Relationship Between Investment Growth And Managerial Ownership

Relationship Between the Investment Growth and Firm’s Usage of Derivatives

Discuss about the Relationship Between Investment Growth and Managerial Ownership.

The use of derivatives is primarily directed to achieve risk reduction. There are different strategies that can be formed using various derivative products such as forward contract, Futures, Options, and Swaps (Lynch, 2011). The primary objective of these strategies is to reduce the financial risk that may arise due to change in interest rates, inflation, foreign exchange rates, and the capital market indices. The investment growth is coherently related to the risk of investment (Titman, Wei, and Xie, 2004). The risk of investment is the possibility of incurring losses on the proposed investments. Thus, as the probability of incurring losses on the proposed investments goes high, the risk of investment mounts up and the growth of investment is affected adversely. Conversely, when the risk of investment is low, the firms believe in increasing the amount of investment and the growth of investment is enhanced (Titman, Wei, and Xie, 2004). Thus, there exists a strong adverse relationship between the investment growth and the risk of investment.

Further, the risk of investment could be correlated to the use of derivatives of a firm. The derivatives are used to reduce the risk, thus, with the use of derivatives the risk of investment goes down which increases the growth of investments. Therefore, it could be inferred that a firm with usages of derivatives will achieve high growth in investment in comparison to the one which does not use derivatives (Sajjad, Noreen, and Zaman, 2013). A research was conducted by Shaari (2013), to explore the impact of use of derivatives on the investment growth. For this purposes, two factors such as capital expenditure and dividend payout ratio were taken as the representatives of investment growth. The empirical evidences show that there exists a positive relationship between the capital expenditure and use of derivatives (Shaari, et al., 2013).

This implies that the firms using derivatives get the coverage against risk and that gives them the confidence to diversify and expand by increasing the amount of capital expenditure. For example, a firm considering expanding its operations in other countries gets exposed to the risk of foreign exchange (Shaari, et al., 2013). In order to cover this risk of foreign exchange, the firm can do currency hedging using derivatives such as future contract, forward contract, and option contracts. Now, since the risk of foreign exchange is covered, the firm can go for expansion beyond local boundaries with confidence (Shaari, et al., 2013).

Use of Derivatives for Risk Reduction

Further, it has been observed that the analysts have now started considering derivatives in investment appraisals. The real option in capital budgeting is the prominent example. Real option in capital budgeting can be used to cover the risk of failure of the investment project. The founder of business can enter into a contract to sell the business for a specified value at some pre-fixed date (Jacque, 2014). Thus, it reduces the risk of failure of business by covering the sales consideration. In this regard, it should be noted that if the risk of failure of business is adequately covered the investors will be willing to enhance their investment and an automatic rise in the investment growth could be observed (Jacque, 2014). 

In the context of decision making, the managerial ownership refers to the mix of insiders and outsiders who take active part in taking strategic decisions for the firm. The insiders in this context refer to the people of management such as managing director, chief financial officer, and chief executive officer while the outsiders refer to the equity owners (Shaari, et al., 2013). The structure and size of the management within the firm does have great bearing on the strategic decision making of the firm. Further, the size of management of the firm is also linked with the scale of operations of the firm. The larger the scale of operations of the firm, wider will be the size of management. It could be observed that a small firm is managed by the owner himself while the large corporations have dedicated teams for specified jobs (Shaari, et al., 2013).

In order to understand the relationship between the managerial ownership and the use of derivatives, it is important to re-emphasize the need of use of derivates. The firms use derivatives to hedge against the price fluctuations. These price fluctuations could be related to stock prices, commodity prices, currency rates, or interest rates. Now, three different variables could be used to assess the relationship between the managerial ownership and the firm’s usages of derivative (Adkins, Carter, Simpson, 2006). These three different variables are ownership by insiders, ownership by institutional block holders, and CEO compensation. In regard to the ownership by insiders, the findings of the research reveal that larger the ownership is with the insiders; lesser will be the possibility to use derivatives for hedging the risk (Adkins, Carter, Simpson, 2006).

This happened because when the insiders own large part of equity of the firm, they would want to increase value of their holding. The value of their holdings could be increased with the increased volatility or risk, thus, they may take decision to not to opt for hedging (Adkins, Carter, Simpson, 2006). Further, in regard to the second variable that is ownership by institutional block holders, it was observed that as the ownership on the institutional shareholders increases, the firm’s use of derivatives for hedging also increases. This happens because the institutional investors are considered risk-averse investors and they do not want to keep their exposure open. Further, the institutional investors also does not take part in the day to day management of the firm, therefore, they want to be affirmed about the bottom line performance by appropriately guarding it against any type of risk (Adkins, Carter, Simpson, 2006).

Impact of Derivatives on Investment Growth

The third variable that is CEO compensation is the most crucial in understanding the relationship between managerial ownership and the use of derivatives by the firm (Adkins, Carter, Simpson, 2006). This is because the chief financial offer is the upper most authority in the management and finality of the decision to hedge or not depends upon him. In this regard, it has been explored that if the CEO compensation is given to a large extent in the form of share options, the likelihood of using derivatives to hedge the risk goes down. This happens because the CEO would want to enhance value of his share options (compensation), which is possible with increased risk. Thus, in such cases, the CEO might decide not opt for derivatives and hedge the risk (Adkins, Carter, Simpson, 2006).  

