The Underinvestment Problem and Corporate Derivatives Use

Abstract

We analyze the underinvestment problem as a determinant of corporate hedging policy. We find evidence of a positive relation between a firm’s derivatives use and its growth opportunities, as proxied by several alternative measures. For firms with enhanced investment opportunities, derivatives use is greater when they also have relatively low cash stocks. Firms whose investment expenditures are positively correlated with internal cash flows tend to have smaller derivatives positions, which suggests potential natural hedges. Our findings support the argument that firms’ derivatives use may partly be driven by the need to avoid potential underinvestment problems.