Alice Adams Bonaime, Kristine Watson Hankins, and Jarrad Harford
Financial Flexibility, Risk Management, and Payout Choice
Review of Financial Studies | Volume 27, Issue 4 (Apr 2014), 1074-1101

Two key components of financial flexibility are payout policy and risk management. A firm's form of payout affects its financial flexibility: Because repurchases provide managers with more discretion than dividends in terms of the amount and timing of distributions, a payout structure favoring repurchases, relative to dividends, increases financial flexibility. Risk management also increases financial flexibility because hedging reduces cash flow volatility and can prevent underinvestment and financial distress. Thus, all else equal, smaller dividend payments relative to repurchases and lower cash flow volatility both enable a firm to invest when opportunities arise and to service outstanding debt obligations.

We use detailed data on a large sample of firms over an extended period of time and find that a more flexible payout structure offers operational hedging benefits. Firms that favor repurchases over dividends hedge less and vice versa. Using separate samples of financial and nonfinancial firms, we document that payout and risk management are interrelated decisions.

Measuring payout flexibility and risk management

To investigate the relationship between payout and hedging, we initially focus on a sample of bank holding companies from 1995 to 2008. Unlike other publicly traded companies, bank holding companies are required to report the level of derivatives use and to separate trading from hedging activity. Therefore, for a large sample of firms, we can examine directly whether the amount of hedging affects payout choices within firms. We measure hedging as the dollar value spent on interest rate derivatives, the most common derivative used by bank holding companies. Further, bank holding companies report the impact of derivatives on income and their interest rate exposure, the dominant hedgeable exposure. Hence, we can control for the risk profile of the firm using the income volatility calculated without the impact of hedging and the interest rate exposure. This ensures that hedging changes are not driven by changing risk exposures. Lastly, we define “payout flexibility” as the ratio of repurchases to total payout—although our results are also robust to alternative definitions.

Are payout flexibility and risk management simply related to underlying firm characteristics?

We begin by showing a strong negative relationship between hedging and payout flexibility in the cross-section. However, there is the concern that the same types of firms that engage in active risk management programs also pay regular dividends, which would result in a cross-sectional relationship between hedging and dividends but not support our premise that payout flexibility and hedging are jointly determined hedging tools. To rule out this possibility, we examine how the same firm trades off hedging and payout flexibility over time. Table 1 presents results for our main sample of financial firms, where we identify a negative and significant relationship between the level of interest rate hedging in bank holding companies and their payout flexibility.

1: The Substitution of Payout Flexibility and Hedging
Financial firms Nonfinancial firms
Dependent variable: Payout flexibility Hedging Payout flexibility Hedging
Hedging –0.259** –3.639**
Payout flexibility –4.418** –0.215**
Number of observations 12,628 12,402 19,661 19,767
Control variables Yes Yes Yes Yes
Firm fixed effects Yes Yes No No
Financial and non-financial firms substitute hedging for payout flexibility (repurchase/total payout) and vice versa.

We further verify our results using additional robustness checks. We use the state level adoption of Prudent Investor legislation as a shock to the cost of dividends and large increases in firm size as a shock to the cost of hedging. Lastly, we estimate a Heckman selection model to address the choice to hedge or distribute earnings, including both firm fixed effects and instrumental variables. All of our empirical analysis documents that payout and hedging are jointly determined, consistent with payout flexibility being a risk management device.

These findings are robust to controlling for the effect of hedging on cash flow volatility, the level of total payout, other measures of financial flexibility (including capital levels and cash ratios), and the presence of a major blockholder and firm size, which are commonly cited as determinants of hedging and payout decisions (e.g., Grinstein-Michaely (JF 2005);

We confirm our analysis using a panel of nonfinancial firms. Although the nonfinancial data are far less detailed, firms begin reporting gains and losses due to derivatives in 2004 which allows us to test whether our general conclusions extend to all publicly traded firms. Our results support the hypothesis that non-financial firms also substitute financial hedging and payout flexibility.

Paralleling the empirical work presented for bank holding companies, we find that nonfinancial hedging firms have significantly less flexibility in their payout structure, consistent with hedging substituting for payout flexibility. Table 1 includes the results from our instrumental variable model using nonfinancial firms. This indicates that a broad range of firms use payout flexibility as an operational hedge.


In sum, both bank holding companies and nonfinancial firms recognize that payout policy and risk management both contribute to financial flexibility and are substitutes. Consequently, payout policy—and the broader issue of financial flexibility—can be fully understood only within the context of the firm's related hedging choices.