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Adam [2002] gives empirical support to Froot et al. [1993] in many ways. He shows that
less diversified firms are more likely to hedge. More importantly, he finds a strong and
robust relationship between the minimum revenue guaranteed by hedging and investment
expenditures, suggesting that firms hedge their future investment expenditures. In addition,
he finds that investment expenditures are a major determinant of the amount of capital that
firms raise externally. Finally, he shows that the median firm that does not hedge finances
100% of its investment expenditures externally, while the median firm that hedges finances
only 86% of its investment expenditures externally. 179 These results are consistent with the
hypothesis that firms hedge to reduce their dependence on external capital markets, and are
also consistent with Minton/Schrand [1999] who show that cash flow volatility reduces
investment spending. 180
Carter, Rogers, and Simkins [2003] investigate jet fuel hedging behavior of firms in the US
airline industry during 1994-2000. 181 Their results suggest that jet fuel hedging is
positively related to airline firm value because on one hand hedging allows larger airlines
more ability to fund investment during periods of high jet fuel prices (low operating cash
flow) by investing in aircraft of financially distressed airlines at discount prices.
Alternatively, (smaller) airlines may wish to hedge to avoid the possibility of selling assets
at below-market values (forced sale-out), thus reducing expected financial distress costs.
Both considerations fit into the conclusions of Froot et al. [1993] on the purpose of
hedging: assurance of adequate internal cash for investment opportunities, and lowering
the cost of external finance by reducing distress costs and/or information asymmetry.
Carter et al. [2003] show that airlines hedging jet fuel demand a value premium in the
range of 14%-16% in firm value. They also measure the value impact of changes in
hedging policy, and suggest that hedgers are 12%-13% more valuable as a result of
179 He investigates the North American gold mining industry with a total sample of 111 companies.
180 The adverse impact of cash flow volatility on investment spending is empirically documented in
Minton/Schrand [1999]. They find that cash flow volatility is associated with both lower investment spending
and higher costs of accessing capital through external sources. They also find that firms do not appear to
smooth their investment spending to cash flow fluctuations (by using external funds) but seem to forego
investment permanently.
181 Their industry selection is deliberate since it conforms well to the theoretic framework of Froot et al.
[1993]: other value-increasing reasons for hedging (e.g. convexity of tax function, increases in debt tax
shields) do not fit the airline data particularly well; on the other hand, operating cash flow is highly exposed
to a very volatile market factor (jet fuel price), airlines possess valuable investment opportunities when jet
fuel prices are high, and airlines face significant distress costs increasing the deadweight costs on external
financing. Hence, it is an ideal framework to analyze the interplay between hedging and investment policies.
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