Tim R. Adam

THE INVESTMENT OPPORTUNITY SET AND ITS PROXY VARIABLES

We use a real options approach to evaluate the performance of several proxy variables for a firms investment opportunity set. The results show that, on a relative scale, the market-to-book assets ratio has the highest information content with respect to investment opportunities. Although both the market-to-book equity and the earnings-price ratios are related to investment opportunities, they do not contain information that is not already contained in the market-to-book assets ratio. Consistent with this finding, a common factor constructed from several proxy variables does not improve the performance of the market-to-book assets ratio. 2008 The Southern Finance Association and the Southwestern Finance Association.

Managerial Overconfidence and Corporate Risk Management

We examine whether managerial overconfidence can help explain the observed discrepancies between the theory and practice of corporate risk management. We use a unique dataset of corporate derivatives positions that enables us to directly observe managerial reactions to their (speculative) gains and losses from market timing when they use derivatives. We find that managers increase their speculative activities using derivatives following speculative cash flow gains, while they do not reduce their speculative activities following speculative losses. This asymmetric response is consistent with the selective self-attribution associated with overconfidence. Our time series approach to measuring overconfidence complements cross-sectional approaches currently used in the literature. Our results show that managerial overconfidence, which has been found to influence a number of corporate decisions, also affects corporate risk management decisions.

Why Do Firms Engage in Selective Hedging

Surveys of corporate risk management document that selective hedging, where managers incorporate their market views into firms’ hedging programs, is widespread in the U.S. and other countries. Stulz (1996) argues that selective hedging could enhance the value of firms that possess an information advantage relative to the market and have the financial strength to withstand the additional risk from market timing. We study the practice of selective hedging in a 10-year sample of North American gold mining firms and find that selective hedging is most prevalent among firms that are least likely to meet these valuemaximizing criteria -- (a) smaller firms, i.e., firms that are least likely to have private information about future gold prices; and (b) firms that are closest to financial distress. The latter finding provides support for the alternative possibility suggested by Stulz that selective hedging may also be driven by asset substitution motives. We detect weak relationships between selective hedging and some corporate governance measures, especially board size, but find no evidence of a link between selective hedging and managerial compensation.

Strategic Risk Management and Product Market Competition

How does competition affect corporate risk management strategies? The the-oretical literature has derived conflicting predictions. Allayannis and Ihrig (2001) predict that firms operating in more competitive industries are more likely to hedge, while Mello and Ruckes (2008) predict that firms hedge less if competition is more intense. Adam, Dasgupta, and Titman (2007) show that competition can have a positive or negative impact on the number of firms that hedge in equilibrium. While the theoretical literature has produced conflicting answers, anecdotal evidence suggests that the competitive environment does affect firms’ hedging strategies. For example, Brown (2001) reports that competitive pricing concerns in the product market, rather than the traditional models of hedging, determine how a major durable goods producer in the US hedges its FX exposures.

Managerial Optimism and Debt Contract Design: The Case of Syndicated Loans

We examine whether managerial overconfidence impacts the use of performance-pricing provisions in loan contracts (PSD). Managers with biased views may issue PSD because they consider this form of debt to be mispriced. Our evidence shows that overconfident managers are more likely to issue rate-increasing PSD than regular debt. They choose PSD with steeper performance-pricing schedules than rational managers. We reject the possibility that overconfident managers have (persistent) positive private information and use PSD for signaling. Finally, firms appear to benefit less from using PSD ex post if they are managed by overconfident managers rather than rational managers.

Do Managers Exhibit Loss Aversion in Their Risk Management Practices? Evidence from the Gold Mining Industry

For years, hedging made Southwest Airlines Co. the most consistently profitable airline in the US. But included in its third-quarter earnings, released Thursday, was a

The Use of Credit Default Swaps by U.S. Fixed-Income Mutual Funds

247 million accounting charge, which reflected the decline in the value of its hedges as the price of oil dropped during the quarter. The charge caused Southwest, which had a healthy operating profit, to post a quarterly net loss for the first time in 17 years. ‘Southwest is looking for opportunities to “de-hedge” some of its fuel,’ Gary Kelly, the airline’s chief executive, said Thursday. ‘Low fuel prices are a good thing … and an opportunity that we’ll want to take the best advantage of that we can.’ Wall Street Journal, ‘Fuel Hedges Cloud Airline Results,’ 17 October 2008.

Hedging, speculation, and shareholder value

We examine the use of credit default swaps (CDS) in the U.S. mutual fund industry. We find that among the largest 100 corporate bond funds the use of CDS has increased from 20% in 2004 to 60% in 2008. Among CDS users, the average size of CDS positions (measured by their notional values) has increased from 2% to almost 14% of a fund’s net asset value. Some funds exceed this level by a wide margin. CDS are predominantly used to increase a fund’s exposure to credit risks rather than to hedge credit risk. Consistent with fund tournaments, underperforming funds use multi-name CDS to increase their credit risk exposures. Finally, funds that use CDS underperform funds that do not use CDS. Part of this underperformance is caused by poor market timing.