This paper investigates the motivations and practice of nonfinancial firms with regard to using options in their risk management activities.
The paper provides a comprehensive account of the existing empirical evidence and analyzes data on the use of derivatives in general and options in particular by nonfinancial corporations across different underlyings and countries.
Overall, a significant number of 15‐25 per cent of the firms outside the financial sector use options. This reflects the fact that options are very versatile risk management instruments that can be used to hedge various types of exposures, linear as well as nonlinear. In particular, options are a useful component of corporate risk management if exposures are uncertain, e.g. due to price and quantity risk. Depending on the correlation between price and quantity risk, the optimal hedge portfolio consists of a varying combination of linear and nonlinear risk management instruments. Moreover, the accounting treatment as well as liquidity effects can impact the choice of derivative. At the same time, there may be agency‐related incentives to use options because of their role to present dual bets on both direction as well as future volatility of the underlying.
The findings are important with regards to assessing whether the full potential of derivative financial instruments is being realized, since not all firms use these instruments and not all of them use all types and, more importantly, whether they are used appropriately.
The paper provides an up‐to‐date analysis of the motivations for nonfinancial firms to use financial derivatives in general and options in particular as well as comprehensively characterizes the extent of their use in practice.
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