Derivative Hedge: Is It a Shot to Financial Distress? : A Case of Companies on the Zimbabwe Stock Exchange

Abstract

The study mainly sought to determine the extent of the use of derivative hedges by companies listed on the Zimbabwe Stock Exchange, and to find out whether there is a relationship between the use of derivative hedge and ability of a company to lower probability of financial distress as propounded by Smith and Stultz (1985).Literature was reviewed to position the study and identify the gap. A survey method was used to collect data. The target population was comprised of 63 companies listed on the Zimbabwe Stock Exchange (ZSE) as at 6 April 2017. A sample of 20 companies was drawn from three strata (listed banks, listed insurance companies and listed non-financial companies). Data gathered by way of a questionnaire and interviews was analysed using SPSS and Microsoft Excel. It was found out that despite the absence of an organised derivative exchange market in Zimbabwe, a significant percentage (68.7%) of companies listed on the Zimbabwe Stock Exchange use derivatives (mostly over the counter derivatives and derivatives sourced off-shore) as a hedging technique. The statistical tests (Pearson's Correlation) that measure the relationship between variables revealed that there is a negative relationship between a company's probability of financial distress (as measured by Altman's Z Score) and use of derivatives for hedging purposes. In other words, it was found out that an increase in the use of derivative hedges can lead to a decrease in the probability of financial distress. Conversely, it means that the more a company uses derivatives for hedging, the more its chances of meeting its promises to creditors. The existing laws and regulations in Zimbabwe are viewed as detrimental to derivative hedging and trading, especially to the banking and insurance companies. The study concluded that geeing up the use of derivatives for hedging can only be possible if an organised derivative exchange market is established pari passu with the ideal supporting infrastructure components such as clearing houses and automated trading systems in an adequately regulated, but not prohibitive environment guided by seasoned players.