The role of derivatives’ use on firms’ capital cost and financial stability: evidence from South African listed non-financial firms Open Access

Profit-oriented firms primarily aim to maximise shareholder value, often achieved through investments with positive Net Present Value (NPV) — returns exceeding the cost of capital. A firm’s investment efficiency relies on securing low-cost funding, which boosts expected returns. Over the years, extensive theoretical and empirical analyses have explored the drivers of the cost of capital. However, these analyses remain insufficient due to the dynamic nature of the global economy and financial markets. Modigliani and Miller (1958), theory posited that in a perfect market, a firm’s financing decision doesn’t affect its value. However, real-world inefficiencies and information asymmetry challenge this notion. Evolving economic theories recognise market imperfections, asymmetric information, and global financial advancements, revolutionising traditional economic theories. Sharpe (1977) highlights that the primary driver of shareholder-demanded returns is the level of embedded risks in investments, leading to increased demand for returns in high-risk projects. While rising risks typically induce investors to demand higher returns, managing these risks raises questions about investor responses and financing strategies.

Globalisation and technological advancements have increased economic and market integration, exposing firms to greater domestic and international risks (Luo, 2021). This prompts investors to demand higher returns, raising financing costs and hindering value creation. In Africa, risks are amplified by, economic volatility, political instability and climate change, with extreme weather threatening businesses (Ihinegbu, 2021). Socio-economic issues like high inflation, currency volatility, and civil unrest further exacerbate the risk profile of firms operating in Africa (Wang et al., 2025), driving investors to seek higher returns to offset uncertainty (Dix-Carneiro et al., 2023). This increases financing costs and limits access to competitive funding. Despite being a promising emerging market, South Africa faces challenges like low private investment, economic stagnation, and rising country risks – exacerbating the cost of raising funds (Nicolai and Vincent, 2018). South African firms operate amid high currency volatility, inflation, political uncertainty, and structural constraints, further driving up financing costs and limiting investment (Asongu et al., 2020; Marcelle Amelot and Subadar Agathee, 2021). Recent financial crises and pandemics — including COVID-19 and geopolitical conflicts — have added complexity, highlighting the need for strong risk management strategies.

The use of derivatives (such as futures, swaps, and forwards) has emerged as a key strategy to manage financial risks and optimise capital costs (Bachiller et al., 2021). In South Africa, 54% of firms use derivatives for hedging, compared to just 5% in other African countries. This highlights the importance of understanding the role of derivatives in the African context, especially given the unique economic and financial challenges faced by firms in this region. Derivatives hedge against price, interest rate, and commodity price volatility, stabilising cash flows and lowering capital costs (Butt et al., 2024). Studies show that effective derivatives use can reduce financing costs and enhance financial stability, supporting shareholder value (Holman et al., 2013). Recent studies on African markets show derivatives help mitigate financial distress, improve performance, and enhance firm value (Al Fazari et al., 2022; Chikwira and Vengesai, 2020; Holman et al., 2013; Vo et al., 2020). These works emphasise the unique economic realities facing African firms, particularly exposure to exchange rate swings and commodity price volatility. However, derivatives carry a dual role — while they mitigate risk, they can also be used for speculation, which may amplify risk exposure. This raises questions about whether the net effect of derivatives use lowers or increases the cost of capital.

Though complex, derivatives function as both risk management tools and speculative instruments. Their growth raises questions about their impact on economic growth, crises, and financial stability. While often criticised, they support capital mobilisation, enhance market liquidity, and help investors diversify portfolios and manage risk. The literature remains divided on whether derivatives promote stability or fuel volatility. Some studies show they boost stability by facilitating risk transfer and hedging, helping firms mitigate price shocks and stabilise cash flows (Liu, 2021). They also enhance capital allocation efficiency, supporting productive investments (Vo et al., 2020). However, others link derivatives to financial crises, highlighting their potential to amplify instability (Nguema et al., 2023). Derivatives, by their nature, can either increase firm risk or be used to manage it. An increase in risk typically translates to a higher cost of capital. In contrast, a successful risk management strategy that reduces risk should lead to a lower return demanded by investors.

