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TRANSCRIPT
The Thin Edge of the Hedge
Is director hedging part of an optimal
contract or a manifestation of executive
power?
Olivia Bible and Dr Peter Pham
Olivia Bible will be attending and presenting at the conference.
Address: 160C Terry Street Phone: +614 04 230 937
Connells Point Fax: +612 9547 2612
NSW, 2221 Email: [email protected]
Australia EFMA codes: 150, 190, 440
TABLE OF CONTENTS
LIST OF TABLES ................................................................................................................................... i
LIST OF FIGURES ................................................................................................................................. i
ABSTRACT ............................................................................................................................................ ii
1. INTRODUCTION ........................................................................................................................... 1
2. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT ............................................. 7
2.1 Principal-agent problem .......................................................................................................... 8
2.2 Theories of compensation ...................................................................................................... 10
2.2.1 Optimal contracting .................................................................................................... 10
2.2.2 Executive power hypothesis ....................................................................................... 13
2.3 Managerial hedging ............................................................................................................... 15
2.3.1 Desirable hedging ....................................................................................................... 16
2.3.2 Regulatory changes ..................................................................................................... 18
2.4 Hypotheses development ....................................................................................................... 19
2.4.1 Portfolio diversification .............................................................................................. 21
2.4.2 Incentive misalignment ............................................................................................... 22
2.4.3 Insider trading ............................................................................................................. 23
2.4.4 Wealth effect ............................................................................................................... 24
3. DATA AND RESEARCH DESIGN ............................................................................................. 25
3.1 Institutional detail .................................................................................................................. 25
3.1.1 Collars ......................................................................................................................... 25
3.1.2 Margin loans ............................................................................................................... 27
3.1.3 Loans over protected puts ........................................................................................... 27
3.1.4 Equity swaps ............................................................................................................... 28
3.2 Data ....................................................................................................................................... 29
3.3 Research design ..................................................................................................................... 32
3.4 Test 1 – Determinants of hedging and hedging amount ........................................................ 32
3.4.1 Logit regression .......................................................................................................... 35
3.4.2 Tobit regression .......................................................................................................... 36
3.5 Test 2 – Short-run event study ............................................................................................... 37
3.6 Test 3 – Do hedging decisions reflect long-run expectations? .............................................. 39
3.6.1 Share price declines .................................................................................................... 39
3.6.2 Increase in volatility .................................................................................................... 40
3.7 Test 4 – Directors‟ buying and selling patterns surrounding the hedging event ................... 41
4. RESULTS ..................................................................................................................................... 42
4.1 Test 1 – Determinants of hedging and hedging amount ........................................................ 42
4.1.1 Descriptive statistics ................................................................................................... 42
4.1.2 Binary logit regression ................................................................................................ 45
4.1.3 Multinomial logit regression ....................................................................................... 48
4.1.4 Tobit regression .......................................................................................................... 50
4.2 Test 2 – Short-run event study ............................................................................................... 54
4.2.1 Returns for the pre and post event windows ............................................................... 54
4.2.2 Market reaction to announcement ............................................................................... 55
4.3 Test 3 – Do hedging decisions reflect long-run expectations? .............................................. 60
4.3.1 Long term share price ................................................................................................. 60
4.3.2 Changes in volatility ................................................................................................... 62
4.4 Test 4 – Directors‟ buying and selling patterns surrounding the hedging event ................... 64
4.4.1 Share trading around hedging date ............................................................................. 64
5. CONCLUSION ............................................................................................................................. 66
REFERENCES ..................................................................................................................................... 69
APPENDICES ...................................................................................................................................... 75
i
LIST OF TABLES
Table 1: Scenarios on expiry of the collar ............................................................................... 26
Table 2: Descriptive statistics for the variables in the logit and tobit regressions ................... 43
Table 3: Results of the Wilcoxon signed-rank test for logit and tobit variables ...................... 44
Table 4: Results for binary logit regression ............................................................................. 46
Table 5a: Results for multinomial logit regression – corporate governance variables only .... 48
Table 5b: Results for multinomial logit regression – corporate governance and firm variables
only .......................................................................................................................... 49
Table 5c: Results for multinomial logit regression – corporate governance, firm and financial
variables ................................................................................................................... 50
Table 6: Results for tobit regression ........................................................................................ 51
Table 7: Significance of average cumulative abnormal returns for a three day event window
.................................................................................................................................................. 55
Table 8: Significance of average cumulative abnormal returns for a five day event window. 58
Table 9: Significance of adjusted buy-hold returns for three years after hedging ................... 61
Table 10: Volatility in hedging companies‟ share prices before and after hedging ................ 63
Table 11: Overall ratios of directors‟ trading around the hedging date ................................... 64
Table 12: Results of Wilcoxon signed-rank test for net purchases .......................................... 65
Table 13: Explanation of the source and calculation of the corporate governance, firm and
financial variables used in the logit and tobit regressions ....................................... 76
Table 14: Banks involved in hedging contracts ....................................................................... 77
LIST OF FIGURES
Figure 1: Payoff for a collar ..................................................................................................... 26
Figure 2: Payoff for a loan over a put option and underlying share ........................................ 28
Figure 3: Average cumulative abnormal returns for hedging companies ................................ 54
Figure 4: Average cumulative abnormal returns for a three day event window ...................... 57
Figure 5: Average cumulative abnormal returns for a five day event window ....................... 59
ii
ABSTRACT
Hedging contracts such as collars, margin loans, loans over protected puts and equity swaps
provide insiders with the opportunity to reduce the risk associated with their personal
holdings in the company‟s equity. This can be part of a portfolio diversification strategy or
an opportunity for directors to alter their existing incentives and to trade on insider
information. Consequently, the motivations and use of these contracts have important
implications for whether executives‟ compensation can be explained by the optimal
contracting theory or the executive power hypothesis. The issue of executive hedging is also
highly topical in the Australian market due to recent changes in the regulatory sphere and
investment banks increasing their marketing effort for these products. Using hand-collected
data on director hedging in Australian firms, this thesis documents that the impact of the
hedging decision on a director‟s portfolio is not trivial. The directors who do hedge, hedge,
on average, forty-three percent of their shareholdings. The findings of this thesis indicate that
directors of firms that have weaker corporate governance mechanisms and less financial
stability are more likely to hedge and hedge a greater proportion of their share holdings. In
terms of immediate price effects, the announcement of director hedging attracts a
significantly negative market reaction. Over the longer horizon, there is some weak evidence
to suggest that directors hedge before significant share price decreases. However, they do not
appear to reverse their share purchase patterns after hedging. Overall, while these findings
are somewhat consistent with the executive power hypothesis, the evidence is not conclusive
enough to say that directors use hedging as an alternative means of insider trading.
1
1. INTRODUCTION
Arguably the most contentious issue being debated post global financial crisis (GFC) is the
potential misalignment of executive and shareholder interests. Directors of companies are
partly paid in shares in an attempt to make them act like shareholders and work in their best
interests. Therefore, it seem incongruent that there has been an increase in the development,
sophistication and use of strategies that enable directors to hedge their stock ownership
positions in the firm and reduce their exposure to adverse stock price movements.
This thesis discusses the growing use and possible motives behind directors of Australian
publicly listed companies using hedging instruments. It specifically examines the
motivations behind and effects of collars, margin loans, loans over protected puts and equity
swaps. A collar involves the simultaneous purchase of a put option funded by the proceeds
received from the sale of a call option on the stock of a company. A margin loan is a loan
secured by shares and subject to margin calls if the underlying shares fall below a certain
level. Although this does not protect directors against the downside risk of their own
companies, such loans can be used for the purchase of other investments, and hence, help
directors diversify and improve the liquidity of their portfolios. A loan over a protected put is
a loan secured by put options and the underlying shares, thereby protecting downside risk and
an equity swap is an exchange of the returns on the firm‟s stock for the cash flows on another
asset such as an index fund or risk-free security. The primary feature of these hedging
transactions is that they reduce downside risk and/or give the director an opportunity to
reduce their exposure to the company by diversifying their portfolio. However, there are
potential adverse consequences on director incentives. Directors may hedge to change the
2
alignment feature of their incentive contracts and use it as a way to trade on insider
information.
Analysing these hedging instruments and the motivations behind using them is of important
theoretical value. Currently, the existing literature on executive compensation is delineated
into two main strands of theoretical propositions. The optimal contracting theory suggests
that directors‟ employment contracts are the right balance between fixed and variable pay to
align directors‟ incentives with those of shareholders. If this is the case, then why do some
directors hedge part of their share holdings thereby reducing their sensitivity to share price
decreases? One benign reason could be for risk reduction. Some factors that influence the
company‟s share price are beyond directors‟ control and yet it still affects their variable pay.
Due to this reason, risk reduction through diversification has to be taken into account when
designing directors‟ contracts to achieve an equilibrium outcome satisfactory to both
directors/managers and shareholders. Amihud and Lev (1981) and Stulz (1984) suggest that
providing insiders, who hold relatively undiversified portfolios, with the ability to hedge,
may benefit shareholders by reducing investment distortions. Hedging has advantages over
open market sales; including deferring personal income taxes, maintaining some of the upside
gain in share price and maintaining voting and dividend rights on the underlying shares that
are hedged.
However, by engaging in these hedging transactions, insiders can reduce the sensitivity of
their wealth to firm performance to the point where their compensation contracts are no
longer optimal. This motivation behind hedging would be consistent with the executive
power hypothesis; that executives use their power and influence in the firm to shape policies
so they can extract rents and fulfil their own motives. This ability to alter the link between
3
managerial wealth and shareholder value is of particular concern if directors act on their
information advantage and reduce the exposure of their ownership positions to firm
performance in advance of declines in the company‟s stock price or increases in share price
volatility. Concerns over how these transactions can be used to alter incentive alignment and
trade on insider information have prompted the Australian federal government to introduce
the Corporations Amendment (Improving Accountability on Director and Executive
Remuneration) Act 2011 that places a ban on executive hedging of unvested and restricted
shares and makes it a criminal offence for all involved. However, as the ban does not extend
to other types of shares, director hedging still remains to be a serious corporate governance
issue with regards to insider trading implications. These types of hedging contracts are also
interesting because the structure and reporting requirements for these instruments suggest
they may be less likely to attract market scrutiny than open-market purchases and sales.
Unlike open-market trades, insider trading in these hedging instruments has not been readily
observable by market participants (Bettis, Bizjak and Lemmon, 2001). When announced,
these transactions appear only on Part 2 of Appendix 3Y filed by the company secretary with
the ASX. In general, the services that provide insider trading data do not release the data
needed to identify hedging transactions.
Although a large body of theoretical and empirical literature exists for the importance of
managerial ownership, the optimal contracting theory and executive power hypothesis,
relatively little attention has been paid to the ability of insiders to directly influence the
structure of their incentive contracts through the use of hedging contracts. Jensen and
Meckling (1976) demonstrate the benefits of profit sharing schemes to incentivise managers
to work in the best interests of the firm rather than themselves. However, these contracts may
be far from optimal if managers are allowed to alter their shareholdings ex post to achieve
4
their own aims or if managers have access to private information. Yermack (1997) examines
the timing of stock option grants to CEOs and finds that managers are more likely to receive
an option grant prior to significant improvements in the firm‟s share price which indicates
that managers who have inside information may influence the board to grant more
performance-based pay. Two notable studies in the US, Bettis, Bizjak and Lemmon (2001)
and Bettis, Bizjak and Kalpathy (2010), look specifically at the motivations behind executive
hedging, in particular as a way of trading on insider information. There are no papers on this
subject in Australia.
This thesis aims to breach this gap by presenting this topic in an Australian context in light of
the recent ban on hedging unvested and restricted stock for key management personnel. Its
main analysis focuses on the determinants of the hedging decision and how shareholders
react to director hedging announcements. Expanding on the Bettis, Bizjak and Lemmon
(2001) and Bettis, Bizjak and Kalpathy (2010) papers, it examines a greater range of hedging
contracts such as margin loans and loans over protected puts and looks at a longer term view
in share price returns and volatility when examining the motivations behind director hedging.
Another new direction taken in this thesis is a look at directors‟ share trading activities after
their hedging transactions to analyse in greater detail the insider trading angle.
This thesis attempts to cover the entire population of hedging transactions from 2003 to 2011,
and finds that directors use hedging instruments to cover a significant proportion of their
holdings of the firm‟s stock. The average number of shares covered by the hedging
transaction represents 43 percent of directors‟ total holdings and the contracts are in effect for
an average of 23.5 months.
5
The evidence uncovered by this thesis on the motivations behind hedging appears to support
the use of these financial instruments primarily for purposes of portfolio diversification.
Directors are more likely to hedge more of their shares if they are working in companies
where directors have high levels of ownership and where the company has been listed on the
stock exchange for less time. Young firms may have more uncertain prospects compared to
older firms, and executives of these firms tend to hold substantially larger equity stakes, are
restricted from selling shares for a period of time after the initial public offering (IPO) and
may be reluctant to sell their shares due to the negative signal that it could give the market.
Furthermore, directors still purchase shares after they hedge, although they buy fewer shares
than they did before hedging. This is in contrast to the findings of Ofek and Yermack (2000)
who found managers sell stock when options are exercised. However, this type of evidence
does not provide a clear conclusion that hedging is part of an optimal contract as
diversification can still have adverse consequences on misaligning incentives and
shareholders do not like directors hedging their shares.
