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The corporate use of derivatives (including employee share options): a study of annual reports. Presenter: Dr Glen Holman Authors: GLEN HOLMAN, Carlos Correia, & GOOLAM MODACK UNIVERSITY OF CAPE TOWN. Introduction.

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The corporate use of derivatives (including employee share options): a study of annual reports

Presenter: Dr Glen Holman

Authors: GLEN HOLMAN, Carlos Correia, & GOOLAM MODACK



Significant growth in the use of derivatives by the corporate sector in South Africa

Research has focused on determinants of hedging policies, impact on firm value and surveys of the corporate use of derivatives

Our study is the first study of derivative usage by analysingthe accounting disclosure in annual reports

Accounting disclosure in terms of IFRS (International Financial Reporting Standards)

Qualitative & quantitative research based on IFRS

Research Questions

  • To what extent are derivatives used by large listed South African companies as indicated in the 2009 and 2008 annual reports

  • Which risks are most often hedged by companies?

  • Which derivative securities are most often used by companies to hedge foreign exchange, interest rate, and commodity price and equity risks?

  • How many types of derivative contracts do firms use?

  • What was the value of outstanding derivative contracts as at the 2009 reporting date?

  • To what extent did companies use employee share options in setting management remuneration

  • What was the dilutive effect of the employee share options outstanding as at the 2009 financial year end?

Survey versus analysis of Annual Financial Statements

  • International Financial Reporting Standard 7 sets out the disclosure required to be presented in annual financial statements relating to financial instruments employed by companies.

  • This standard became effective from 1 January 2007.

Review of prior international studies

  • Most prior studies are based on survey questionnaires

  • USA – survey of 2000 non-financial firms – 65% of large firms used derivatives whilst only 13% of small firms used derivatives

  • New Zealand – 67% of all firms used derivatives but 95% of large firms used derivatives. Open nature of NZ economy. Use of OTC forwards and interest rate swaps

  • Germany – 78% of all firms included in the survey used derivatives. Integration of tax and financial accounting.

  • Sweden – 59% of firms used derivatives but 86% of large firms used derivatives

Review of prior international studies

  • Belgium – 66% of firms used derivatives – survey of only large firms. Firms mainly hedge currency risk – both contractual and anticipated obligations – and interest rate risk. Only 16% of firms hedge commodity risk. Focus on use of OTC forwards, options and interest rate swaps

  • UK – 60% of firms used derivatives – mainly to hedge contractual obligations. Main reason for non-use is non-exposure

  • Netherlands – 96% of firms hedge currency risk, 81% hedge interest rate risk and only 20% of firms hedge commodity risk

  • Singapore & Hong Kong – 90% of firms hedge currency risk, 70% of firms hedge interest rate risk and only 19% of firms hedge commodity price risk. Also, 78% of firms hedge anticipated exposure.

Review of prior South African study

  • Questionnaire survey by Holman, Correia and Jahrescog to 98 large listed South African non-financial firms in 2006

  • Survey design based on Wharton surveys by Bodnar et al, 1998 and the surveys by Alkeback and Hagelin for Sweden published in 1999 and 2006

  • Response rate: 53.1%

  • 90% of responding companies indicated use of derivatives

Review of prior South African study by Correia, Holman & Jahreskog (2006)

  • 90% of responding firms in South Africa used derivatives as compared to 50% for USA firms, 67% of NZ firms, 78% of German firms and 67% of firms in the UK

  • USA economy is less dependent on international trade & due to pricing in US Dollars

  • Derivative use in South Africa is high and compares favourably with developed economies and exceeds by far other developing economies such as Malaysia (20%). Bartram et al (2009) found that only 39.6% of companies in non-OECD countries make use of derivatives.

  • The high use of derivatives belies South Africa’s status as an emerging economy that is subject to exchange controls

  • Significant growth in the use of interest rate swaps

  • Volatility of the Rand and the relative level of liquidity

  • Reasons for hedging: mainly to hedge contractual obligations [compare to countries – to hedge expected future transactions]

Review of prior South African study: types of risks hedged by S A Companies

  • Focus on currency risk (FX) and Interest rate risk is similar to results of international studies

Review of prior South African study: types of derivatives used by SA companies

  • Focus on OTC forwards and swaps and to a lesser extent – the use of OTC options

  • Insignificant use made of ET Futures and Options

Which derivatives are used for each type of exposure?

  • Focus on OTC forwards to hedge currency risks and interest rate swaps to hedge interest rate risk. This is similar for other studies

Companies wishing to hedge expected forex exposures

  • Exchange Control in South Africa

  • Documentary proof of transactions in order to enter into OTC forward contracts

  • The final question in all the questionnaires that were forwarded to all companies asked companies whether or not the companies in the survey population would hedge future expected foreign exchange exposures if this was permitted under South African law.

