CEO stock and option holdings as a determinant of option hedging by gold mining firms

Abstract

This paper seeks primarily to analyze CEO holdings of stocks and options in their firm as a determinant of the decision to hedge and the intensity of hedging with option-like securities in the gold mining industry. The findings show that CEO holdings play an important role in the choice and intensity of the use of option-like hedging instruments. In addition, results also show that the intensity of option-like instrument use for hedging is diminished when the CEO is also the chairman of the board. This original finding provides additional insight into the decision making process in this context. Moreover, our results show that when non-hedgeable quantity risk and hedgeable price risk are highly correlated, gold mining firms resort to operational hedging strategies through their production flexibility. Consistent with previous studies, our findings reveal that firm liquidity and profitability are positively related to both the use option-like instruments and the intensity of such use while cost structure and debt are positively related to use intensity. But contrary to previous findings, our results show that company sales are negatively related to the intensity of using option-like hedging instruments and investment opportunities are negatively related to the intensity of such use. Finally, investment opportunities as well as the high correlation between production levels and gold prices seem to have a negative impact on the decision to use option-like hedging in the gold mining industry. Several studies have focussed on the theoretical and empirical motives of hedging financial risks with derivative products by business firms. However, relatively few studies have examined the determinants of the specific choices that firms make in order to build an optimal portfolio of these instruments, or the level of risk coverage that they achieve by using them. The issue has gained in importance recently with the increasing use of derivatives for hedging purposes under the growing impulse of globalisation and of the higher volatility of commodity and financial prices. In the same vein, the development of new types of structured products that fit the specific needs of corporate and other users, and of more sophisticated models to value them, has provided firms with a greater range of instruments to choose from and has given even more relevance to the study of the determinants of that choice. To be sure, notwithstanding their apparent differences, derivative products could be grouped according to the symmetry of their payoff vectors into non-linear, option-like, instruments and linear instruments. This paper seeks to shed light on the choice that hedging firms make in this regard by analyzing the impact of CEO holdings of stocks and options in their firm on the decision to hedge with option-like instruments. The study uses a sample of firms in the gold production industry for the period 2002-2004. By focussing on a single industry the analysis is conducted within the context of a homogeneous source of risk for all the firms concerned, namely gold price fluctuations. More specifically, the study will focus on the factors affecting the choice of the hedging instrument on the one hand and on the level of risk coverage with that instrument on the other in the context of the sample under study. The paper is organised as follows: section I provides a review of the literature on the choice between linear and non-linear, option-like, instruments for hedging financial risks. The methodology and data of the study are described in section II and the empirical results are analyzed in section III. Concluding comments are presented in section IV.