Explaining the diversity in findings on derivatives uses and firm value: Insights from firms' commodity futures use

Abstract

Empirical studies show mixed and inconclusive findings on the relationship between derivatives uses and firm value, with reasons remaining unclear. This paper addresses this issue by applying the enterprise discounted cash flow (DCF) model. Based on commodity futures uses in China's non-financial publicly listed companies, this paper shows that the use of commodity futures, either for the purpose of hedging or speculation, diminishes the firm value. Specifically, the hedging ones damage the operational portion of firm value through a modest decline in free cash flow—primarily attributable to a substantial increase in capital expenditure—and a relatively stable cost of capital. Conversely, the speculation ones harm the non-operating portion of firm value via a steep rise in the cost of capital and the investment gains. Our findings show that hedging and speculation derivatives impact different aspects of firm value through cash flow and cost of capital channels. These findings help to explain the diverse empirical findings on the relationship between derivatives and firm value.