Hedging and Taking Risk : On the Role of Derivatives and Stock Options

This paper empirically examines the relation between the use of derivatives and the risk level of firms in a sample of 431 large Japanese nonfinancial firms. Previous studies investigating whether firms systematically reduce or increase their risk with derivatives show that firms reduce their risk. By contrast, this paper shows that the use of derivatives increases total risk and firm-specific risk. However, the magnitude of the increase is not economically significant. Further analysis provides some evidence on the association between derivatives and stock options. The results show that there is a positive relation between the use of derivatives and stock options. In addition, firms introducing stock options invest in Ramp;D activities to a greater extent than firms that do not introduce stock options. These findings suggest that Japanese firms use derivatives to hedge homogeneous risk and adopt stock option compensation to take core-business risk