The liquidity refers to the firm’s ability to pay off short term debt as and when it falls due for payment. The liquidity of a firm is indicated by the current and quick ratio (Shaari, et al., 2013). The current ratio which is computed by dividing the current assets by the current liabilities is considered to be the prominent indicator liquidity. The use of derivatives in respect to the items of current assets and current liabilities is essential in establishing its linkage with liquidity. In respect to current assets, a firm may use derivatives to hedge the foreign currency accounts payables and bills receivables. Further, in regard to the current liabilities, the firm could use derivatives to hedge the exposure on the foreign currency accounts payables, note payables, and other short terms foreign currency loans (Shaari, et al., 2013).

In order to find out the relationship between liquidity and the use of derivatives, current ratio has been considered as proxy (Shaari, et al., 2013). The result of empirical research conducted in this area depicts that there exists an adverse relationship between current ratio and the usages of derivatives. This implies that when the current ratio goes up, the firm’s usage of derivatives in hedging the risk goes down and vises a versa. Thus, it could be inferred that an adverse relationship exists between liquidity and the usages of derivatives by the firm (Shaari, et al., 2013).

It has been observed that the firms with high current ratio (adequate liquidity), face little risk and thus, the need to reduce the risk further using derivatives remains less. The adequacy of funds to meet out the short term debt makes the firm independent and reduces the financial risk to a great extent. This appears to be the most probable reason for adverse relationship between the usages of firm’s derivatives and liquidity (Shaari, et al., 2013). 

Real Option in Capital Budgeting

It is crucial to understand the relationship between profitability and the firm’s usages of the derivatives. All the firms operate with the primary objective of bringing stability in the profitability. Therefore, it is quite common to understand that all strategies and policies of the firm will be directed to stabilize the profitability, whether those strategies are risk management strategies with usages of derivatives or other strategies and plans. It is an established fact that the firms with adequate risk management outperform the others which are not able to manage the risk adequately (Chanzu and Gekara, 2014). The use of derivatives is a strategy that a firm plans for financial risk control and reduction. Thus, there would be definitely an impact of usages of derivatives on the firm’s profitability. However, the magnitude of the impact will depend upon the efficacy with which the firm usages the derivatives to reduce the financial risk (Chanzu and Gekara, 2014).

Generally, the usages of derivatives will reduce the risk exposure and thus, the portability can be expected to stabilize (Shaari, et al., 2013). However, the use of derivatives to reduce the risk exposure could be quite costly and for that reason it may reduce the profits of the firm. The firm has to pay high premiums in the case of derivatives such as future contracts, forward contracts, and option contracts. Thus, if the strategies to hedge the risk are not planned appropriately, it may adversely affect the profitability. The commonly accepted principle that lower the risk lower will be the profitability and vice a versa, also proves to be true in the case of usage of derivatives. The use of derivatives reduces the volatility in profitability but at the same time it also increases the cost thus, bringing the profitability down (Shaari, et al., 2013).

The researches have been conducted to find out the impact of use of derivatives on return on equity and return on assets. The return on equity and return on assets are considered to be adequate representatives of profitability. The return on equity measures the percentage of net profit to the shareholder’s equity deployed in the business while the return on assets shows overall profitability of the firm. The empirical evidences depicts that both the return on equity as well as return on assets goes down with the usages of derivatives (Shaari, et al., 2013). There has been observed a negative relationship between the use of derivatives and the return earned by the firm. These empirical evidences can also be supported by the theories of financial management also. The theories of financial management state that as the risk reduces, the return goes down (Brigham and Ehrhardt, 2007).

Further, there is one more reason for reduction in the return on equity and the return on assets with the usage of derivatives. This is related to the impact of derivative contracts on the balance sheet (Ramirez, 2015). The derivative contracts increase equity or liability on one side and assets on the other side of the balance sheet. Further, the cost of derivatives such as premium reduces the net profits of the firm. Thus, the combined effect of increase in equity and reduction in net profits causes the return on equity to go down. Similarly, the increase in assets and reduced profits cause the return on assets to decrease (Ramirez, 2015).

References

Adkins, L.C., Carter, D.A., Simpson, W.G. 2006. Managerial incentives and the use of foreign-exchange derivatives by banks. Retrieved January 08, 2017, from https://learneconometrics.com/pdf/cragg12.pdf

Brigham, E. and Ehrhardt, M. 2007. Financial Management: Theory & Practice. Cengage Learning.

Chanzu, L.N. and Gekara, M. 2014. Effects of Use of Derivatives on Financial Performance of Companies Listed in the Nairobi Security Exchange. International Journal of Academic Research in Accounting, Finance and Management Sciences, 4(4), pp. 27-43.

International Corporate Finance, + Website: Value Creation with Currency Derivatives in Global Jacque, L.L. 2014. Capital Markets. John Wiley & Sons.

Lynch, T.E. 2011. Derivatives: A Twenty-First Century Understanding. Loyola University Chicago Law Journal, 43, pp. 1-51.

Ramirez, J. 2015. Accounting for Derivatives: Advanced Hedging under IFRS 9. John Wiley & Sons.

Sajjad, F., Noreen, U., and Zaman, K. 2013. Impact of Derivatives on Financial Services Sector and Risk Management. Middle-East Journal of Scientific Research, 18(6), pp. 748-758.

Shaari, N.A., Hasan, N.A., Palanimally, Y.R., Kumar, R., and Mohamed, M.H. 2013. The Determinants of Derivative Usage: A study on Malaysian firms. Interdisciplinary Journal of Contemporary Research in Business, 5(2), pp. 300-316.

Titman, S., Wei, K.C., and Xie, F. 2004. Capital investment and stock returns. The Journal of Financial and Quantitative Analysis, 39(4), pp. 677-700.