Financial Derivatives and Firm Performance: Empirical Evidence from Financial and Non-financial Firms

Abstract

There is a general perception that financial derivatives have significant impact on firm performance when they are used to hedge financial risks. The study attempted to examine the effect of the use of forwards, futures, options and swaps to hedge interest rate and foreign exchange rate risks of 5 financial and 5 nonfinancial firms selected from the UK FTSE 100 index, between the years 2005—2014, with the objectives of supporting or refuting extant literature on the benefits of hedging, testing the impact of hedging on return on assets and capital employed, as well as revealing which financial derivative assert the highest influence in the period. The panel least squares (PLS) regression analysis was used on a balanced panel dataset of 100 observations. The results revealed the following: (1) financial firms tend to hedge more of interest rate risks while nonfinancial firms hedge more of foreign exchange rate risks;(2) hedging interest rate risks by both groups with the use of a combination of forwards and futures derivatives was found to be positive and statistically significant with return on assets, hence increases firm performance, but directly has a reverse effect when only swap derivatives are used; and (3) the use of one or more of any financial derivatives to hedge foreign exchange rate risk is seen to be negative and statistically significant with return on capital employed, which translates to a decrease in firm performance. Nevertheless, the study supports the financial distress and stakeholder theories of financial risk management, with recommendations of a comparative study and a longer time frame to be employed, in order for models to be subjected to long run performance analysis and other robust tests.