New Look at Hedging Reveals Wide-Reaching Potential Tax Benefits
For many firms, hedging--which uses derivatives to offset future values--has become a fundamental risk-management strategy. In fact, hedging has been referred to as the single most powerful economic justification for futures markets. Now Clifford W. Smith Jr., Clarey Professor of Finance and Economics at the Simon School, and John R. Graham of the University of Utah, have teamed up to take a unique and detailed look at one of the major factors in the complex decision to hedge corporate exposures to risk.
In their paper "Tax Incentives to Hedge," the authors state that firms which face "tax progressivity"--that is, tax rates that increase with the level of income--may benefit significantly by hedging their taxable income to protect against volatility from one year to the next. In order to identify and analyze tax-related incentives for hedging, the authors have created a sophisticated simulation of key aspects of the corporate tax code.
This approach differs from prior research, which has relied on surveys of managers, and on "proxy" representations of important data--both of which, the authors argue, can be misleading. Managers, they write, may be reluctant to disclose their true motives for hedging, and indicators used as proxies may reflect incomplete and distorted information.
"We discovered that there's a tremendous amount of richness in the structure of the tax code which the proxies just don't capture," Smith says. "What we're trying to do in this paper is to recognize and exploit that richness."
In doing so, Smith says he was surprised to find that tax incentives for hedging can be potentially important for a large number of firms. "A lot of people, myself included," Smith says, "thought that the tax incentive among NYSE corporations would be important only to a handful of smaller firms, but that most companies would be in the top corporate tax bracket facing no progressivity."
"We were surprised to find," he continues, "that this intuition was not right. We found instead that in approximately 50 percent of the cases we considered, firms faced tax functions where there was some progressivity. It turned out that we had been underestimating the potential importance of this tax factor."
In their paper, the authors point out that the potential tax benefits of hedging must be viewed together with other major hedging incentives, which include: 1) a reduction in the cost of compensating corporate claimholders for the risk they take, as that risk is diminished; 2) the reduced likelihood of excessive leverage and the "underinvestment problem"; and 3) a reduction of the required rate of return, for firms with relatively closely held
ownership.
They also caution that any potential benefits must be weighed against the known costs of hedging. These include out-of-pocket costs, such as brokerage fees, as well as the cost of building and maintaining an internal system to manage and control the hedging program. The latter cost, the authors point out, has grown in the wake of derivative mishandlings at Gibson Greetings, Procter & Gamble and Barings Bank.
The authors do not claim to have devised a system which can yet determine whether or when a particular firm should hedge. Instead, they have analyzed one of several major factors in the equation, and they have brought a fresh approach to that analysis.
"What we've tried to do here," Smith summarizes, "is carve out one section of a much larger problem. By itself, the paper doesn't provide final answers to these questions. But I think it is going to change the way people think about one important motive for hedging, and therefore it will shape the way they think about the other motives. And it will spur more work toward taking the next bite out of the problem."
(FR 96-03)
RSS