In fact, many other findings of this thesis point to an explanation of director hedging
consistent with the executive power hypothesis; that directors may use their influence in the
firm to allow themselves to hedge to suit their own motives. Directors in companies that
have weaker corporate governance mechanisms (such as a higher percentage of executive
directors on the board), higher debt levels and negative ex post stock price returns are more
likely to hedge a larger portion of their share holdings. These variables, particularly the
negative returns post hedging, may indicate opportunistic behaviour by the executives. This
is further emphasised by the market‟s significant negative reaction to director hedging on and
one day after the hedging is announced. However, there is no evidence of abnormal negative
returns, one, two and three years after the hedging event and there are only increased levels of
6
volatility in the stock price after hedging for collars and loans over protected puts. This
implies that it is unlikely directors hedge due to insider knowledge about upcoming changes
to the share price or levels of volatility.
Whilst the above mentioned evidence indicates that directors primarily hedge for increased
diversification, the fact that these transactions significantly reduce the link between executive
wealth and firm performance and the evidence suggests that some opportunistic timing may
occur; an increase in the transparency of these filings that provides useful information to the
market and improves monitoring could be of some value. The newly passed legislation, The
Corporations Amendment (Improving Accountability on Director and Executive
Remuneration) Act 2011, that bans director hedging on unvested and restricted securities is
largely unnecessary as the hedging contracts in Australia do not cover these types of shares.
An extension to this legislation to cover vested securities would not be desirable as it would
prevent directors from hedging for legitimate reasons such as risk reduction.
The remainder of the thesis is organised as follows. Section 2 provides a more thorough
review of related literature on the principal-agent problem, optimal contracting theory,
executive power hypothesis and director hedging. It also provides background for the
different motivations directors would have to use these hedging contracts and develops the
hypotheses to be tested. Section 3 describes the structure of the hedging contracts, data used
and methodology used for the tests to be conducted. Section 4 contains the results of the tests
and Section 5 outlines the policy implications of the findings and concludes.
7
2. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT
Executive hedging has its roots in the principal-agent problem and remuneration contracting
theories. Fundamentally, if you do not give managers shares in the company they are
working for, the managers will be less likely to work in the best interests of shareholders.
The alignment of director and shareholder interests achieved by making directors also owners
of the firm seems to be undone when the directors can limit their economic risk. This may
lead to a moral hazard situation where the directors do not work for the best interests of the
shareholders because their own personal wealth is no longer closely aligned to the company‟s
share price.
Executive hedging presents a dichotomy between two remuneration contracting theories – the
optimal contracting theory and the executive power hypothesis. On the one hand, optimal
contracting theory suggests that directors‟ employment contracts not only remunerate them
adequately for their expertise and effort but also incentivises them to work in the best
interests of shareholders by giving them shares and options in the company. However, if this
was the case, then why would directors hedge the equity component of their remuneration in
order to limit the downside risk of the company‟s share price falling? The alternate
explanation is the executive power hypothesis which suggests that directors have enough
power in the company and their remuneration contracts, to allow them to hedge their equity,
even though, prima facie, it appears contrary to the purpose of awarding shares.
This thesis aims to weigh up these two theories by shedding light on director hedging in
Australia. It is a topic particularly relevant to the Australian market as no empirical work has
8
been conducted and there have been recent regulatory changes in the area. The Corporations
Amendment (Improving Accountability on Director and Executive Remuneration) Act 2011
prohibits directors from hedging unvested and restricted shares and makes it a criminal
offence for all parties involved.
2.1 Principal-agent problem
Very few issues in corporate finance have received as much attention as the principal-agent
problem and associated moral hazard. The theory has its origins in Adam Smith‟s “Wealth of
Nations” and deals with the idea that when there is a separation of ownership and control, the
owners have no way of knowing the effort of their agents/managers even when a contract is
put in place. They can only observe their final output/performance (Berle and Means, 1932).
Barnard (1938) emphasises the need to induce appropriate effort levels from members of the
organisation and to create authority relationships to deal with the incompleteness of incentive
contracts. Arrow (1963) introduces the idea of control of management and moral hazard by
examining the insurance industry. This recognises that providing work incentives is only part
of the principal-agent problem. To secure proper behaviour is equally important. Firms
frequently express concern over the risks management take. Some think managers take too
much risk, while others are seen as overly risk averse. Wilson (1968) and Ross (1973) extend
the work by redefining it as an agency problem and designing reward schemes which induce
correct incentives for risk taking.
To combat this principal agent problem, two seminal principal-agent models publicise the
benefits of managerial ownership (Jensen and Meckling, 1976 and Holmström, 1979).
9
Jensen and Meckling (1976) argue that the optimal contract design should employ profit
sharing schemes as managerial ownership deters executives from increasing their
consumption of perquisites. The consumption of perquisites leads to lower firm values.
Holmström (1979) argues that any measure of performance that reveals information about the
effort level chosen by the agent should be included in the compensation contract. The
principal agent problem and appropriate contracting to align incentives and encourage proper
risk taking is still relevant today. In the aftermath of the GFC there have been numerous new
studies on the principal-agent problem especially in the banking sector. Lang and Jagtiani
(2010) argue that the failure to apply well understood risk management principles in terms of
banks having too high a concentration in mortgage related securities is a result of principal-
agent problems internal to the banks. Additionally, their corporate governance systems, that
are designed to overcome these principal-agent problems, often break down.
The idea of incentivising executives to behave in the best interests of shareholders (and the
best way to do this) is being increasingly discussed in the media. Adam Bryant wrote
extensively about it in The New York Times in the mid and late 1990s, particularly in relation
to executives in publicly listed companies. Since the GFC, there have been a myriad of
articles reporting on executives‟ compensation packages with calls for the Australian federal
government to introduce a cap on pay. In July 2011, the government introduced the “two
strikes rule” which states that if a company receives more than a twenty-five percent “no”
vote against a remuneration report at two consecutive annual meetings, the shareholders must
vote on a board spill. GUD Holdings is the first company in Australia to be hit with a protest
vote under the new rules in its annual general meeting on 20 October 2011.
10
2.2 Theories of compensation
Up until the 1980s, executives were generally only paid a fixed salary (O‟Neill, 1999). In the
1980s, while many organisations experienced poor performances, the executives in charge
experienced no change in their salaries. This resulted in a resurgence of shareholders who
wanted to see executive compensation linked to the performance of the company (Brown and
Samson, 2003). More recently, this desire for compensation to incentivise managers is once
again a main driver of shareholder activism, especially with the introduction of shareholders
being able to spill boards of directors if the remuneration report is voted against for two
consecutive years.
2.2.1 Optimal contracting
Executives‟ compensation takes three main forms; flow compensation1, the changes in the
value of the executive‟s portfolio of shares and options and the possibility of the market‟s
downgrade of the executive‟s human capital following poor firm performance (Core, Guay
and Larcker, 2003). These components of compensation are intended to optimise the
incentive alignment between principals (executives) and agents (shareholders). However,
Matolcsy and Wright (2007) shows that in Australia around one third of the CEOs of
Australia‟s largest firms only receive cash and cash bonuses, no equity based compensation.
This may be because executives have enough influence over their own employment contracts
that they can shape them however they want.
1 Flow compensation is defined as the total of the executive‟s annual salary, bonus, new equity grants and other
compensation.
11
Optimal contracting for executive compensation strives to minimise the costs associated with
the principal-agent problem by providing executives with fair remuneration while giving
them “skin in the game” so they act in the best interests of shareholders (Fama and Jensen
1983, Easterbrook 1984; Fischel, 1982; and Wolfson 1980). Murphy (1985), Jensen and
Murphy (1990) and Hall and Liebman (1998) suggest that the primary incentive for
executives to increase their firms‟ stock prices is an increase in the value of their share and
option portfolio rather than an increase in their flow compensation or their reputations. Thus,
optimal pay contracts are derived and bargained over to distinguish executives by their talents
and efforts and to align executives‟ compensation most closely with increases in the
company‟s share price which is the goal of shareholders.
Optimal contracts focus on “the trade-off between incentives and insurance” (Gibbons, 1998)
by using fixed or risk-less pay and “risky” performance measures such as shares and options.
There is inherent risk for the managers that receive stock-based pay. If the share price goes
down, so too does their personal wealth. Similarly, if they are awarded stock options, there is
a risk that their options will never “come into the money”. This risk is meant to induce
managers to work harder at increasing the firms‟ stock prices. To incentivise managers for
the long term, companies restrict managers from trading a portion of their stocks for a
number of years. This vesting of securities makes managers more likely to stay with the firm
and strive for a higher share price in the longer term. However, more recently, Wu (2011)
determines that an optimal executive compensation package includes stock options rather
than restricted shares when information manipulation is present.
12
The idea of incentivising managers with pay is easily illustrated with Milgrom and Roberts‟
(1992) basic interest alignment model:
(1)
They defined the executive‟s compensation (w) as a linear function of his/her fixed salary (α)
as well as variable pay ( . The variable pay is a function of the executive‟s effort
(e) multiplied by the productivity of that effort (g) plus the factors beyond the executive‟s
control (ε) all multiplied by the output sharing rate or the bonus rate (β).
According to this model, it is assumed that the noise component (ε) is normally distributed,
the executive is risk averse and the shareholders are less risk averse than the executive. This
is because for an executive, their reputation is at stake. Making risky decisions that may not
necessarily result in higher payoffs would cause the market to downgrade the executive‟s
human capital, reducing his/her ability to obtain promotions or increased remuneration.
Shareholders are less risk averse because their investment in the company is a sunk cost, they
will not be required to contribute any more capital due to limited liability.
An executive‟s certain compensation (wE) has to be greater than zero to reward the executive
for his/her risk and effort cost.
(2)
The certain compensation (wE) is the fixed salary (α) plus the productive gains of his/her
effort multiplied by the output sharing rate ( ) less the cost of effort (C(e)) less the risk
premium (½r2βVar(ε)). This risk premium is because the executive is worried about factors
13
that are beyond his/her control. The executive will pick an effort level (e) that maximises wE
at . This is known as “the incentive compatibility constraint”. For the contract
to motivate the executive to exert high effort, the interests of the principal and the agent have
to be compatible.
Milgrom and Roberts (1992) also suggest that more profit sharing should be used when the
firm‟s potential profit is more dependent on effort (i.e. when the productivity of effort is
large), when the executive is less risk averse and when there is less variation from factors
beyond management‟s control. Bisin, Gottardi and Rampini (2008) argue that optimal
incentive compensation and governance provisions should monitor the manager‟s portfolio
when: the firm performs poorly; the manager‟s compensation is more sensitive to firm
performance; when the cost of monitoring is higher; and when hedging markets more
developed. This would suggest that hedging goes against the optimal contracting theory.
2.2.2 Executive power hypothesis
Like the optimal contract approach, the executive power hypothesis recognises the principal-
agent problem. However, the executive power hypothesis assumes that executives have the
power to influence their own compensation schemes and thus compensation is not the sole
remedy for the principal-agent problem. Certain features of the compensation package can be
part of the problem. Executives use their compensation to provide themselves with rents
(Bebchuk, Fried and Walker, 2002). Directors on remuneration committees are captured or
are influenced by management, resulting in a deviation from the optimal contract. As a
result, executives can receive pay in excess of the level that is optimal for shareholders
14
(Fried, 1998). In a recent study, Capezio, Shields and O‟Donnell (2011) find that Australian
companies with stronger corporate governance such as those chaired by non-executives and
dominated by non-executive directors at the board and compensation committees are no more
adept at enforcing CEO pay-for-firm-performance than executive-dominated boards. This
suggests that policy makers' faith in optimal contracting may be misplaced.
Furthermore, to camouflage or facilitate the extraction of rents, managerial power can lead to
the use of inefficient pay structures that weaken or distort incentives and thus, in turn, further
reduce shareholder value (Monks and Minow, 2001). For instance, an empirical study by
Yermack (1997) discovers that managers negotiate for more equity-based pay in advance of
anticipated stock price increases. The composition of the “risky” portion of managers‟
compensation packages can also induce managers to make certain investment timing
decisions. At the time their shares are about to vest or their options are about the expire,
managers may make investment decisions that drive the share price up in the short term but
are detrimental for the company in the long term, in an attempt to reduce the risk associated
with their performance pay decreasing in value.
The widespread use of equity remuneration and investment in the firm with their human
capital has lead to executives having undiversified wealth (O‟Brian 1997). Adam Bryant in
The New York Times reported on a survey conducted by the United States Trust Corporation
that cited that the top executives in the US held more than one third of their net worth in their
firm‟s stock in 1997. Portfolio theory predicts that managers should sell shares when they
receive additional stock in their firms to diversify away the unsystematic risk associated with
concentrating their wealth in a single company. This is consistent with the findings of Ofek
15
and Yermack (2000) where equity compensation increases the incentives of lower ownership
managers but higher ownership managers negate this impact by not only selling previously
owned shares but also selling nearly all of the shares after options were exercised to acquire
stock. For this reason and the executive power hypothesis, many executives are able to
extract rents by entering into other contracts that aim to limit the economic risk of some of
their equity compensation.
2.3 Managerial hedging
There has been a recent increase in the prevalence of managers hedging their equity
compensation, particularly in well established derivative markets such as the US and UK
(The Economist, 1999). Hedging facilities (especially the use of derivatives) have been
lucrative product lines for investment banks around the world; they privately confirm it is a
multi-million dollar business (The Economist, 1999). Demand for these structured products
may increase post GFC due to concerns that volatility in share prices could negatively affect
their personal wealth as it did in 2008 and 2009. Merrill Lynch in Sydney is currently
developing executive hedging strategies that will be rolled out in late 2011 and early 2012.