  • 60% of companies would hedge expected future exposures and only 10% of companies would not hedge expected exposure

Accounting Standards and Disclosure

  • In terms of the Companies Act, 2008, companies are required to comply with International Financial Reporting Standards (IFRS), as APB adopted IFRS for South Africa from 2005.

  • Listing requirements

  • IFRS applicable to derivatives

    • IFRS 7 Financial Instruments: Disclosures

    • IAS 39 Financial Instruments: Recognition and Measurement (superseded by IFRS 9 – effective from 2013)

    • IFRS 2 Share-based Payments

    • IFRS 9 Financial Instruments

Accounting Standards and Disclosure

  • IAS 39 Accounting for Financial Instruments – mixed measurement model – some financial assets and liabilities were required to be measured at fair value and others at amortised cost – dependent on intention of the holder. [IFRS 9 all derivatives at fair value]

  • Definition of a financial instrument

    • Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable

    • It requires no initial net investment (or a smaller investment than normally required)

    • It is settled at a future date

IAS 39

  • Standard requires that fair value changes be recognised in profit or loss unless the firm opts to apply cash flow hedge accounting.

  • Therefore, reported performance may be significantly impacted by changes in the value of derivatives

  • Fair value – amount that asset or liability settled between willing parties in an arm’s length transaction

    • Quoted market prices in an active market

    • Valuation method that makes maximum use of market inputs – recent transactions – fair value of similar instrument – DCF

    • If no active market and there is a significant range of reasonable fair values – use amortised cost

  • Disclosure in terms of IFRS 7

IFRS 7 Financial Instruments: Disclosures

  • IFRS 7 Financial Instruments effective from 1 Jan. 2007

  • IFRS 7 requires disclosure of qualitative and quantitative information about the entity’s exposure to risks arising from financial instruments.

  • Minimum disclosures required in regard to credit risk, liquidity risk and market risk.

  • Disclosure of the significance of financial instruments for an entity’s financial position and performance & changes in fair value

  • Description of each hedge, hedging instrument, fair values of those instruments and nature of risks being hedged


  • Qualitative disclosures

    • Risk exposures fro each type of instrument

    • Management’s objectives, policies and processes for managing those risks

  • Quantitative disclosures

    • Summary of exposure to each risk

    • Disclosures about credit risk, liquidity risk and market risk and how these risks are managed (market risk – sensitivity analysis of each type of risk)

    • Concentrations of risk

IFRS 2 Share-based payments

  • Prior to IFRS 2 No accounting for the cost of employee share options – off-balance sheet

  • IFRS 2 requires the reporting of expense through profit and loss relating to share options issued to employees

Data and methodology

  • Sample of 100 companies based on the Ernst & Young Excellence in Corporate Reporting (ECR) survey for 2010 – these are the 100 largest listed companies in South Africa based on market capitalisation at 31 December 2009.

  • Range of market capitalisation – from R5.1bn (JSE Ltd) to R528bn (BHP Billiton)

  • These companies accounted for about 90% of the total market capitalisation of the JSE.

  • Annual reports - hard copy and electronic versions

  • Review of notes dealing with financial instruments, derivatives and risk management


  • Number of top 100 companies using derivatives: 93 in 2009 and 89 in 2008.

  • Excluding financial institutions, 80 of 86 (93%) companies reported use of derivatives

Types of derivatives used by firms

  • Very large companies – yet 41% of companies employ only one type of derivative.

  • Results are very much in line with the results of prior survey.

Types of derivatives used

Companies mainly employed forwards (3/4), and then interest rate swaps. Close to 1/3 of companies used options. Futures used by only 10% of companies.

Foreign currency is a major risk for most companies;

Percentage of companies using each type of derivative

Use of derivatives by sector

  • 85% of all financial companies use interest rate swaps

  • 75% of basic materials firms reported the use of forwards

  • 58% of all financial firms used options

  • 67% of food producers used futures

Which risks are all companies exposed to?