While extensive research examines derivatives’ impact on firm performance globally, studies on their link to the cost of capital, particularly in African contexts, remain scarce. Nguema et al. (2023) and Asongu and Odhiambo (2020), highlight that African non-financial firms face unique barriers, including limited global market access and higher country risk premiums, warranting deeper exploration of derivatives’ role in financing policies. This study focuses on South African listed non-financial firms due to their key role in the economy and capital markets, driving industrial output and employment. Financial firms, in contrast, are heavily regulated and mainly use derivatives for profit and speculation rather than risk management these fundamentally different behaviours could skew the analysis (Holman et al., 2013).

Prior studies often link derivatives to economic growth, investment, firm value, and performance (Ayturk et al., 2016; Kim et al., 2017; Chikwira and Vengesai, 2020; Holman et al., 2013), overlooking financing policies — leaving a gap in Africa-specific literature. Recent research calls for region-specific analysis, recognising Africa’s unique economic challenges. This study addresses that gap by examining how derivatives influence financing strategies in South African non-financial firms, contributing to the broader discussion on financial risk management in African economies.

Derivatives serve dual roles as risk management tools and speculative investments. While risk management applications typically lead to lower capital costs, speculation may raise them. This raises questions regarding which function investors perceive as dominant. The investigation seeks to determine whether derivatives predominantly serve as hedging tools to lower financing costs or if they amplify risk exposure, leading to higher capital costs and instability. This study fills a crucial gap by offering a region-specific perspective, contributing to the broader literature on derivatives usage and firm financing in emerging economies, particularly in Africa. Initial findings suggest that derivatives can reduce capital costs and enhance earnings stability, but excessive reliance on them may increase capital costs and destabilise firms. This highlights the need for a balanced approach to derivatives integration, understanding the delicate balance between speculation and risk management. Sections 2, 3, and 4 of the study delve into the literature review, methodology, and findings, respectively.

Numerous studies have examined financing policies and capital structure theories. The foundation of capital structure theories stems from the Modigliani and Miller (1958) irrelevance proposition, which argued that, in a perfect, frictionless market, a firm’s financing decisions do not affect its value— only its income-generating ability matters. This implies risk management, including hedging, adds no value (Antoniou et al., 2008). However, this assumption collapses with market imperfections like taxes, bankruptcy costs, and asymmetric information. Subsequent studies challenged this irrelevance proposition, developing theories considering market imperfections and agency costs. The trade-off theory suggests firms balance debt’s tax benefits against financial distress costs (Myers, 2001). The use of derivatives can mitigate risk and lower the likelihood of financial distress. Agency theory (Jensen and Meckling, 1976) highlights conflicts between shareholders (principals) and managers (agents), who may prioritise personal interests. Derivatives can align interests by reducing free cash flows, limiting managers’ ability to engage in non-value-maximising activities and mitigating risks that could threaten firm value. However, in poorly governed firms, derivatives may be misused for speculation, exacerbating agency costs (Jankensgård and Moursli, 2020). This underscores derivatives’ dual role — as a risk control tool or a means of managerial opportunism.

Most recently Baker and Wurgler (2002) proposed the Market Timing Hypothesis, which posits that firms adjust their capital structure by issuing equity when stock prices are high and debt when interest rates are low to minimise the cost of capital. Derivatives can facilitate this strategy by hedging against unfavourable market movements, such as using interest rate swaps to lock in lower borrowing costs or currency forwards to mitigate exchange rate risk, thereby providing firms with greater flexibility to time the market. However, derivatives can also obscure price signals, particularly if investors view their use as speculative rather than protective, potentially increasing perceived risk and distorting the firm’s valuation. This effect is especially pronounced in emerging markets like South Africa, where extensive derivatives usage may raise scepticism among investors, undermining the firm’s ability to time the market effectively.