There is a distinct lack of empirical work conducted on managerial hedging. There are four
papers that look at the price-performance sensitivity of executives hedging their
remuneration, all set in a US context. Bolster, Chance and Rich (1996) look at a single equity
swap transaction by the CEO of Autotote in 1994. Bettis, Bizjak and Lemmon (2001)
examine eighty-five zero cost collars between 1996 and 1998 and find that hedging results in
a decrease in ownership of twenty-five percent and high ranking insiders are usually the ones
16
who hedge. Zero cost collars are the simultaneous purchase of a put and sale of a call. The
proceeds of the call pay for the put option, thereby allowing the executive to hedge without
having to pay a premium. Jagolinzer, Matsunaga and Yeung (2007) study 200 forward
contracts between 1996 and 2004 and Bettis, Bizjak and Kalpathy (2010) look at pre-paid
variable forwards, zero cost collars, exchange trust and equity swaps over a ten year period
from 1996.
There are no empirical studies of this nature conducted in an Australian context. However,
the idea of managerial hedging is discussed in a wider context through opinion and anecdotal
evidence, particularly by legal commentators and newspapers. Legal commentators argue
that this hedging activity undermines incentives in the executives‟ contracts, alters their
ownership levels in the firm and has adverse effects on share price performance (Easterbrook,
2002 and Lavelle, 2001). The fundamental question is if executives‟ employment contracts
are optimal, why do they hedge the equity component of their remuneration?
2.3.1 Desirable hedging
Not all hedging activity is undesirable. There are a large number of factors that decrease the
share price but are outside the executive‟s control. Allowing executives to hedge part of their
remuneration may actually benefit shareholders. While the subjects of these papers are not
on managerial hedging, Amihud and Lev (1981) and Stulz (1984) conclude that providing
insiders, who hold relative undiversified portfolios, with the ability to hedge, may benefit
shareholders by reducing investment distortions and/or preventing the hedging of cash flows
at the corporate level. Acharya and Bisin (2002) further emphasise this idea by showing that
17
if risk-averse managers are restricted from trading in their own firms, they have an incentive
to substitute the “unhedgable, firm-specific risk of their firm‟s cash flows for hedgable,
aggregate risks” (Acharya and Bisin, 2008, p.1) by reducing their entrepreneurial activity. If
all managers in the economy engage in this kind of behaviour, then the cash flows of firms
become more correlated with each other and the lack of entrepreneurial activity produces
excessive aggregate risk in the stock market. This means that shareholders and investors
have a decreased ability to use the stock market for risk-sharing purposes, thus resulting in a
“diversification externality” (Acharya and Bisin, 2002, p.1).
This thesis aims to breach the gap that currently exists between the theoretical and opinion
based work and empirical work in the managerial hedging topic area. It also aims to shed
light on the question of whether the motivation behind executive hedging is explained by the
optimal contracting theory or executive power hypothesis. It contributes to this area of work
by examining the topic in an Australian context, particularly in light of regulatory changes in
the area of executive compensation and hedging practices. The Bettis, Bizjak and Lemmon
(2001) and Bettis, Bizjak and Kalpathy (2010) papers look at numerous types of hedging
instruments in the US market. They conduct logit regression analysis to determine the factors
that would most likely decide whether directors of a company would hedge and the impact it
has on share price in the short term. However, these papers have conflicting results. Bettis,
Bizjak and Lemmon (2001) find no evidence of managers hedging at opportunistic times
while Bettis, Bizjak and Kalpathy (2010) find that managers would hedge before a share
price decline. Given that opportunistic trading and misalignment of incentives are the main
reasons for recent regulatory change in Australia, it is important to determine what happens
in this market. This thesis will introduce and examine a number of less conventional methods
of hedging such as loans granted over protected puts and transactions that do not involve the
18
use of derivatives such as margin loans used to fund the purchase of other investments.
These types of hedging transactions still achieve the same outcomes as collars and equity
swaps, they allow directors to raise money, protect share value and diversify their portfolio.
Additionally, this thesis will increase the robustness of testing these theories by employing a
number of different tests such as tobit regression and event studies. Tobit regression analysis
highlights the variables that determine the amount of shares directors hedge. Event studies
look at the overall wealth effect and market perception of director hedging. Likewise, the
examination of volatility and share price performance for the longer term i.e. 6 months, 1, 2
and 3 years post hedging event, expands the results of the US studies. The maximum length
of time the previous papers examined is six months. As most hedging contracts are for a
longer period of time, it is logical that the longer term is also examined.
2.3.2 Regulatory changes
The Corporations Amendment (Improving Accountability on Director and Executive
Remuneration) Act 2011 (The Act) was given Royal Assent on 27 June 2011 and prohibits
key management personnel from entering into hedging transactions from 1 July 2011. The
legislation is a result of the Rudd government asking the Productivity Commission to
undertake a review of the Australian executive remuneration legal framework for listed
companies in the aftermath of the GFC and concern about excessive executive remuneration
(Productivity Commission, 2009).
It was unclear from the explanatory memorandum of the draft legislation whether the
government was banning managerial hedging on vested and unvested remuneration or just
19
unvested remuneration. The Productivity Commission received a number of diverse opinions
on the issue and the final legislation specifically states that it is a ban on hedging unvested
remuneration or vested remuneration that is subject to a holding lock. This will have no
effect on managerial hedging as most companies state in their securities trading policy that
they disallow hedging on unvested securities and restricted securities and investment banks
only hedge vested and unrestricted securities as they take effective ownership of the shares.
The Chartered Secretaries Australia (CSA) and Macquarie Group argued that executives
should be permitted to hedge vested remuneration while the Australian Institute of Company
Directors (AICD) “said that the corporations and other black-letter law „might not prove
effective given the complexities of hedging arrangements, and the difficulties in legislating
for all possible vesting conditions and trading limitations‟” (Productivity Commission, 2009).
It is important to note that the legislation does not expressly ban margin lending.
Both sides of parliament seem to agree that managerial hedging distorts the incentive
alignment that equity remuneration achieves. In the second reading of the bill, Joe Hockey,
Shadow Treasurer said that the coalition “will be supporting this measure as, from our
perspective, the executive remuneration of key management personnel should be closely
linked to their performance and the performance of the company they lead.” (Australia,
House of Representatives, Debates, 2011, p3177).
2.4 Hypotheses development
The hypotheses for this thesis focus on the reasons why executives hedge. The first are
legitimate reasons for portfolio diversification and tax deferral. Directors do not want to
20
extract rents or trade on insider information, they just want to reduce the risk that they
currently face by having their wealth concentrated in one firm. This goes against the
executive power hypothesis as the compensation contracts align the incentives of managers
and shareholders, so much so that the managers seek to legitimately reduce the risk in their
undiversified portfolio. Additionally, hedging shares is another way directors can defer tax,
another legitimate reason that does not involve the directors extracting rents or distorting
incentives. In an open market when a director sells equity, he/she is taxed on the sale (s104-
25 of Income Tax Assessment Act 1997), however, when using these derivative transactions,
the tax on any gains is generally deferred until the expiration of the contract. Additionally,
the interest paid on a margin loan or loan over a protected put is tax deductible (s8-1 of
Income Tax Assessment Act 1997). Consequently, directors may choose to use these
structured products for diversification rather than selling their shares when tax rates are high
or they anticipate changes in tax rates. In Australia since 2003, there have been no changes
to the income tax or capital gains tax legislation that would have a material effect on the tax
directors pay when they sell their shares.
The second set of motivations behind director hedging is to misalign incentives between
directors and shareholders and profit from private information about future performance.
These motivations are in line with the executive power hypothesis. Directors influence the
trading policies and practices of the firms so they can allow themselves to hedge to achieve
their own goals of rent extraction. Hedging to reduce their incentives to work harder in the
interests of the shareholders and to capitalise on their information advantage about the firm‟s
future performance allows them to wrongly profit from lower levels of personal exertion and
private information.
21
2.4.1 Portfolio diversification
Given that managers generally have significant amounts of their wealth and human capital
invested in the firm; managers have incentives to reduce the idiosyncratic risk associated with
their ownership positions in the firm (Bettis, Bizjak and Lemmon, 2001). Hedging, and in
particular the use of derivatives, is a straightforward way of managing the risk that
executives‟ options will expire worthless. This can be done by locking-in gains on the
underlying shares ahead of the time at which the executive share options can be exercised
(Ali and Stapledon, 2000). Studies by Muelbroek (2000) and Ofek and Yermack (2000) find
that undiversified executives are willing to sell shares at a discount if it means they can
reduce their exposure to firm-specific risk. This leads to the following hypothesis:
H1: Hedging transactions are associated with high prior ownership levels or a significant
increase in stock price.
There are corporate events that affect the incentives of insiders to seek diversification of their
ownership. Executives of firms that have recently undertaken an IPO tend to hold a
considerable number of shares (Mikkelson, Partch and Shah, 1997) and are often subject to
lockup provisions that prevent them from immediately selling their shares (Field and Hanka,
2001). Additionally, directors of newly listed companies may not want to sell their shares
immediately after the listing due to the negative signal it sends to the market, i.e. that they do
not believe in the long term viability of the company (Leland and Pyle, 1977). This suggests
the hypothesis:
H2: Hedging is more frequent for firms that have been publicly listed for less time.
22
2.4.2 Incentive misalignment
In recent years, hedging of executive compensation has received negative publicity with
George Lekakis from the Herald Sun and other journalists deeming it “controversial” and an
“aggressive way to reduce exposure”. One of the reasons is that hedging equity
compensation seems contrary to the aim of minimising the agency problem by aligning the
incentives of the executive and shareholder (Easterbrook, 2002). It is expected that boards
and shareholders would take managers‟ ability to hedge into account when designing their
incentive compensation packages. However, in practice, managers‟ portfolios are not
publicly disclosed and they are difficult to monitor. This is reflected in the paper by Bisin,
Gottardi and Rampini (2008) where they recommend lowering the manager‟s compensation
when his/her portfolio is monitored because preventing the manager from hedging is costly.
If derivative use weakens equity incentives for the executives of the firm, it is more likely
that these instruments will be used by directors of firms that have weaker corporate
governance due to the increase in directors‟ influence over policies and practices in the firm.
In addition, the directors would want to hedge the majority of their equity holdings so that
their pay is no longer reliant on the share price increasing. This leads to the following
hypotheses:
H3: Firms whose directors hedge have fewer non-executive directors on the board and
higher levels of insider ownership.
H4: Directors sell more shares post hedging event than before.
23
2.4.3 Insider trading
Information asymmetry exists between the insiders of the firm and the shareholders.
Directors should have a better idea than shareholders about what is going to happen to the
firm‟s share price in the future and consequently, directors can, in theory, profit from this
inside knowledge by trading shares in anticipation of price movements. As the buying and
selling of shares by directors is closely scrutinised, directors may engage in hedging activities
to profit from their insider knowledge.
Previously, executives just needed to disclose to the market when they were exercising their
options or hedging their shares. They also needed to record it in the Remuneration Report of
the company‟s annual report. However, The Act proposes that managers be prohibited from
removing the at-risk component of their equity remuneration. It makes executive hedging a
criminal act not only for the executives but also for the institutions that provide them with the
hedging facilities, indicating that there may be ulterior motives behind hedging. This is much
stricter than the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US
which only requires disclosure regarding employee and director hedging.
The empirical study in this area by Bettis, Bizjak and Lemmon (2001) finds no evidence of
negative abnormal stock price performance in the six months following the hedging
transactions, indicating that, on average, insiders do not appear to act on inside information
when hedging their equity remuneration. However, Bettis, Bizjak and Kalpathy (2010) find
that the use of collars, forwards and other hedging contracts preceded material declines in the
stock price and negative corporate events such as shareholder litigation which suggests
24
opportunistic timing on the part of the managers. In order to determine what happens in
Australia, the following hypotheses will be tested:
H5: Directors hedge immediately before share price decreases.
H6: Directors hedge at points immediately preceding periods of high levels of volatility
2.4.4 Wealth effect
The negative perception of executive hedging can be attributed to both the legitimate and
opportunistic motivations. Consideration of the overall wealth effect of executives to
shareholders encompasses all of the motivations outlined above. It is expected that when a
director announces that he/she is hedging, the market has a negative reaction to the news.
This leads to the hypothesis:
H7: There are negative abnormal returns surrounding the hedging date.
The empirical analysis, does not try to distinguish if directors hedge prior to events that
change firm risk or if the hedging transaction itself encourages risk taking. This thesis tries
to identify if there is an association between the use of these structured products and changes
in the firm that can increase firm specific risk. Additionally, the explanatory powers of the
optimal contracting and executive power hypothesis cannot be directly tested. It can only
shed light on a possible reason by testing shareholder reaction through event studies.
25
3. DATA AND RESEARCH DESIGN
3.1 Institutional detail
There are four types of hedging contracts examined in this thesis: collars; margin loans; loans
over a protected put; and equity swaps. Only vested securities are used in all four hedging
types as the investment bank takes possession of the underlying securities and they can only
do that if the executive owns the shares. This questions the need for The Act that only
prohibits hedging on unvested securities, when, in practice, it is only the vested securities that
are hedged.
