Is vertical integration a substitute for derivative hedging in mitigating risk?

Ozcakir Yilmaz, Ferda
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University of Delaware
This study makes a significant contribution to the existing literature by examining vertical integration and derivative hedging policies together. Although the present studies theoretically prove the substitutability of vertical integration and derivative hedging, the interaction of these two risk management strategies has not been empirically tested. I assert that vertical integration is used as a substitute for derivative hedging by many managers to achieve the desired level of volatility. This hypothesis is validated by various univariate and multivariate tests. The results of the univariate tests show that the decrease in firms' derivative use following a vertical integration is highly significant. I also find a significant difference in derivative use between high and low vertical integration firms. The results of Heckman's selection models also show that vertical integration negatively affects the decision to hedge and that high vertical integration firms use derivatives less compared to low vertical integration firms. These findings empirically support the substitutability theory of vertical integration and derivative hedging. Additionally, I examine the other determinants of the decision to hedge and the extent of hedging. The results provide consistent evidence for the extant theories of hedging such as financial distress cost, underinvestment cost, economies of scale and corporate tax theories. The implication of this research is much broader than previous studies that have concentrated on single industries.