Recent African-focused studies highlight that African firms face structurally higher costs of debt and equity due to country risk premiums and market illiquidity (Asongu and Odhiambo, 2020) This makes traditional capital structure models less predictive and challenges the universal applicability of these theories. Some studies suggest that derivatives usage in African markets serves dual roles: hedging against macroeconomic volatility and signalling financial sophistication to attract international investors (Nguema et al., 2023). This complicates the simple dichotomy of hedging versus speculation, indicating a need for nuanced interpretation. Conflicting theoretical perspectives, with some models predicting cost reduction and others emphasising risk amplification, imply that derivatives’ role is context-sensitive. This study extends the theoretical discourse by examining how South African non-financial firms navigate these competing dynamics, contributing to a more region-specific understanding of derivatives’ strategic functions.

From a risk management perspective, Diamond (1984), Smith and Stulz (1985) and Froot et al. (1993) highlight the value of derivatives hedging in financing decisions. Hedging reduces cash flow volatility and financial distress costs, improving a firm’s ability to raise capital and increase value. However, Shimpi (2002) and Doherty (2005) note that derivatives also introduce additional risk. Froot et al. (1993) found that debt financing boosts firm value by lowering risk through hedging, maximising expected returns. Shimpi (2002) proposed a risk management and cost of capital model, suggesting firms using derivatives for hedging can free up “risk capital” — excess capital otherwise reserved for credit needs. Still, this underscores the dual nature of derivatives, providing risk mitigation while adding risk. This study explores investor perceptions of such instruments. Doherty (2005) observed that while hedging can release capital and affect the cost of capital, this new cost may be underestimated. This could lead to poor management decisions, like pursuing value-destroying projects, and create arbitrage opportunities as investors rely on conventional WACC calculations.

Empirical research on derivatives has mainly focused on developed markets, with less attention on African economies. Among those studies, the literature has predominantly focused on derivatives’ role in mitigating cash flow risk, reducing costs, and their impact on firm value, performance, and economic growth. Studies like Campbell et al. (2023), Lee (2019) on Asian firms, Zhou (2021), Holman et al. (2013) on Africa, Rossi (2009) on Brazilian firms and Ameer et al. (2011) on Malaysian firms show that firms with high foreign exchange exposure, price fluctuations, financial distress, external financing costs, and short-term liquidity pressures often use derivatives to stabilise cash flows. Supporting this, Paligorova and Staskow (2014) found that Canadian firms using derivatives achieved smoother earnings. These findings suggest derivatives are strategic tools for managing volatility and ensuring financial stability.

Most studies examined the impact of derivatives on firm value, performance, and economic growth, yielding mixed results. Many, including Nguyen et al. (2018), Kim et al. (2017), and Paligorova and Staskow (2014), found that derivatives reduce earnings volatility, improve access to external financing, and allow firms to hold less cash, boosting profitability. Lee (2019) observed a positive link between derivatives usage and firm value in Asian firms, especially those with strong governance where managers focus on hedging rather than speculation. Bachiller et al. (2021)’s meta-analysis supports this, showing foreign currency derivatives enhance firm value, particularly in developed economies. In South Africa, Stevens and Vermeulen (2024) connected exchange-traded futures to economic growth, while Chikwira and Vengesai (2020) found a significant hedging premium for non-financial firms using derivatives. This suggests effective hedging strategies promote financial stability and increase firm value. Conversely, studies like Bae and Kwon (2023) found derivatives failed to enhance firm value during the Asian and 2007 global financial crises, despite reducing exchange rate exposure for Korean firms. Ullah et al. (2023) found UK oil and gas companies combining hedging with capital expenditures saw reduced value, especially those with foreign operations. Chu et al. (2025) reported that Chinese firms using commodity futures, whether for hedging or speculation, experienced operational value declines. These studies indicate hedging can unintentionally signal over-investment, weaken market monitoring, or raise capital costs, ultimately reducing firm value.

