A Survey on the Usage of Derivatives and Their Effecton Cost of Equity Capital

What is it about?

This research investigates the usage of derivatives and their impact on the listed companies’ cost of equity (COE) capital in Malaysia. We find that the usage of derivative instruments differs across industry sectors. Foreign exchange exposure management is one of the key components of financial risk management. Standardized over-the-counter forward contracts are used largely for hedging foreign exchange risk, while swaps are used for hedging interest rate risk. Most of the companies have policies for the derivatives activity, and internal and external auditors review such activities, either monthly and/or quarterly. VaR (value at risk) is a prominently used method for risk evaluation followed by stress testing. We also explored the behavioral factors affecting the usage of derivatives. We find that lack of expertise in handling derivatives is a source of concern for managers. Difficulty in understanding complex derivatives is perhaps an intimidating factor. Transaction costs associated with derivatives are another source of concern for managers. Last, we find several reasons for not using derivatives: not having sufficient exposure; their high cost compared with their benefits; lack of expertise; and their non-availability. Multivariate analysis does not support our central hypothesis that a negative relationship exists between the usage of derivatives and the COE capital.

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Why is it important?

The findings of this study imply that regulatory firms should train managers who have difficulty understanding complex derivatives. MASB and the Malaysian Institute of Accountants are two notable regulatory authorities that can also provide such training. The directors should take the responsibility to know about financial reporting standards, such as FRS 132 and FRS 139. Most important, managers should be advised to be open-minded and think strategically about the risk management function, with the aim of creating value for shareholders. We propose that senior management monitor risk management on a regular basis and penalize managers for any lack of transparency in risk management disclosure. Management should put in place a reporting framework that reviews derivatives knowledge and risk according to industry standards.

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