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

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. This study carefully examines the underinvestment problem as a determining factor of corporate hedging policy. The study employed Tobit regression models on a sample of 198 non-financial Johannesburg Stock Exchange-listed firms over the period 2009-2018. 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. The study determines the role of derivatives in alleviating the underinvestment problem crippling firms in the South African context.