3.1.1 Collars
Collars protect the executive from a fall in the share price but are cheaper than buying a put
option because they cap increases in the share price over a certain level. It has the economic
effect of buying a European put option and selling a European call option2 on a stock the
executive already owns. Figure 1 below shows a collar that has a floor price of 90 per cent of
the current share price and a cap price of 110 per cent of the current share price. A collar can
be structured so that an option premium is payable to the investment bank (for a higher cap
price and lower floor price), a premium is payable to the executive (for a lower cap price and
higher floor price), or there is no premium (a zero cost collar). The executive is also required
to deliver the underlying shares to the investment bank to hold as mortgaged property to
secure the executive‟s obligations under the collar. Table 1 outlines the possible scenarios
that could occur on the expiry date of the collar in Figure 1.
2 A European option may only be exercised at maturity.
26
Figure 1: Payoff for a collar
Whilst owning the share, the director buys a European put option with a floor price of 90% of the current share
price and simultaneously sells a European call option with a ceiling price of 110% of the current share price.
Aggregate value of securities and
the collar (premium)
Option premium
paid by the executive
Table 1: Scenarios on expiry of the collar
Scenario Payoff on settlement
The closing share price is within
the range set by the floor and cap
prices e.g. 90-110%.
The collar expires without value and the investment
bank will return the securities used as collateral back
to the executive.
The closing share price is below
the floor price e.g. below 90%.
The collar is automatically exercised. If a cash
settlement applies then the executive keeps his/her
securities and receives the cash settlement amount3
from the investment bank. If a physical settlement
applies then the executive sells the securities to the
investment bank at the floor price.
The closing share price is above
the cap price e.g. above 110%.
The collar is automatically exercised. If a cash
settlement applies, the executive is required to pay the
cash settlement amount4 to the bank. If a physical
settlement applies, the executive is obliged to sell the
securities to the bank at the cap price.
Source: UBS Structured Option and Loan Facility Product Disclosure Statement, 2008 and Credit Suisse
Option Platform Product Disclosure Statement, 2010.
3 The cash settlement amount in this case is the difference between the floor price and the closing share price.
4 The cash settlement amount in this case is the difference between the closing share price and the cap price.
80% 90% 100% 110% 120%
27
3.1.2 Margin loans
While margin loans do not use derivatives to limit the economic risk of shares, they can be
used by executives to diversify their portfolio. By using their existing shareholdings in the
company as security to obtain finance, the executive can use the funds for other investments
(i.e. not for additional purchases of shares in the company), thus reducing the risk that their
personal wealth decreases if the share price of their company falls. The executive‟s ability to
use margin loans is usually covered in the company‟s securities trading policy; however, it is
stated separately to the use of hedging. The Act does not prohibit directors from taking out
margin loans.
3.1.3 Loans over protected puts
Directors can obtain loans secured by a put option and the underlying share. An executive
can purchase a put option on his/her shares and mortgage that option with the share to obtain
a loan from the investment bank. Purchasing a put option will effectively lock-in a minimum
value for those shares and the investment bank will generally lend an amount equal to a
percentage of the protected value5. Figure 2 shows the payoff for a put option and underlying
share that the executive owns.
5“Protected value means, for a loan transaction, the strike price multiplied by the number of underlying
securities for the accompanying option transaction” (UBS Structured Option and Loan Facility Product
Disclosure Statement, 2008).
28
Figure 2: Payoff for a loan over a put option and underlying share
Whilst owning a share, the director buys a European put option over the share. The share combined with the put
option creates an asset that the director can use as collateral for a loan.
For instance, an executive owns 100,000 shares at $40 per share in the company he/she works
for and he/she bought a one year put option over the 100,000 shares with a strike price of $40
and paid $2 per underlying share as the first premium amount6. Upon maturity, if the share
price is at $38, the executive could sell his/her underlying shares to the investment bank for
$40 by exercising the put option. He/she would make or lose no money on the underlying
shares, however, he/she would have lost the first premium amount of $2 per underlying share.
However, if the share price is $43 at maturity, the put option would expire worthless but the
executive would be able to sell the underlying share in the market for $43, therefore, making
on paper $3 per underlying share. Taking into account the first premium amount of $2 per
share paid up front, the profit would be $1 per share.
3.1.4 Equity swaps
In an equity swap, the executive exchanges the future returns on his/her stock for the cash
flows of another financial instrument such as the ASX200 or the returns tied to some interest
6 The first premium amount is the amount payable by the holder of the option.
-$3
-$2
-$1
$0
$1
$2
$3
$4
$30 $32 $34 $36 $38 $40 $42 $44 $46
Pro
pfi
t/lo
ss a
t ex
pir
y
Share price at expiry
29
rate e.g. LIBOR. Equity swaps have not been a popular choice of hedging in Australia due to
their higher costs over other hedging strategies (Lavelle, 2001).
3.2 Data
The ASX Principles of Good Corporate Governance and Best Practice recommendation 3.2
states that publicly listed companies should disclose their policy concerning trading in
company securities by directors, officers and employers. While there are no set rules as to
what to include in the policy, most companies state whether they permit their key
management personnel to hedge their shares in the company in their securities trading policy.
Where companies do not explicitly disclose this, it was assumed that management could
hedge.
This thesis looks only at directors‟ use of hedging rather than key management personnel.
This is due to disclosure issues; directors‟ share holdings and interests in contracts must be
disclosed to the market, whereas it is not compulsory for broader management. As the first
edition of the ASX Good Corporate Governance Principles and Recommendations was
released in March 2003, the time period being examined is from 2003 to the present day.
If a director hedges his/her share holdings, they must disclose it to the market within fourteen
days (s205G, Corporations Act 2001). Most companies use the “Appendix 3Y „Change in
Director‟s Interest Notice‟” form, however, using this form is not compulsory. The hedging
30
transactions are found by conducting key word searches7
of ASX announcements in
Morningstar DatAnalysis. If a director enters into a contract with a third party to form a
collar or swap or take out a margin loan then it is detailed in part 2 of the form, “Change of
Director‟s Interests in Contracts”.
The quality of reporting for hedging transactions varies with only eighteen containing the
contract details such as cap and floor prices. The majority only included generic references
to the hedging instruments. Ideally, more firms would disclose the cap and floor prices so a
collar delta8 could be calculated, however, due to the small number of events with this
information, this variable could not be included. When available the following data are
collected: the type of instrument used; name of the executive who entered into the contract,
his/her title, the announcement date, number of shares hedged in the transaction, the
investment bank that assists with the transaction and the length of the contract.
The hedging companies‟ annual reports in the years the hedging took place are used to gather
corporate governance information. This included the number of years the company has been
listed, the percentage of director ownership of the company at that time, the non-executive
and executive director split on the board and whether the chairman of the board is an
executive or non-executive director. The ASX Principles of Good Corporate Governance and
Best Practice recommendation 2.2 suggests that the chairman of the board be an independent
director. However, because the majority of companies whose directors hedge are not widely
held, the only distinction between the independent and non-independent chairmen is the
7 A list of key words can be found in Appendix A.
8 A collar delta calculates the change in the value of the collar resulting from a one dollar increase in the firm‟s
stock price. It provides a sense of the extent to which these transactions alter the incentive alignment between
managers and shareholders.
31
ownership of a very small parcel of shares. In this case, non-executive chairmen are
considered a more appropriate proxy for board independence. This is also consistent with the
Capezio, Shields and O‟Donnell (2011) study that looked at the executive power hypothesis
in Australian listed companies with executive and non-executive chairmen.
Accounting and financial data are collected from the DataStream Database and IRESS while
any missing information is supplemented by data from Aspect Huntley FinAnalysis and
Morningstar DatAnalysis. Specifically, the information collected is market capitalisation,
book value of total assets, net debt, individual companies‟ adjusted closing share prices and
the ASX200 index values. Adjusted share prices are used to account for distributions and
corporate actions such as stock splits.
For each of the hedging events, two control firms are identified. The firms are matched
firstly on GICS sector and industry codes and then on the average market capitalisation for
the calendar year in which the hedging event took place. In accordance with the test
conducted by Bettis, Bizjak and Lemmon (2001), a suitable match is decided to be within
twenty percent of the hedging company‟s average market capitalisation and the same GICS
sector. To allow for differences in hedging restrictions, two matching firms are selected.
One firm would allow their directors to hedge their shares in the firm (however, no director
would take part in hedging), while the other firm would not permit their directors to hedge.
32
3.3 Research design
The empirical analysis first examines the corporate governance and financial variables that
determine whether executives hedge and how much they hedge. It then turns to investigating
the impact hedging has on the short term share price and explores the motivations behind
executive hedging. The analysis also seeks to document the hedging executives‟ buying and
selling patterns around the hedging event.
3.4 Test 1 – Determinants of hedging and hedging amount
The first test examines whether the decision to hedge can be explained by corporate
governance, firm and financial variables. The corporate governance variables are the
ownership levels of company directors, the percentage of non-executive directors on the
board, whether the chairman is executive or non-executive and the number of years the
company has been listed. The firm variables are the book to market value and net debt to
assets. Financial variables include ex post and ex ante share price returns and the ratio of the
volatility in share price post hedging to the share price volatility prior to hedging. Similar to
Bettis, Bizjak and Lemmon (2001), the following variables are incorporated in an Australian
context: ex post returns; ex ante returns; a ratio of the volatility post hedging versus prior to
hedging; the percentage of ownership of the firm by directors; the age of the firm; and the
fraction of non-executive directors on the board. However, unlike Bettis, Bizjak and
Lemmon (2001), this test also includes: a dummy variable of one if the chairman is non-
executive and zero if the chairman is an executive director; the book to market value; and net
debt to assets. These additional variables are important to shed light on the financial stability
of the hedging firms and make the proxy for the firms‟ corporate governance mechanisms
more robust. As many of these variables are yearly measures, only the first hedging event in
33
the calendar year for each firm is chosen. Bettis, Bizjak and Lemmon (2001) also use
matching firms in their regressions. This thesis uses two sets to account for the differences in
hedging policies, i.e. allowed to hedge but do not and not allowed to hedge.
The corporate governance variables aim to proxy the level of strength of the corporate
governance mechanisms in the firms9. This relates to the executive power hypothesis. If a
firm has been captured by its directors, shaping policies to suit themselves, typically, it will
have lower levels of independence. This is accounted for by the percentage of non-executive
directors on the board, director ownership and status of the chairman. The first variable is the
percentage of non-executive directors on the board. It is calculated by dividing the number of
non-executive directors on the board of the company by the total number of directors. This is
done as at the day of the hedging transaction. The second variable, director ownership, is
calculated in a similar fashion. It is the amount of shares in the company beneficially held by
the total number of directors on the board divided by the number of issued shares
outstanding. In some instances, directors own shares through private companies or in join
name with another director and/or spouse. If the director has control over the private
company, then those shares the private company owns are included in the ownership
calculation. If the shares are jointly held with another director, those shares are only counted
once in the calculation. However, if the shares are jointly held with someone other than a
director, they are included in the calculation. Firms with high insider ownership are those
that have authoritarian corporate governance and directors, especially executive directors,
have enough power to do whatever they want. The third variable, the status of the chairman,
is expressed as a dummy variable as at the hedging date. A value of one is given if the
chairman is non-executive and zero is given if the company has an executive chairman. The
9 Please see Appendix B for a detailed description of each variable.
34
final corporate governance variable is the number of years listed. It is calculated as the
hedging date minus the listing date divided by 365.25 days to account for leap years.
Independence will be less likely the fewer years the company has been listed. In addition,
companies that have recently floated tend to have higher levels of ownership and control
among the directors. Governance mechanisms are often developed and acquired with time.
Companies that have recently floated tend to have higher levels of ownership and control
among the directors and still tend to be run like family businesses. The number of years
listed variable also captures the possibility that owners of recently listed firms want to
diversify but do not want to sell their shares which confer control. Due to the large range of
values for this variable, the variable is logged for the logit and tobit regressions. The
corporate governance variables are chosen based on the Bettis, Bizjak and Lemmon (2001)
paper and the most recent corporate governance paper conducted in Australia by Capezio,
Shields and O‟Donnell (2011).
The firm specific and financial variables10
proxy for directors‟ ex ante beliefs about the
stability and future performance of the firm. If directors believe the company is not
financially secure, may experience difficulty in the future and/or expect the share price to
decline or become more volatile, they may hedge to protect their wealth. Due to directors‟
insider status, their information about the company and future performance is superior, thus
hedging their shares because of this information is seen as opportunistic. The main driver of
firm financial instability is the level of debt in the company as it directly influences the firms‟
liquidity. The first firm variable is the book to market value of the firm and is calculated as
the book value of total assets divided by the market capitalisation of the firm as at the
hedging date. Next is net debt to assets and it is the net value of the company‟s total
10
Please see Appendix B for a detailed description of each variable.
35
liabilities and debts with its cash and other liquid assets divided by the book value of total
assets. As the firms are matched on market capitalisation, this is not included as a variable in
the regression. Total assets are included only to control for additional differences in asset
size. Due to the large range of values, this variable is also logged for the logit and tobit
regressions.
Similarly, any negative news or signs of financial trouble will manifest itself into increased
volatility in the share price and/or declines in the share price. Ex post returns are the
company‟s abnormal returns 120 days after the hedging event while ex ante returns are the
company‟s abnormal returns 120 days prior to the hedging event. It is calculated by
regressing the company‟s share price against the ASX200 to calculate the intercept and slope
and subtracting the actual return from this expected return. A detailed description of this
method is outlined in Section 3.5. The standard deviation ratio is the standard deviation in
the share price returns 120 days post hedging divided by the standard deviation in returns 120
days prior to the hedging event.
