when used wisely – have an upside and should not be discounted as a potential instrument for company growth, he said in a pioneering study published in the Journal of Finance.

The researchers examined the value of publicly-traded electric and gas utilities in the US both before and after a weather derivatives market opened in the late 1990s.

The market allowed the utilities to sell weather futures to investors.

Before the market opened, utility companies that were susceptible to unpredictable weather – such as those in the Midwest – were valued 3 percent to 4 percent lower, on average, than utilities where the weather was more stable, such as in southern California and Texas.

After the weather derivative market opened, that difference disappeared.

Investors no longer cared the utility was located in an unstable-weather locale.

The use of derivatives leveled the playing field, and utilities in the Midwest and other areas with unstable weather had equal value to those in stable-weather areas – as well as increased leverage and investments, explained the study.

IANS