UK corporate use of derivatives

Abstract

The recent, and ongoing, large losses on derivatives transactions announced by UK corporates and the ensuing fears for systemic risk, highlight the need for focused research on derivative practices and corporate risk management activity in particular. This paper provides a descriptive analysis of the derivative practices of UK non-financial institutions, and attempts to evaluate whether these practices are consistent with value maximizing behaviour. Starting from the basic Modigliani and Miller Capital Structure proposition, more recent academic works on the subject are reviewed and analysed in the light of market Imperfections. Unlike previously published UK based research, this study encompasses a broad spectrum of both derivative instruments and companies surveyed, and offers a wider picture of derivative activity. The paper starts with an analysis of potential benefits and pitfalls of derivative instruments in risk management. The results of a survey, sent to 629 of the 637 corporates listed in the FTSE actuaries as of 1 April 1998 are discussed and compared to existing surveys which report mainly from North American markets. As a whole, the derivatives activity of UK corporates appears to be fairly similar to that of Canadian and US firms, but is still limited in view of the potential benefits that can be derived from their use in risk management. Small firms in particular do not seem to take advantage of the products available to manage their exposure to financial price risks, and initial findings suggest that this is because of a lack of knowledge in derivatives. The results support a positive relationship between derivative usage and firm size and a strong positive correlation between interest rate derivatives usage and firm size. Results also confirm that a significant proportion of firms appear to take unnecessary chances on financial markets using derivatives, although as expected, UK corporates do not use equity derivatives. Finally, although large firms seem to have adopted fairly consistent practices towards derivatives’ risk management; smaller firms have a far less consistent approach. Indeed, a significant number of them also do not appear to report their activity to the board of directors, and/or do not have a policy covering the use of these instruments.

Keywords:

• derivatives
• hedging
• risk management