3.4.1 Logit regression
Binary logit regression analysis is conducted first. The dependent variable is one for the
hedging firms and zero for the two sets of matching firms, those that are allowed to hedge but
do not and those that are not allowed to hedge, similar to the methodology in Bettis, Bizjak
and Lemmon (2001). This is illustrated in equation 3 below.
36
(3)
For robustness, multinomial logit regression analysis is also conducted. This is to distinguish
between the two sets of matching firms; those that cannot hedge and those that can hedge but
do not hedge. The dependent variables are two for the hedging firms, one for the firms that
cannot hedge and zero for the firms that do not hedge. This is illustrated by equation 4
below.
(4)
3.4.2 Tobit regression
The same variables and matching firms are used in a tobit regression to ascertain the
variables that determine how much of their share ownership directors hedge. The dependent
variables for the hedging firms are the percentage of directors‟ ownership that are hedged and
zero for the matching firms. Equation 5 illustrates this.
37
(5)
3.5 Test 2 – Short-run event study
Standard event study methodology is used to determine the overall impact hedging has on
directors‟ wealth in the form of abnormal share price returns. It is expected that if there are
significant negative abnormal returns on and after the announcement dates, the market has a
negative perception of hedging due to the possibility of opportunistic timing and
misalignment of incentives. If this is not the case, there should be no significant price
reaction surrounding the hedging event date. To limit the amount of noise in the share price
on and after the hedging announcement, only those hedging announcements that have no
other material market announcements on the event day will be used.
The event study design follows the general method outlined in Binder (1998). The estimation
period used to calculate the expected returns is 120 days preceding the hedging
announcement. The pre and post event windows are twenty days either side of the hedging
announcement and for robustness purposes there are two event windows; five days
surrounding the announcement and three days surrounding the announcement.
38
The stock‟s daily returns (ri) are regressed against the daily returns of the ASX200 (rm) for
the estimation period to find the slope (β) and intercept (α) and daily expected returns of each
firm (E(rit)). This is illustrated by equation 6.
(6)
The daily abnormal return (ARi) for each stock is a measure of the impact of the
announcement on the market value of the stock. It is found using the following equation
(7)
The cumulative abnormal return (CARt) is thought to be a truer measure of the market‟s
repricing of the company than the abnormal return on the event date as the market may take a
longer period of time to absorb the news of the announcement. It is calculated for the pre and
post event windows using the following formula.
(8)
To increase the robustness of the small number of observations, bootstrapped t-statistics to
one thousand iterations are employed to test for the significance of the cumulative average
abnormal returns (CAAR) for the five day and three day event windows. The t-statistics are
shown below:
(9)
39
where: SEECAR is the standard error of estimates of the cumulative average abnormal returns
of observations within the event period; k is the beginning of the event period and l is the end
of the event period.
3.6 Test 3 – Do hedging decisions reflect long-run expectations?
The following tests are designed to increase the robustness of the findings from the logit and
tobit regression analyses. It does this by expanding the timelines to determine whether
directors hedge opportunistically because they possess insider knowledge for the future
direction of share prices and/or volatility over the medium to long term future. The share
price and levels of volatility after the hedging event can also be caused by the misalignment
effect. Directors who hedge no longer care about share price changes as their personal wealth
is not affected by it. As a result, they do not work to increase share price or maintain share
price stability and as a result, the share price falls and/or volatility increases. This test cannot
disentangle these two effects, however, certain evidence would either support or cast doubt
on the executive power hypothesis. The previous studies conducted in the US on this topic
did not examine the longer term future. It is an important consideration as hedging contracts
can remain in effect for years rather than months.
3.6.1 Share price declines
This test examines the share price returns for the medium to long term future i.e. 1, 2 and 3
years after the hedging date. Significant negative adjusted buy-hold returns post hedging can
be a sign of insider trading but it can also reflect the incentive misalignment hedging causes.
40
The yearly returns for the hedging companies and their associated matching companies are
calculated for three years post hedging event. Matching companies rather than the ASX200
are used to make the test robust. Over a longer period of time, using matching companies as
a benchmark is deemed more appropriate as it more closely reflects the changes in the
industry and market that would affect the hedging company. The returns are calculated for
each of the three years by subtracting the share price at the end of the year from the share
price at the beginning of the year. It is divided by the share price at the beginning of the year
to get the percentage change.
The adjusted buy-hold returns are then calculated by subtracting the matching company‟s
return from the hedging company‟s return. The returns for years two and three are
compounded. Using this calculation rather than a geometric average calculation avoids
cumulative problems when there were outliers because there was only one matching
company. Bootstrapped t-statistics to one thousand iterations are conducted to test for
significance. The adjusted buy-hold returns and compounded buy-hold returns are divided by
the standard deviation of the returns to obtain the t-statistic.
3.6.2 Increase in volatility
Directors want certainty and stability in their firm‟s stock price as they want certainty and
stability in their remuneration and wealth. For this reason, directors may seek to hedge to
lock in share price certainty before periods of increased volatility. As mentioned previously,
an increase in volatility post hedging may be known or may be due to directors‟ incentives no
longer aligning with those of shareholders as a result of hedging. The standard deviations in
41
the stock prices one year before the hedging event and one year after the hedging event are
measures of the level of volatility. Bootstrapped matched pair t-statistics to one thousand
iterations is used to test for significance and as a robustness check.
3.7 Test 4 – Directors’ buying and selling patterns surrounding the hedging event
Finally, the buy and sell patterns of the executives who hedge are examined to shed light on
whether directors use hedging to limit their exposure to the company and misalign incentives
or whether they replenish the shares they hedged via purchases after the event. If directors
tend to sell shares after hedging, this implies that they are limiting their exposure to the firm
and seeking to undo the incentive alignment constructed by their employment contract. In
contrast, if they tend to buy shares after hedging, this implies that directors merely want to
reduce their risk and lock in the current share price for reasons of certainty in their wealth
rather than to misalign incentives. Scaled net purchase ratios are constructed for the six
months before hedging and six months after hedging.
(10)
These same ratios are constructed for the corresponding matching companies from Test 1.
For these companies, all directors‟ buy and sell patterns are examined and scaled by all the
directors‟ holdings in the companies at the time of the hedging event. A Wilcoxon signed-
rank test is performed to test for the differences between medians for the net purchases for
hedging companies and their matching companies. Due to the very small number of
observations, testing the differences between medians is considered to be more robust than a
matched t-test for means.
42
4. RESULTS
4.1 Test 1 – Determinants of hedging and hedging amount
4.1.1 Descriptive statistics
Observations are culled so that hedging transactions from the same company are at least one
month apart and this leaves 96 hedging transactions from 49 companies and 68 directors. Of
the 68 directors, 47 of them are executive directors and 21 are non-executive directors at the
time of hedging. Thirty-nine of them hold positions on the board such as chief executive
officer, chief financial officer, managing director and/or chairman. Collars are the most
popular method of hedging with 53 transactions recorded. There are 25 margin loans, 15
loans over protective puts and 3 equity swaps. There are 24 hedging contracts announced in
2008, 11 in 2011 and 10 per year in 2010, 2005 and 2003. Eight hedging contracts per year
were announced in 2004, 2006 and 2007 while seven were announced in 2009. Fifteen banks
are identified as assisting the executives in hedging, the most frequently used bank is
Macquarie Bank11
. The average length of a hedging contract is 23.5 months. It is important
to note that while the number of events being studied is small, it is the population of hedging
events for publicly listed companies in Australia from 2003 to 2011.
The observations are on a yearly basis from 2003 to 2011. Only the first hedging transaction
of the year per director is chosen and the corporate governance, firm and financial variables
for the corresponding firms and years are found, this leaves 64 hedging events. Table 2
reports the descriptive statistics for all variables for the hedging companies.
11
A full list of all banks involved can be found in Appendix C.
43
Table 2: Descriptive statistics for the variables in the logit and tobit regressions
The percentage of shares directors hedge is used as the dependent variable for the 64 hedging companies in tobit
regression analysis. The percentage of shares directors own, percentage of non-executive directors on the board, a
dummy variable for non-executive chairman and the number of years the company has been listed are used as
corporate governance variables. The book to market value, net debt to assets and total assets are the firm specific
variables and the standard deviation ratio, ex post returns (120 days) and ex ante returns (120 days) are the financial
variables.
Descriptive Statistics
Mean Median Minimum Maximum St. Dev. Skewness
Percentage hedged 0.430 0.349 0.001 1 0.335 0.481
Director ownership % 0.125 0.077 0.000 0.683 0.177 1.663
Non-exec director % 0.677 0.667 0 0.9091 0.177 -1.083
Non-executive chairman 0.697 1 0 1 0.462 -0.859
Years listed 10.058 8.906 0.041 50.404 8.713 2.340
Book to market 0.401 0.384 -1.389 2.439 0.512 0.485
Net debt to assets 0.293 0.134 -48.240 17.010 6.462 -5.201
Total assets 7078.3 609.8 1.607 1.67E+05 22686 5.759
SD ratio 1.035 0.982 0.220 2.125 0.500 0.194
Ex post returns -0.062 -0.006 -0.927 0.593 0.255 -1.165
Ex ante returns 0.002 0.000 -0.839 1.201 0.319 0.709
Due to the large range of values for years listed and total assets, the logs of these variables
are used in the logit and tobit regressions.
On average, the directors who hedge, hedge 43 percent of their shareholdings in the
company. This is a large proportion of their share holdings, more than what the US studies
found. Overall, directors own twelve percent of the shares in the company and two-thirds of
the board consists of non-executive directors. These companies experience more volatility
and negative abnormal returns post hedging event.
Table 3 presents the results of a Wilcoxon Signed-Rank test which tests for the median
difference between matched pairs for hedging companies and their corresponding matching
companies. This test is considered more suitable and the results more powerful than a
44
matched pair t-test for means due to the small number of observations. The results are not
shown for loans over protected puts and equity swaps due to the small number of
observations.
Table 3: Results of Wilcoxon signed-rank test for logit and tobit variables
Testing for differences between medians for the 64 hedging companies and 64 companies whose directors are
allowed to hedge but choose not hedge.
All hedging types
no. observations = 64
Collars
no. observations = 33
Margin loans
no. observations = 23
Z-value P-value Z-value P-value Z-value P-value
Director ownership % 6.952 0.000 *** 5.003 0.000 *** 4.182 0.000 ***
Non-exec director % -3.000 0.003 *** -2.523 0.011 ** -0.867 0.386
Non-executive chairman 0.621 0.535 0.820 0.412
Years listed -1.635 0.102 -1.251 0.211 -0.806 0.420
Log years listed -1.755 0.079 * -1.090 0.276 -1.110 0.267
Book to market -2.725 0.006 *** -2.073 0.038 ** -1.536 0.125
Net debt to assets 2.397 0.017 ** 1.965 0.049 ** 1.810 0.070 *
Total assets -6.390 0.000*** -4.860 0.000 *** -3.483 0.000 ***
Log total assets -6.377 0.000 *** -4.717 0.000 *** -3.574 0.000 ***
SD ratio -0.311 0.756 0.876 0.381 -1.080 0.280
Ex post returns -1.929 0.054 * -0.071 0.943 -1.780 0.075 *
Ex ante returns -1.722 0.085 * -0.465 0.642 -2.053 0.040 **
***, ** and * represent significance at the 1%, 5% and 10% level, respectively
Overall, the variables that differ between hedging companies and their matching
counterparties are: the level of director ownership; the percentage of non-executive directors
on the board; book to market value and; net debt to assets. This means that some corporate
governance mechanisms and firm stability proxies differ significantly for companies that
hedge. It is an initial indication that these variables may determine whether the directors of
these companies hedge and the proportion of their share holdings they hedge. The variables
that differ in this test indicate that those companies with weaker corporate governance
mechanisms, higher levels of debt and lower book to market value, hedge. This could lend
weight to the executive power hypothesis; directors influence policies so they can hedge
because they have insider information on the financial stability of the firm.
45
There are marginal differences in the variables when hedging contracts are examined
according to type. For collars, the percentage of non-executive directors on the board; book
to market value; net debt to assets and total assets are significant. Financial variables become
significant for margin loans. Ex post and ex ante abnormal returns; net debt to assets; and
percentage of director ownership are significantly different for directors of companies who
took out margin loans compared to their matching companies.
4.1.2 Binary logit regression
As previously mentioned, there are 64 hedging observations. These are matched with 64
observations from companies that are allowed but do not hedge. Unfortunately, only 34
matching observations (based on the matching criteria outlined in Section 3.2) for companies
that are not allowed to hedge have been found. For robustness purposes, the explanatory
variables of interest are separated into corporate governance, firm and financial variables and
tested progressively. Table 4 reports the results for the binary logit regression. Robust
standard errors were used to adjust for heteroskedasticity.
46
Table 4: Results for binary logit regression
The are 64 observations for the hedging companies, 64 observations for companies who are allowed but do not
hedge and 34 observations for companies who are not allowed to hedge. If there are multiple observations for
the same company, the observations are separated by 1 year. The dependent variable for the hedging companies
is one and zero for the two sets of matching companies.