The literature on derivatives’ impact on firms’ cost of capital and financial stability is limited and presents mixed results across different markets. Studies like Lee (2019) and Ahmed et al. (2018) show that firms hedge to reduce financial distress, protect growth opportunities, and stabilise future cash flows. Ahmed et al. (2018) found that German non-financial firms using derivatives saw lower costs of equity due to reduced market risk. Similarly, Ahmed and Guney (2024) observed that hedging lowered stock return volatility and cost of equity for UK public firms. However, other studies report mixed outcomes. Bae and Kwon (2023) found currency derivatives did not significantly reduce capital costs for Korean firms, particularly during financial crises when borrowing costs rose. Chu et al. (2025) argued that speculative derivatives use increases capital costs. Ameer et al. (2011) noted that derivatives usage varies by industry, with Malaysian firms citing complexity, high costs, and lack of expertise as barriers to effective risk management. In Africa, Nguema et al. (2023) found market inefficiencies limit banks’ ability to benefit from derivatives, raising doubts about their role in enhancing financial stability. These contradictions emphasise the need to understand how derivatives influence financing costs and stability across different economic environments and market structures.

The empirical literature on derivatives and the cost of capital in African contexts remains fragmented. While studies recognise derivatives’ potential to lower financing costs and stabilise cash flows, they often overlook regional peculiarities of African financial markets that may affect the effectiveness of derivatives in reducing capital costs and enhancing financial stability. Conflicting findings, with some studies reporting cost reductions and others noting increased financial risks, suggest derivatives’ impact is highly context-dependent, shaped by market structures, volatility, and investor perceptions. This study focuses on South African non-financial firms to provide a more context-specific analysis of derivatives’ impact on financing in emerging African markets. Additionally, scant empirical evidence exists on derivatives’ role in different component capital costs, this study addresses these issues and examines whether derivatives induce investors to demand a higher return.

To assess the impact of derivatives on firm financing policy, the study examined all JSE-listed firms, selected for their reliable public financial data from the Bloomberg database. Financial institutions were excluded due to their complex structures, regulatory constraints, speculative and profit-driven derivatives use rather than risk management. After screening missing variables and coding errors (removing financial firms, removing firms with missing data, and firms with less than 5 years of data -for the GMM instrumentation), 176 non-financial firms remained. Panel data methodology was employed to improve econometric efficiency by reducing collinearity and enabling multi-period observations (Akhtar and Oliver, 2009). The study’s primary dependent variable is the cost of capital, comprising equity and debt costs, three components were analysed: the cost of equity, estimated using the Capital Asset Pricing Model (CAPM) a widely accepted framework due to its simplicity, practical applicability, and strong theoretical foundation despite the emergence of multifactor alternatives like the Carhat model (Kumar et al., 2023), Although CAPM offers a straightforward way to estimate the cost of equity, its restrictive assumptions and failure to account for factors like momentum and value effects can impact accuracy. The cost of debt, reflecting lenders’ required returns, and the Weighted Average Cost of Capital (WACC), representing total financing costs from equity and debt. The model is specified as follows:

Where $kE$ represents the cost of equity, $β$ denotes the firm’s return sensitivity to market returns, and $(Rm−rf)$ is the equity market risk premium. The JSE All-share index served as the market proxy, reflecting overall market returns, while government bond returns represented the risk-free rate (⁠$rf)$⁠, aligning with prior studies. $β$ is derived by regressing the firm’s daily stock returns against market returns.

The weighted average cost of firm financing (WACC) was determined as follows:

Where $ri$ captures financing source $i(debtorequity)$ cost; $Wi$ is the proportion of that source in the firm’s market-value capital structure. The cost of debt was calculated as the weighted average after-tax yield to maturity on all outstanding debt.

The study examines the impact of derivatives on a firm’s cost of capital using two measures: a dummy variable indicating derivatives use and the ratio of total notional derivatives value to book assets, reflecting hedging extent. While the dummy identifies the decision to hedge, the continuous measure reflects the intensity of hedging among users, allowing for a more nuanced analysis (Rammala and Toerien, 2024). Control variables include leverage (long-term debt to total assets), liquidity (cash to current liabilities), asset tangibility, firm size (log of total assets), and cash flow (operating cash flow to total assets) — standard factors from empirical literature influencing financing and capital costs.

The study employed a dynamic panel model. Dynamic models account for the effects of past financing costs (Yuan and Motohashi, 2014) and help mitigate autocorrelation from potential model misspecification (Arellano and Bond, 1991).