  • 74% of companies are exposed to currency risk, followed by interest rate risk

  • Link to use of OTC forwards to hedge foreign currency risk

  • Only 7% of companies reported that they entered into derivatives to hedge exposure to credit risk

Exposure to risks – number of risks reported

Reported risk exposures and types of derivatives used

Employee share options

  • 90% of the top 100 companies reported use of employee share options (ESOPs)

  • All sectors reported a high use of ESOPs – except for the listed property companies

  • Average dilutive effect of the employee share options is 3.91%

  • The dilutive effect for Consumer Services companies is 7.31%, for Consumer Goods companies it is 4.7% whilst for Financials it is 3.34%. For Basic Materials, the dilutive effect was 1.77%

Derivative use by small caps

  • The introduction of IFRS 7, and IAS 39 enables us to more effectively determine derivative use by small companies as surveys are less effective (low response rates by small companies)

  • Sample of companies with a market capitalisation below R1 billion and companies listed on the AltX – 104 companies analysed in this study

  • Total market capitalisation of companies under review = R18.9bn

  • Service sector = 69%, Manufacturing = 19% & Primary sector = 12%

Derivative use by Small Caps

  • Only 17% of small companies reported the use of derivatives

  • Comparable studies in the USA – 12-13% of small companies

  • NZ – 36%, Netherlands – 42% and Sweden – 34%

  • South Africa – higher weighting of firms in the Services sector

  • Of the companies that use derivatives, 89% use derivatives to manage foreign currency exposure, 11% use options to manage equity exposure and 5% use swaps to manage interest rate exposure

Derivative use by Small Caps

  • Only 1 company hedged interest rate risk – using interest rate swaps

  • Study found that 16 companies used forwards and 1 company used options to hedge foreign currency risk

  • It was found that only 1 company hedged interest rate risk using swaps

  • Almost all exposure hedged relates to the use of forwards to hedge foreign exchange exposure

  • Only 6% of companies use more than one derivative

Employee Share Options by Small Caps

  • It was found that 20% of companies had issued employee share options

  • The study found that 47% of these companies reported a dilutive impact below 2.5%, whilst 24% reported a dilutive effect of between 2.51 – 5%, 19% of companies reported a dilutive effect of between 5.1-7.5% and 5% of companies reported a dilutive impact of between 7.6-10%.

Derivative use by 2nd 100 JSE Companies

  • Review of 88 companies as funds were excluded from the sample

  • Study found that 49 of 88 companies (56%) reported using derivatives

  • Number of companies and % of companies facing foreign exchange risk , interest rate risk and commodity price risk

Derivatives used by companies

Only one company, Afgri Ltd reported using all four derivatives

Derivative use by 2nd 100 companies

  • For companies with a market capitalisation of over R5bn, 11 of 13 companies (85%) used derivatives

  • For companies with a market capitalisation of over R5bn, 12 of 13 companies (92%) issued employee share options

  • For companies with a market capitalisation of R2bn to R5bn, 44% of companies use derivatives and 77% have issued ESOPs

  • For companies with a market capitalisation below R2bn, 20 of 43 companies used derivatives (47%)

  • Companies mainly use forwards and only 15% of smaller companies use swaps

Employee Share Options

  • The study found that 73 of 88 companies (83%) reported issuing employee share options

  • The average dilutive effect for issued share options was 1.76%.

  • It was found that 10% of companies had a greater than 5% dilutive impact on EPS with Hudaco being at 18.42%

  • It was found that 22% of companies reported a dilutive effect of 1-5% and balance reporting a below than 1% dilutive impact on the company’s EPS.

Derivative use by the 3rd tier of JSE firms

  • Sample of 111 companies – average market capitalisation = R235.5m with range from R66m to R596m

  • The study found that 40.5% of companies used derivatives

  • Only 9% of companies used Swaps – average value of swaps = R29m and 8 0f 9 companies used interest rate swaps

  • The study found that 34% of companies used forwards and average value = R27.5m

  • Only 3 companies used options and only 1 company used futures

Derivative use by the 3rd tier of JSE firms

  • It was found that 64% of manufacturing firms use derivatives

  • Comparable Wharton study found that 45% of medium firms($50m-$250m) used derivatives

  • The study found that 66 (59%) of companies used ESOPs

  • Average dilutive effect = 4%. Largest dilutive impact was 26.5%, and 8 0f the companies had dilutive effects higher than 10%


  • Derivative use and use of ESOPs for all JSE listed companies is as follows;


  • The study used annual reports to determine derivative use of JSE listed companies

  • In terms of IFRS 7, IAS 39 (IFRS 9) companies are required to provide quantitative and qualitative information regarding derivative use. Information is mandatory and is audited – thereby should result in reliable information regarding derivative use

  • The study of annual reports found that 93% of the large JSE listed companies reported using derivatives. This supported the results of a prior study which reported that close to 90% use by the top 100 JSE firms

  • Only 17% of small caps reported using derivatives


  • Companies mainly use OTC forwards and then swaps. Few companies use futures. Forwards mainly used to hedge foreign currency exposure and Swaps used mainly to hedge interest rate risk exposure.

  • Derivatives not used to hedge credit risk

  • Few companies hedge commodity price risk – except for food producers

The End

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