Coefficient Std. Error P-value
Panel A: Corporate governance variables only
Constant 1.674 0.724 0.021 **
Director ownership % -0.173 0.765 0.822
Non-exec director % -2.146 0.958 0.025 **
Non-executive chairman 0.300 0.366 0.411
Log years listed -0.391 0.147 0.008 ***
McFadden R-squared 0.050 Log-likelihood -126.588
Panel B: Corporate governance and firm variables only
Constant 3.076 0.790 0.000 ***
Director ownership % -1.391 0.973 0.153
Non-exec director % -1.404 0.933 0.132
Non-executive chairman 0.142 0.411 0.729
Log years listed -0.362 0.158 0.022 **
Book to market -0.522 0.355 0.142
Net debt to assets 0.043 0.040 0.282
Log total assets -0.194 0.048 0.000 ***
McFadden R-squared 0.147 Log-likelihood -113.710
Panel C: Corporate governance, firm and financial variables
Constant 2.816 0.998 0.005 ***
Director ownership % -1.363 0.986 0.167
Non-exec director % -1.507 0.928 0.104
Non-executive chairman 0.195 0.415 0.638
Log years listed -0.347 0.160 0.030 **
Book to market -0.494 0.374 0.188
Net debt to assets 0.042 0.038 0.279
Log total assets -0.195 0.047 0.000 ***
SD ratio 0.213 0.497 0.668
Ex post returns -1.165 0.683 0.088 *
Ex ante returns 0.139 0.565 0.805
McFadden R-squared 0.157831 Log-likelihood -112.2521
***, ** and * represent significance at the 1%, 5% and 10% level, respectively
When only corporate governance variables are tested, the less non-executive directors on the
board and the less number of years the company has been listed on the ASX, the more likely
the directors are to hedge their share holdings. However, when firm variables are added, the
percentage of non-executive directors on the board is no longer significant and instead, the
47
coefficient on the log of total assets is significant at one percent. The significant financial
variables indicate that the lower the ex post returns, the more likely the directors of the
companies are going to hedge their share holdings. The explanatory power of the models
appears to be low with McFadden R-squared statistics ranging from 5-15 percent. However,
models with cross-sectional data usually have low R-squared figures; generally 20-30
percent. Also, given the small sample size, the expanded regressions are less parsimonious
and have fewer degrees of freedom. As a result, some of the corporate governance variables
are no longer significant but their signs are still in the same direction.
The results from the various models are consistent with the hypotheses that hedging
transactions are associated with firms that have been publicly listed for less time and firms
whose boards of directors have fewer non-executive directors. Younger companies tend to
have more concentrated ownership, particularly among the directors. Directors would most
likely seek to reduce their concentrated ownership as soon as the firms goes public and
continue to sell shares in their company for portfolio diversification and risk reduction
reasons. Additionally, directors may be more likely to want to protect the value of their
shares in a company with lower asset values due to the increased risk of firm distress. If a
company has a low book value of assets, the firm‟s value is low, its ability to borrow is
greatly reduced and the ability to pay debtors and creditors in the case of liquidation is
diminished. Directors would want to hedge their shares and lock in value now rather than
risk a decrease in share price or even collapse in the future. There is some evidence that
directors hedge opportunistically with the share price decreasing the six months after the
directors hedge. Furthermore, given that non-executive directors are recommended for board
independence, the results of the logit regression indicate that if a firm has weaker corporate
governance, the directors of that firm are more likely to hedge. This lends weight to the
48
executive power hypothesis; directors hedge because they have power and influence in the
companies‟ policies and can influence them to achieve their own aims.
4.1.3 Multinomial logit regression
The dependent variables are two for the hedging companies, one for companies not allowed
to hedge and zero for companies allowed to hedge but do not hedge. Once again, the hedging
observations are matched with 64 observations from companies that are allowed to hedge but
do not; however, only 34 companies that are not allowed to hedge have been found. Table 5a
displays the results for the multinomial logit regression for the corporate governance
variables. Robust standard errors are used to adjust for heteroskedasticity.
Table 5a: Results for multinomial logit regression – corporate governance variables only
The are 64 observations for the hedging companies, 64 observations for companies who are allowed
but do not hedge and 34 observations for companies who are not allowed to hedge. If there are
multiple observations for the same company, the observations are separated by 1 year. The dependent
variable for the hedging companies is two, one for the companies not allowed to hedge and zero for
companies allowed to hedge.
Coefficient Std. Error P-value
Not allowed to hedge vs. allowed to hedge
Constant -1.702 1.053 0.106
Director ownership % 1.691 0.953 0.076 *
Non-exec director % 0.265 1.362 0.846
Non-executive chairman 0.808 0.481 0.093 *
Log years listed 0.115 0.203 0.571
Hedge vs. allowed to hedge
Constant 1.717 0.861 0.046 **
Director ownership % 0.563 0.960 0.557
Non-exec director % -2.031 1.109 0.067 *
Non-executive chairman 0.581 0.405 0.152
Log years listed -0.350 0.174 0.044 **
Log-likelihood -207.234
***, ** and * represent significance at the 1%, 5% and 10% level, respectively
49
The results for the hedging companies are consistent with the results in Table 4. The higher
the percentage of director ownership, the fewer non-executive directors on the board and
fewer years listed on the stock exchange, the more likely companies are to hedge. However,
when firm variables are added, the significance of the corporate governance variables
disappears as can be seen in Table 5b. Robust standard errors are used to adjust for
heteroskedasticity.
Table 5b: Results for multinomial logit regression - corporate governance and firm variables only
The are 64 observations for the hedging companies, 64 observations for companies who are allowed but do
not hedge and 34 observations for companies who are not allowed to hedge. If there are multiple observations
for the same company, the observations are separated by 1 year. The dependent variable for the hedging
companies is two, one for the companies not allowed to hedge and zero for companies allowed to hedge.
Coefficient Std. Error P-value
Not allowed to hedge vs. allowed to hedge
Constant 0.097 1.277 0.940
Director ownership % -0.391 1.134 0.730
Non-exec director % 2.573 1.624 0.113
Non-executive chairman 0.747 0.585 0.202
Log years listed 0.375 0.239 0.117
Book to market -0.624 0.397 0.116
Net debt to assets -0.005 0.017 0.754
Log total assets -0.410 0.074 0.000 ***
Hedge vs. allowed to hedge
Constant 4.281 0.972 0.000 ***
Director ownership % -1.666 1.130 0.140
Non-exec director % -0.638 1.115 0.567
Non-executive chairman 0.422 0.525 0.421
Log years listed -0.195 0.198 0.323
Book to market -0.873 0.457 0.05625 *
Net debt to assets 0.041 0.039 0.299
Log total assets -0.361 0.067 0.000 ***
Log-likelihood -170.959
***, ** and * represent significance at the 1%, 5% and 10% level, respectively
A lower book to market value indicates the market values the firm‟s assets less than what the
firm values them. This may make directors worry about a share price drop and motivate
them to “lock in” the current share price. The results are similar when the financial variables
50
are added. This is seen in Table 5c. Robust standard errors are used to adjust for
heteroskedasticity.
Table 5c: Results for multinomial logit regression - corporate governance, firm and financial variables
The are 64 observations for the hedging companies, 64 observations for companies who are allowed but do
not hedge and 34 observations for companies who are not allowed to hedge. If there are multiple observations
for the same company, the observations are separated by 1 year. The dependent variable for the hedging
companies is two, one for the companies not allowed to hedge and zero for companies allowed to hedge.
Coefficient Std. Error P-value
Not allowed to hedge vs. allowed to hedge
Constant -0.535 1.611 0.740
Director ownership % -0.314 1.132 0.781
Non-exec director % 2.881 1.682 0.087 *
Non-executive chairman 0.731 0.573 0.202
Log years listed 0.354 0.243 0.145
Book to market -0.584 0.414 0.158
Net debt to assets 0.006 0.019 0.773
Log total assets -0.425 0.075 0.000 ***
SD ratio 0.507 0.741 0.494
Ex post returns 1.564 1.003 0.119
Ex ante returns -0.764 0.794 0.335
Hedge vs. allowed to hedge
Constant 3.757 1.377 0.006 ***
Director ownership % -1.659 1.131 0.142
Non-exec director % -0.690 1.132 0.542
Non-executive chairman 0.458 0.526 0.384
Log years listed -0.197 0.204 0.333
Book to market -0.797 0.459 0.083 *
Net debt to assets 0.045 0.037 0.232
Log total assets -0.364 0.065 0.000 ***
SD ratio 0.489 0.702 0.486
Ex post returns -0.459 0.863 0.595
Ex ante returns -0.316 0.782 0.686
Log-likelihood -167.440
***, ** and * represent significance at the 1%, 5% and 10% level, respectively
4.1.4 Tobit regression
Tobit regression analysis is conducted to investigate what corporate governance, firm and
financial variables determine the joint decision of whether to hedge and how much of his or
her shareholding the director should hedge. The 64 hedging observations are matched with
51
64 observations from companies allowed to hedge but do not; however, only 34 observations
are found for companies not allowed to hedge. The dependent variables for hedging firms are
the percentages of share ownership hedged and zero for the matching companies. Table 6
displays the results. Robust standard errors are used to adjust for heteroskedasticity.
Table 6: Results for tobit regression
The are 64 observations for hedging companies, 64 observations for companies that do not hedge and 34 observations for companies
that are not allowed to hedge. The dependent variables for hedging companies are the percentages of shares hedged and zero for the
two sets of matching companies.
Coefficient Std. Error P-value
Panel A: Corporate governance variables only
Constant 0.295 0.268 0.272
Director ownership % 2.164 0.535 0.000 ***
Non-exec director % -0.635 0.358 0.076 *
Non-executive chairman 0.182 0.125 0.145
Log years listed -0.137 0.042 0.001 ***
Log-likelihood -101.522
Panel B: Corporate governance and firm variables only
Constant 0.536 0.267 0.045 **
Director ownership % 1.595 0.423 0.000 ***
Non-exec director % -0.545 0.355 0.125
Non-executive chairman 0.217 0.122 0.077 *
Log years listed -0.150 0.040 0.000 ***
Book to market -0.029 0.072 0.685
Net debt to assets 0.396 0.074 0.000 ***
Log total assets -0.035 0.013 0.008 ***
Log-likelihood -91.039
Panel C: Corporate governance, firm and financial variables
Constant 0.524 0.276 0.057 *
Director ownership % 1.452 0.379 0.000 ***
Non-exec director % -0.588 0.337 0.081 *
Non-executive chairman 0.182 0.120 0.129
Log years listed -0.155 0.039 0.000 ***
Book to market 0.010 0.074 0.895
Net debt to assets 0.272 0.080 0.001 ***
Log total assets -0.037 0.013 0.005 ***
SD ratio 0.087 0.127 0.496
Ex post returns -0.637 0.174 0.000 ***
Ex ante returns 0.096 0.133 0.472
Log-likelihood -86.964
***, ** and * represent significance at the 1%, 5% and 10% level, respectively
52
Consistent with the logit regression, the fewer non-executive directors on the board and the
less number of years the company has been listed, the greater percentage of shares hedged.
An additional variable, the level of director ownership, is significant at the one percent level.
This lends weight to the hypothesis that hedging transactions are associated with high prior
ownership levels. Firms with higher insider ownership are those that have authoritarian
corporate governance and directors, especially executive directors, have enough power to do
whatever they want. The more shares the directors own in the company they work for, the
more they will want to hedge to diversify their portfolios. This lends weight to the executive
power hypothesis, that directors of firms with lower corporate governance variables can do
whatever they choose to do because they have sufficient power and control, even if what they
want is to reduce their exposure to the company for whom they work.
The firm variables of significance are the log of total assets and net debt to assets. As per the
logit regression, the smaller the value of assets the company has, the more likely directors are
to hedge. Similarly, the more debt the company has the more likely directors are to hedge.
The chairman dummy variable becomes significant when the firm variables are added in this
regression, however, only at ten percent. If the chairman is non-executive, the directors are
more likely to hedge larger amounts of their share holdings which is contrary to the
hypothesis that the weaker the corporate governance mechanisms, the more likely directors
are to hedge. This can only be rationalised by the fact that the chairman can be influenced
regardless of their status or the small number of observations and the fact the explanatory
power of the variable is low means the variable is a statistical anomaly. Given that the other
chairman variables are mostly insignificant in the other regression specifications, there is a
stronger case for the latter possibility.
53
Interestingly, the ex post abnormal returns are significant at one percent. The smaller the
abnormal returns post event, the more the directors hedge. This lends weight to the
hypothesis that directors hedge at opportunistic times in order to protect the value of their
equity in the company and could be a sign that the directors know about the upcoming
decrease in share price. However, as the average length of the hedging contract is 23.5
months and this variable only looks at six months, it is hard to say conclusively that the
directors are acting opportunistically. For a robustness check, the same regressions are
conducted using returns one year post and prior hedging events, however, due to the spacing
of the observations, the correlation between variables is near perfect. Test 3 which looks at
the share price returns over a longer period of time may be able to shed some more light on
this hypothesis.
Overall, the number of years listed, percentage of non-executive directors on the board, level
of director ownership of the firm and level of debt in the firm tend to be determinants of
whether directors hedge and if so, how much they hedge. These findings are consistent with
Bettis, Bizjak and Lemmon (2001) and lend weight to the executive power hypothesis;
directors influence policies such as corporate governance mechanisms to allow themselves to
hedge to suit their own purposes. While there is some evidence to suggest that directors use
their insider knowledge to hedge, it is not conclusive.
54
4.2 Test 2 – Short-run event study
4.2.1 Returns for the pre and post event windows
Only the first hedging transaction of the month per firm is used for the event study to reduce
the risk that the returns in the pre and post event windows would be compounded by other
hedging announcements. This leaves ninety-six observations to study. Figure 3 graphs the
average cumulative abnormal returns for pre-event and post event windows for the companies
that hedged.
