The Underinvestment Problem and Corporate Derivative Use: Evidence from South African Listed Firms

  • Edson Vengesai University of Free State
  • Jivorn Reddy University of KwaZulu-Natal
  • Jhavendran Govender University of KwaZulu-Natal
  • Amanda Marrie Alison University of KwaZulu-Natal
  • Minenhle Nkontwane University of KwaZulu-Natal
  • Tanisha Govender University of KwaZulu-Natal
Keywords: Underinvestment; hedging policy; Derivatives; Growth opportunities

Abstract

Research background: Financial innovation, political and economic instability exposed South African firms to
different risks which led to a gradual fall in the investment levels compared to other emerging economies. Derivatives were
invented to manage risks, among other purposes, more than 90% of the world’s largest firms continuously utilise derivatives
to manage their risk. The underinvestment theory hypothesises that firms with more significant growth opportunities make
greater use of derivatives and companies with amplified investment opportunities together with low cash stock levels use
derivatives more. Purpose: This study carefully examines the underinvestment problem as a determining factor of corporate
hedging policy. Research Methodology: The study employed Tobit regression models on a sample of 198 non-financial
Johannesburg Stock Exchange-listed firms over the period 2009-2018. Results: The study found evidence in support of the
hypotheses that firms’ make use of corporate derivatives as an attempt to reduce their exposure to possible underinvestment
problems. Value: The study determines the role of derivatives in alleviating the underinvestment problem crippling firms in
the South African context.

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Published
2020-10-07
Section
Articles