Applied Financial Economics, 2010, 20, 827–843 Are firms hedging or speculating? The relationship between financial derivatives and firm risk Hoa Nguyen a and Robert Faff b, * a School of Accounting, Economics and Finance, Deakin University, Burwood, Australia b UQ Business School, University of Queensland 4072, Queensland, Australia The focus of this article is an investigation of the relationship between the use of financial derivatives and firm risk using a sample of Australian firms. Our results suggest that this relationship is nonlinear in nature. Specifically, the use of financial derivatives is associated with a risk reduction for moderate derivative users. Derivative usage among extensive derivative users, on the other hand, appears to lead to an increase in firm risk. Nevertheless, compared to firms that do not make use of derivatives, there is no evidence that extensive derivative users are exposed to a risk level in excess of that of nonderivative users. The results are, therefore, indicative of a hedging motive behind the use of financial derivatives. I. Introduction In the past decade or so, financial derivative instruments in association with the so-called ‘risk management’ practices have increasingly attracted serious attention of both academics and practitioners. The reasons for such interest are twofold. On the one hand, derivatives are being used on an increasingly large scale, thereby creating the need for a better understanding of the motives behind and the mech- anism of such corporate usage. On the other hand, derivative disasters, such as the 1996 Sumitomo Corporation’s USD 3.5 billion-dollar loss, 1 raise the question of what types of internal controls are in place to govern these derivative activities. Inadequate supervision, for example, has been quoted as one of the most common reasons leading to derivative failures followed by the inability of pricing models to account for extreme market move- ments and market illiquidity (see, e.g. McCarthy, 2000). Furthermore, whether the use of derivatives is a manifestation of a speculative motive remains a valid concern. While numerous studies into corporate hedging motives have ensured a better understanding of why firms hedge, it is still not so clear how the use of derivatives would impact on the firms’ risk. Several studies have indicated that corporate motives to use financial derivatives are rational and consistent with hedging behaviour. 2 Compared to the much broader *Corresponding author. E-mail: robert.faff@buseco.monash.edu.au 1 Sumitomo is a major copper trader and as such used copper futures contracts extensively to hedge its price risk. Over a period of several years, instead of hedging the company’s price exposure, the head of the trading department engaged in speculation. These speculative activities initially produced substantial profits. However, by the time the company was alerted to these acts of speculation in June 1996, the accumulated loss had grown to USD 1.8 billion, which later blew out to USD 3.5 billion. See Karpinsky (1998) for more detail. 2 See, e.g. Nance et al. (1993), Geczy et al. (1997), Gay and Nam (1998), Graham and Smith (1999) and Haushalter (2000). Applied Financial Economics ISSN 0960–3107 print/ISSN 1466–4305 online ß 2010 Taylor & Francis 827 http://www.informaworld.com DOI: 10.1080/09603101003636204