Figure 3: Average cumulative abnormal returns for hedging companies
The average cumulative abnormal returns for 20 days prior and post the hedging event for the 96 hedging
observations. The description “Other” includes loans over protected puts and equity swaps. They have been
amalgamated due to the small number of observations.
There is a general downward trend in share returns in the post-event window, particularly
after the hedging event and most notably for collars. This is consistent with the hypothesis
regarding directors‟ overall wealth effect. The market‟s reaction to hedging is negative and
directors who hedge are no longer incentivised to work to increase the share price.
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
-20
-1
9
-18
-1
7
-16
-1
5
-14
-1
3
-12
-1
1
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
1
0
11
1
2
13
1
4
15
1
6
17
1
8
19
2
0
Av
era
ge
cum
ula
tiv
e a
bn
orm
al
retu
rns
Number of days before/after the hedging event
ALL
HEDGING
COLLARS
MARGIN
LOANS
OTHER
55
4.2.2 Market reaction to announcement
Table 7 displays the significance of the average cumulative abnormal returns for a three day
event window.
On an aggregated basis, directors hedging their equity cause a significant negative cumulative
abnormal return in the company‟s share price one day after the hedging is announced to the
market. The most popular form of hedging, collars, showed the most significant negative
return in the share price one day before, on the day and one day after the announcement. The
significant abnormal returns one day before the hedging announcement indicate some
information leakage. As directors have fourteen days to announce their interests in hedging
contracts to the market, it is possible that news of the contract was revealed beforehand. This
is followed by margin loans which had negative returns significant at the five percent level
Table 7: Significance of average cumulative abnormal returns for a three day event window
The results of the Student‟s t-test for the 96 hedging observations. The description “Other” includes
loans over protected puts and equity swaps. They have been amalgamated due to the small number
of observations.
Event window (days)
-1 0 1
All hedging types – no. observations = 96
Average CAR -0.007 -0.005 -0.018
Test statistic -0.991 -0.805 -2.622 ***
Collars – no. observations = 53
Average CAR -0.005 -0.007 -0.004
Test statistic -3.434 *** -4.658 *** -2.676 ***
Margin loans – no. observations = 25
Average CAR -0.008 -0.004 -0.052
Test statistic -0.315 -0.149 -1.958 **
Other – no. observations = 18
Average CAR -0.001 0.001 0.003
Test statistic -0.496 0.340 1.495
Hedging transactions carried out by executive directors = 71
Average CAR -0.004
-0.004
-0.007
Test statistic -2.444 ** -2.465 ** -4.186 ***
***,** and * represent significance at the 1%, 5% and 10% level, respectively
56
one day after the announcement. These results lend further support to the hypothesis that the
market has a negative perception of director hedging because it alters the incentive alignment
between directors and shareholders.
The category “Other” which included loans over protected puts and equity swaps produced
unusual results. Looking at Figure 4, the abnormal returns one day after the announcement
are clearly positive. However, as the number of observations is only eighteen, these results
are not considered statistically reliable. For a robustness check, a bootstrapped t-statistic test
for those hedging transactions carried out by executive directors is conducted. These results
are in line with the general results for the entire sample, that is, significant negative abnormal
returns throughout the event window. The reason why executive directors who hedge are
singled out is because these are the directors who have a hand in the day-to-day running of
the company and consequently would have the most accurate knowledge about the firm‟s
current and future performance. If these directors hedge, the market‟s reaction may be more
negative.
57
Figure 4: Average cumulative abnormal returns for a three day event window
The average cumulative abnormal returns for one day prior to and post hedging event for the 96 hedging
observations. The description “Other” includes loans over protected puts and equity swaps. They have been
amalgamated due to the small number of observations.
Table 8 displays the significance of abnormal returns when the event window is expanded to
five days. The expanded event window is used as a robustness check to see if the results
differ significantly over a longer time period.
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
-1 0 1
Av
era
ge
Cu
mu
lati
ve
Ab
no
rma
l R
etu
rns
Number of days before/after the hedging event
ALL
HEDGING
COLLARS
MARGIN
LOANS
OTHER
58
For all hedging types, there are significant abnormal returns at the five percent significance
level one day before the announcement. This suggests that there is some information leakage
before director‟s hedging was announced to the market. Additionally, for hedging contracts
amalgamated and on an individual basis, cumulative negative abnormal returns remain
negative but recover somewhat two days after the announcement. This can be seen in Figure
5.
Table 8: Significance of average cumulative abnormal returns for a five day event window
The results of the Student‟s t-test for the average cumulative abnormal returns 2 days prior to and post
hedging event for the 96 hedging observations. The description “Other” includes loans over protected puts
and equity swaps. They have been amalgamated due to the small number of observations.
Event window (days)
-2 -1 0 1 2
All hedging types – no. observations = 96
Average CAR -0.006 -0.012 -0.014 -0.023 -0.017
Test statistic -1.023 -1.991 ** -2.220 ** -3.754 *** -2.703 ***
Collars – no. observations = 53
Average CAR -0.001 -0.007 -0.008 -0.006 -0.010
Test statistic -0.423 -2.134 ** -2.638 *** -1.968 ** -3.048 ***
Margin loans – no. observations = 25
Average CAR -0.022 -0.030 -0.026 -0.074 -0.007
Test statistic -0.878 -1.211 -1.035 -2.948 *** -0.283
Other – no. observations = 18
Average CAR -0.009 -0.010 -0.009 -0.006 -0.010
Test statistic -5.584 *** -6.178 *** -5.176 *** -3.792 *** -6.252 ***
Hedging transactions carried out by executive directors = 71
Average CAR -0.004
-0.008
-0.008
-0.011
0.010
Test statistic -1.286
-2.773 *** -2.786 *** -3.834 *** -3.610 ***
***,** and * represent significance at the 1%, 5% and 10% level, respectively
59
Figure 5: Average cumulative abnormal returns for a five day event window
The average cumulative abnormal returns for two days prior to and post hedging event for the 96 hedging
observations. The description “Other” includes loans over protected puts and equity swaps. They have been
amalgamated due to the small number of observations.
These results are consistent with the results from the three day event window. The market
views executive hedging as a negative signal and as a result, returns on the shares on and
after the hedging announcement date are significantly negative. It could also be the case that
the director is no longer incentivised to work to increase the share price as the real value of
his/her hedging contract increases when the share price declines. It could also be the start of
a longer downward trend in the share price the director knows about and has hedged in
anticipation. In any of these cases, it lends weight to the executive power hypothesis,
directors hedge their share holdings to extract rents that are otherwise undesirable.
Similar to the results of the three day event window, loans over protected puts and equity
swaps did not follow the same pattern as the other forms of hedging. The reliability of these
statistics is questionable due to the small number of observations. Another possible
-8%
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
-2 -1 0 1 2
Av
era
ge
Cu
mu
lati
ve
Ab
no
rma
l R
etu
rns
Number of days before/after the hedging event
ALL
HEDGING
COLLARS
MARGIN
LOANS
OTHER
60
explanation for the increase in returns is that the market does not view a loan over protected
puts as negatively as the other forms of hedging. This could be because unlike the other
forms of hedging using derivatives, loans over protected puts do not cap the potential for
share price increases, suggesting the director thinks there is a good chance the share price will
increase. Additionally, unlike margin loans, loans over protected puts are not subject to
margin calls and are therefore seen as less risky. For a robustness check, a bootstrapped t-
statistic test for those hedging transactions carried out by executive directors is conducted.
These results are in line with the results of the collar transaction, significant negative
abnormal returns throughout the event window.
4.3 Test 3 – Do hedging decisions reflect long-run expectations?
4.3.1 Long term share price
One suggested motivation behind directors hedging their equity remuneration is that they
expect their company‟s share price to decrease in the future. Table 9 reports the significance
in the adjusted buy-hold returns for three years post hedging event. The number of
observations is reduced to sixty-four after the hedging events that occurred after 2008 are
removed due to the need for long term (three years) availability of share price data.
61
Table 9: Significance of adjusted buy-hold returns for three years after hedging The results of the Student‟s t-test for the adjusted buy-hold returns for 1, 2 and 3 years post hedging event for the 64 hedging
observations. The description “Other” includes loans over protected puts and equity swaps which have been amalgamated
due to the small number of observations.
Number of years after hedging
1 2 3
All hedging types – no. observations = 64
Adjusted buy-hold returns -5.096% 5.705% 15.968%
Test statistic -0.484 0.542 1.516
Collars – no. observations = 29
Adjusted buy-hold returns 3.533% 14.949% 17.684%
Test statistic 0.471
1.992 **
2.356 **
Margin loans – no. observations = 20
Adjusted buy-hold returns -24.220% -32.898% -23.535%
Test statistic -4.640 ***
-6.303 ***
-4.509 ***
Other – no. observations = 15
Adjusted buy-hold returns 15.061% 26.690% 46.433%
Test statistic 0.950 1.683 *
2.928 ***
***,** and * represent significance at the 1%, 5% and 10% level, respectively
Overall, the returns are not statistically significant. When the hedging contracts are separated
by type, some returns are significant. The companies whose directors took out margin loans
had significantly negative returns at the one percent level for the first two years after the
hedging event. As the average length of a hedging contract is 23.5 months, it shows that
directors took out margin loans immediately before material declines in the share price for the
length the hedging contract. Once again, it should be noted that these margin loans are used
to purchase other companies‟ shares, not for further purchases of shares in the director‟s
company. This is consistent with the findings of Bettis, Bizjak and Kalpathy (2010) and may
be a sign of opportunistic hedging. However, if a director hedged his/her portfolio because
they had insider knowledge about an upcoming decrease in the share price, it is hard to
believe that he/she would take out a margin loan as opposed to a loan over a protected put or
a collar. The director would be subject to margin calls if the underlying share price
decreased. It seems incongruent that taking out a margin loan would be a good way to
protect the value of their wealth when the share price fell. However, the margin loan
evidence is consistent with executives not performing because they have diversified or cashed
62
out; their incentives are no longer aligned with that of increasing the firm‟s share price. The
other types of hedging (collars and loans over protected puts together with equity swaps)
showed significant positive returns after the hedging events.
This finding is consistent with Bettis, Bizjak and Lemmon (2001) and indicates that the
director did not hedge opportunistically because he/she thought the share price would decline.
If he/she did act on some insider information, the information was inaccurate. The findings
from Test 1 are the only real indications that directors may act on insider information in terms
of hedging at opportunistic times. Even in Test 1 there is limited evidence of this taking
place.
4.3.2 Changes in volatility
Due to directors want for certainty in the share price so that they have certainty in their
variable pay, they may hedge to lock in the share price before periods of increased volatility.
As volatility is being calculated for the share price returns one year post and one year prior to
the hedging date, the hedging events that occurred after 2010 are removed. This leaves
seventy-five observations. Table 10 displays the significance of the differences between the
level of volatility one year after hedging and one year before hedging.
63
Table 10: Volatility in hedging companies’ share prices after and before hedging
The results of the Student‟s t-test for volatility in the share price one year prior to and one year post hedging
event for the 75 hedging observations.
Years before/after hedging event
1 yr after 1 yr before
All hedging types – no. observations = 75
Average volatility 0.248 0.248
T-statistic 0.036
Two-tail P-value 0.972
Collars – no. observations = 38
Average volatility 0.342 0.310
T-statistic 1.690 *
Two-tail P-value 0.091 *
Margin loans – no. observations = 22
Average volatility 0.071 0.099
T-statistic -7.400 ***
Two-tail P-value 0.000 ***
Loans over protected puts – no. observations = 15
Average volatility 0.407 0.366
T-statistic 2.653 ***
Two-tail P-value 0.008 ***
***,** and * represent significance at the 1%, 5% and 10% level, respectively
Stability in the share price and certainty in equity value is another possible motivation behind
directors hedging. On an aggregated basis there is no significant difference between the
standard deviations in share price one year before and one year after the hedging event,
however, the difference is significant for the individual hedging types. For collars and loans
over protected puts, there is an increase in volatility in the year after the directors hedged.
This is consistent with the hypothesis that directors hedge prior to increases in share price
volatility because they are seeking stability and certainty in the company‟s share price and
thus their personal wealth. The opposite trend is found for margin loans, there is more
volatility preceding the hedging event than there is in the year after the hedging event. While
this finding is not consistent with the hypothesis that directors hedge at opportunistic times
because of insider knowledge, directors may have been worried about the levels of volatility
in the share price, thought that it was going to continue and decided to hedge.
64
There is little evidence to suggest that directors knew about upcoming increases in volatility
and hedged to protect their shares. The fact that overall there was no significant difference
between the levels of volatility pre and post hedging indicates that the timing of the hedging
was more to do with luck than insider trading. While the evidence is not strong enough to
suggest insider trading, executive power is a continuum and the results from the logit and
tobit regressions indicate that some influence was used by the executives to allow them to
hedge.
4.4 Test 4 – Directors’ buying and selling patterns surround the hedging event
4.4.1 Share trading around hedging date
Table 11 displays the ratios for directors‟ buying and selling patterns for the year surrounding
the hedging event. For the directors who hedged, only twenty-six of them traded shares in
their company twelve months around the hedging event date. These twenty-six companies
are matched with their corresponding control firms from Test 1.
Table 11: Overall ratios of directors’ trading around the hedging date
Net purchases (shares bought – shares sold) for the 6 month period before and after the hedging date for the 26
hedging observations.
