Why Do Firms Speculate? Evidence from the Gold Mining Industry

We study the selective hedging puzzle, using data on the speculative activity of a sample of 92 North American gold mining firms, a setting that seems likely to satisfy the conditions stipulated by Stulz (1996) for shareholder value-maximizing selective hedging. Contrary to our predictions, we find that smaller firms speculate more than larger firms, although they are less likely than larger firms to possess the information and financial advantages necessary to outperform the market through speculation. We also find that a higher probability of financial distress is linked to a higher likelihood of corporate speculation. Nonetheless, this finding fails to explain the speculation undertaken by the bulk of the firms in our sample, which are financially sound and far from bankruptcy. Our findings on the relationship between speculation and managerial incentives provide no support for (and indeed, contradicts) the possibility that managers may be speculating in their own self interest. We find that rewarding managers through stock and options, and also insider ownership of the firm's shares, actually work to reduce managerial incentives to speculate. Since neither shareholders nor managers seem to benefit from selective hedging, our findings are consistent with the remaining possibility for selective hedging identified by Stulz (1996) - that managers hedge selectively because they erroneously believe they can outperform the market - which raises many new questions for future research