6 months before 6 months after
Net purchases scaled Net purchases scaled
Hedging company 0.114 0.064
Matching company -0.044 0.072
In the six months leading to the hedging event, directors who hedged bought eleven percent
of the shares they held at the time of the hedging event. However, after the hedging event
they only bought six percent of the shares held.
65
The ratios are opposite for the directors in matching companies. These directors sold more
shares in the lead up to the hedging date and bought more shares after the hedging date.
However, as Table 12 shows, there is only a significant difference between the ratios in the
six months prior to the hedging event.
Table 12: Results of Wilcoxon signed-rank test for net purchases Testing for differences between medians for the net purchases of 26 hedging observations and the net
purchases of the 26 matching companies.
6 months before hedging 6 months after hedging
Hedging firm Matching firm Hedging firm Matching firm
Median ratio 0.031 0.045 0.000 0.001
Z-statistic 2.212
1.085
Two-tail P-value 0.027 ** 0.278
***,** and * represent significance at the 1%, 5% and 10% level, respectively
A bootstrapped matched t-test for means to one thousand iterations is also conducted for a
robustness check. The significance levels are the same.
The fact that the ratios show opposite trends is interesting. It lends weight to the idea that
directors want to diversify their share holding and reduce their exposure to the company they
work for. They used the hedging event as a means of diversification and buy less shares after
they hedge than they did before. It is harder to argue that directors use hedging as a way to
misalign the incentives equity remuneration strives to provide as they still bought shares
before and after the hedging event. One possible explanation for this is that some companies
require their directors to hold a minimum number of company shares. If directors wanted to
hedge some of their shares, they may have to buy some securities to maintain their minimum
balances. The evidence seems to favour the optimal contracting theory. Executives‟ pay
aligns them suitably with the firm, thus they buy (albeit in smaller amounts) after hedging.
They may use hedging for only risk reduction purposes or to raise cash.
66
5. CONCLUSION AND POLICY IMPLICATION
There is a significant gap in the literature regarding the motivations behind director hedging
and the impact it has on the incentive alignment between directors and shareholders. The
four previous studies all conducted in the US only examine the motivations behind director
hedging in the short term and have conflicting results. The recent regulatory response to the
GFC by the Australian government also puts further spotlight on the issue of executive
hedging. This begs the obvious question of whether there are ulterior motives behind
Australian directors hedging in light of recent regulatory changes and a push by the
investment banks to promote these hedging products.
Using Australian data, this thesis finds no conclusive evidence to suggest that directors hedge
because of insider information about up-coming stock price falls or increase levels of share
price volatility. There is, however, evidence that the companies where directors hedge have
weaker corporate governance mechanisms, lower asset values and higher levels of debt. This
suggests that directors may use their power and influence in the firm to allow themselves to
hedge, thus reducing their exposure to the firm and altering the incentive alignment their
employment contracts seek to provide. This is further emphasised by the fact that the
directors are more likely to hedge more of their shares if they are working in companies
where directors have high levels of ownership and have been listed for less time.
Additionally, directors buy fewer shares after hedging. Overall, the results lend themselves
to the conclusion that directors hedge for portfolio diversification and increased certainty –
rather benign reasons.
67
The trend that the firms who hedge have weaker corporate governance mechanisms is
worrying, especially post GFC when companies are trying to align directors‟ incentives with
those of the shareholders. The market definitely has a negative perception of directors
hedging as there are significant negative abnormal returns after the announcement date.
However, as there is no significant impact on share price in the medium and long term,
perhaps the altering of director incentives is not so much of an issue in practice.
The need for legislation prohibiting director hedging on unvested securities and classing it as
a criminal offence is questionable. Banks and other third parties would not enter into these
hedging contracts with directors over unvested securities as they need to take possession of
the shares and contracts over unvested securities is prohibited by most companies‟ securities
trading policies. There would be no need for the same legislation over vested securities as
there is little to no evidence of insider trading and directors should be able to hedge securities
they own in order to diversify their portfolio or raise money. However, an increase in
transparency and information provided by the announcements of hedging to the ASX would
be able to shed more light on this topic and allow for easier and cheaper monitoring. The
findings of a study are only as comprehensive as the data provided. Being able to gain
information about the cap and floor prices in order to calculate a collar delta would be able to
shed more light on the extent to which directors‟ incentives are misaligned by hedging.
This study could be extended by expanding the time period to before 2003 so more
observations can be included and the results examined over a longer period of time.
Additionally, similar tests could be conducted for when directors sell their shares and those
68
results compared to the results from directors hedging. This may be able to determine
whether the effects of hedging are worse than directors selling their shares.
69
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APPENDICES
Appendix A - List of key search terms to identify hedging contracts
1. Collar
2. Cap
3. Zero cost collar
4. Margin loan
5. Loan
6. Put option
7. Call option
8. Swap
9. Financing arrangement
10. Investment bank
11. Hedging
12. Limit
13. Economic risk
14. Protect
76
Appendix B - Variables used in the logit and tobit regressions
Table 13: Explanation of the source and calculation of the corporate governance, firm and financial
variables used in the logit and tobit regressions
Variable and source Calculation description
Non-exec director %
Annual reports
The percentage of non-executive directors on the board is
calculated by dividing the number of non-executive directors on
the board of the company by the total number of directors. This is
done as at the day of the hedging transaction.
Director ownership %
Annual reports
Director ownership is the amount of shares in the company in
which the directors have a beneficial interest divided by the
number of issued shares outstanding. In some instances, directors
own shares through private companies or in join name with another
director and/or spouse. If the director has control over the private
company then those shares the private company owns are included
in the ownership calculation. If shares are jointly held with another
director, those shares are only counted once. However, if the
shares are jointly held with someone other than a director, they are
included in the calculation.
Non-executive
chairman
Annual reports
The status of the chairman is expressed as a dummy variable as at
the hedging date. A value of one is given if the chairman is non-
executive and zero is given if the company has an executive
chairman.
Years listed
DataStream
The number of years listed is calculated as the hedging date minus
the listing date divided by 365.25 days to account for leap years. A
log of this variable is used due to the large range of values.
Book to market
DataStream
Book to market value is the book value of total assets divided by
the market capitalisation of the firm as at the hedging date.
Net debt to assets
DataStream
Net debt is the net value of the company‟s total liabilities and debts
with its cash and other liquid assets. This is divided by the book
value of total assets.
Total assets
DataStream
Total assets are the company‟s book value of its total assets. A log
of this variable is used due to the large range of values.
Ex post returns
IRESS
Ex post returns are the company‟s abnormal returns 120 days after
the hedging event. It is calculated by regressing the company‟s
share price against the ASX200 to calculate the intercept and slope
and subtracting the actual return from this expected return. A
detailed description of this method is outlined in Section 3.5.
Ex ante returns
IRESS
Ex ante returns are the company‟s abnormal returns 120 days prior
to the hedging event. It is calculated by regressing the company‟s
share price against the ASX200 to calculate the intercept and slope
and subtracting the actual return from this expected return. A
detailed description of this method is outlined in Section 3.5.
SD ratio
IRESS
The standard deviation ratio is the standard deviation in the share
price returns 120 days post hedging divided by the standard
deviation in returns 120 days prior to the hedging event.
77
Appendix C – Banks that facilitate hedging
Table 14: Banks involved in hedging contracts
Name of Company Date Type of Hedge Investment bank
Aristocrat Leisure 8/03/2007 Collar Not disclosed
17/03/2008 Collar Not disclosed
Arrow Energy 6/10/2008 Collar UBS
Artist and Entertainment Group 15/04/2008 Margin loan Lift Capital Partners
Asciano 21/06/2007 Swap arrangement Goldman Sachs
20/07/2009 3 Collars UBS
29/01/2010 Margin loan UBS
8/04/2010 Collar Credit Suisse
27/08/2010 Collar Credit Suisse
3/09/2010 Collar Credit Suisse
13/09/2010 Collar Credit Suisse
20/09/2010 Collar Credit Suisse
24/09/2010 Collar Credit Suisse
1/10/2010 Collar Credit Suisse
Augur Resources 28/10/2010 Collar Not disclosed
Australian Vintage 16/01/2003 Collar Macquarie Bank
Bannerman Resources 2/04/2008 Margin loan Opes Prime
BlueScope Steel 3/10/2005 Collar ANZ
3/04/2007 Collar ANZ
Bow Energy 22/05/2009 Collar UBS
Bravura Solutions 15/04/2008 Margin loan Lift Capital Partners
Byte Power 31/03/2008 Margin loan Opes Prime
Centennial Coal 30/09/2003 Collar Macquarie Bank
Challenger 19/12/2006 Loan secured by a protected put Deutsche Bank
18/09/2007 Loan secured by a protected put Deutsche Bank
3/09/2008 Loan secured by a protected put Deutsche Bank
Cochlear 19/09/2003 Collar Macquarie Bank
4/02/2004 Loan secured by a protected put Macquarie Bank
7/11/2006 Loan secured by a protected put Macquarie Bank
28/05/2004 Loan secured by a protected put Macquarie Bank
19/08/2004 Loan secured by a protected put Macquarie Bank
30/08/2004 Loan secured by a protected put Macquarie Bank
18/08/2006 Loan secured by a protected put Macquarie Bank
16/02/2007 Loan secured by a protected put Macquarie Bank
5/03/2007 Loan secured by a protected put Macquarie Bank
17/11/2009 Collar Macquarie Bank
24/02/2010 Collar Macquarie Bank
4/03/2010 Collar Macquarie Bank
78
15/11/2010 Collar Macquarie Bank
16/02/2011 Collar Macquarie Bank
Comtel 2/04/2008 Margin loan Opes Prime
D'Aguilar Gold 15/04/2008 Margin loan Not disclosed
Dart Energy 23/05/2011 2 collars UBS
Deep Yellow Limited 14/04/2008 Margin loan Lift Capital
Eastern Star Gas 13/10/2010 Collar Credit Suisse
25/03/2011 Collar Credit Suisse
Enerji 8/02/2011 Collar Not disclosed
Envirogold 6/07/2009 Collar HSBC
Equinox Minerals 16/04/2008 Margin loan Lift Capital
Fairfax Media 7/11/2003 Collar Macquarie Bank
GBST Holdings 6/02/2008 Margin loan Not disclosed
GUD Holdings 6/11/2003 Collar Macquarie Bank
Hodges Resources 3/04/2008 Margin loan Opes Prime
Hyro Limited 15/05/2008 Margin loan Opes Prime
Ivanhoe 31/01/2011 Collar Citibank
Jameson Resources 2/04/2008 Margin loan Opes Prime
Jumbuck Entertainment 2/04/2008 Margin loan Opes Prime
Karoon Gas 28/06/2006 Margin loan Not disclosed
Macquarie Bank 23/05/2003 3 collars Macquarie Bank
13/06/2003 2 collars Macquarie Bank
8/08/2003 2 collars Macquarie Bank
26/08/2004 Collar Macquarie Bank
17/12/2004 Collar Macquarie Bank
18/08/2005 Collar Macquarie Bank
7/12/2005 2 collars Macquarie Bank
13/06/2003 Collar Macquarie Bank
4/06/2008 Collar Macquarie Bank
Metcash 4/08/2005 Collar ABN Amro
26/08/2005 Collar Macquarie Bank
31/08/2005 Collar ABN Amro
9/09/2003 Collar Macquarie Bank
13/08/2004 Collar Macquarie Bank
30/08/2004 Collar ABN Amro
OM Holdings 29/09/2010 Margin loan
Standard Chartered Bank,
Singapore
Ord River 31/03/2008 Margin loan Opes Prime
31/03/2008 Margin loan Opes Prime
Paladin Energy 14/04/2008 Margin loan Lift Capital Partners
Q Limited 2/04/2008 Margin loan Opes Prime
Renison Consolidated Mines NL 4/04/2008 Margin loan Opes Prime
Rico Resources 4/05/2011 Swap arrangement Goldman Sachs
79
9/05/2011 Swap arrangement Goldman Sachs
8/06/2011 Swap arrangement Goldman Sachs
Santos 8/03/2005 Loan secured by a protected put Macquarie Bank
2/09/2005 Loan secured by a protected put Macquarie Bank
Seek 30/03/2007 Collar Macquarie Bank
Seven 29/04/2005 Loan secured by a protected put Macquarie Bank
16/09/2005 Collar Macquarie Bank
6/10/2005 Collar Macquarie Bank
5/04/2006 Collar Macquarie Bank
14/09/2006 Collar Macquarie Bank
16/04/2007 Collar Macquarie Bank
24/09/2007 Collar Macquarie Bank
21/04/2011 Collar Credit Suisse
13/05/2011 Collar Credit Suisse
Sims Metal Management 29/02/2008 Collar Not disclosed
22/05/2009 Collar Not disclosed
Sonic Healthcare 10/09/2004 Collar Macquarie Bank
Ten 12/12/2003 Collar Macquarie Bank
24/12/2003 Collar Macquarie Bank
24/12/2004 Collar Macquarie Bank
Transfield Services 19/04/2006 Margin loan Westpac
20/04/2006 Margin loan Westpac
11/09/2006 Collar Macquarie Bank
2/04/2008 Margin loan Westpac
Transpacific 7/08/2009 Collar Perpetual
Western Areas 17/10/2008 Margin loan Commsec
27/10/2008 Collar UBS
12/05/2009 Collar UBS
12/05/2010 Margin loan Commsec
1/03/2011 Margin loan Commsec
23/05/2011 Collar UBS
1/05/2009 Collar UBS
Woolworths 10/09/2003 Collar Macquarie Bank