A general dynamic panel model is specified as follows:

Where $Yi,t$;$yi,t−1$⁠: the dependent, lagged dependent variable $srespectively.$$xit$ the main explanatory variable and $Zit$ A vector of independent variables. $εi,t∽N(0,σε2)$ random disturbance and assuming $σε2>0,∈(εi,t,εj,s)=0$

The study analysed how derivative usage affects WACC, cost of equity, and cost of debt through three separate models, each focusing on one component. The models take the following form:

Where: $Kdi,t$ is the cost of debt, $Kei,t$ is the cost of equity; $WACCi,t$ is the weighted average cost of capital. $Li,t$ is leverage. $Si,t;ATi,t;LQi,t;and$$CFi,t$ Respectively are firm size, asset tangibility, liquidity, and cash flows $γ;β;ϑ;λ;π;ξ;ϕ$ are parameters to be estimated.

Second, the study examined how hedging extent (HE) affects the three capital cost components. Since the derivatives dummy doesn’t capture the hedging extent Ayturk et al. (2016), a continuous variable was used to measure it to distinguish the cost effect of hedging.

The models take the following form:

Where: $HEi,t$ Is the extent of hedging measured as a ratio of a firm’s total notional value of derivatives instruments to the book value of assets.

Third, the study assessed the Impact of derivatives use on financial stability. Drawing from bank stability literature, the study adopted a Z-Score as a measure of firm stability calculated as a ratio of return on assets (ROA) plus equity to total assets to the standard deviation of ROA (Pham et al., 2021) Firm s $tability=ROA+E/TAσROA$⁠, where ROA represents the return on assets, and $σROA$ is the standard deviation of ROA. The estimated models take the following form:

$Si,t$ is firm i’s stability for period t, all other variables are as defined before.

The Generalised Method of Moments (GMM), particularly the system GMM developed by Blundell and Bond (1998), is preferred for its robustness in handling endogenous variables, heteroscedasticity, and serial correlation. By creating a system of equations through differenced instruments, the system GMM technique efficiently addresses endogeneity and autocorrelation. Blundell and Bond (1998) affirm the system’s GMM technique’s effectiveness in controlling for endogeneity, errors over time, and heteroscedasticity.

The descriptive statistics in Table 1 indicate that firms utilising derivatives tend to have higher mean costs of capital, reflected in higher WACC, $KEandKD$ Values compared to non-derivative users.

The study applied the Pesaran (2004) cross-sectional dependence (CD) test; the results are presented in Table 2. The findings show no significant evidence to reject the null hypothesis, suggesting there is no substantial indication of cross-sectional dependence, units are relatively autonomous and operate independently (De Hoyos and Sarafidis, 2006).

Table 3 shows mean differences in capital costs between derivatives users (hedgers) and non-users. Hedgers have a higher average WACC of 10.38 vs 8.95 for non-hedgers, reflecting a 1.43 financing premium. The cost of equity (KE) is also higher for hedgers at 10.88 vs 9.45, with a 1.42 premium. A significant mean difference in the cost of debt (KD) similarly favours non-hedgers. These results suggest that firms using derivatives for risk management face higher capital costs. The findings imply that while derivatives help manage risk, they also raise capital costs, possibly due to perceived higher risk, prompting lenders to demand higher returns. However, no significant difference in financial stability is found between hedgers and non-hedgers, implying derivatives may not enhance stability. Firms should consider alternative strategies to stabilise earnings. Overall, the results highlight a trade-off: derivatives can serve as risk management instruments but also introduce additional risks, increasing financing costs., and requiring firms to balance risk management and cost of capital to achieve optimal financial performance and sustainability.

Table 4 presents the results of a dynamic panel regression model examining the link between derivatives use and capital costs, represented by a dummy variable indicating users (1) and non-users (0). The findings show a consistently negative, statistically significant relationship between derivatives use and all three capital costs (WACC, KE, and KD), suggesting firms using derivatives face lower financing costs. This supports the view that derivatives help hedge risks, lowering the returns demanded by lenders and investors. Reduced financing costs can enhance a firm’s competitiveness, financial performance, and growth potential by fostering investor confidence and attracting more capital.

Beyond the statistical results, these findings provide practical financial insights: investors may perceive derivative-using firms as more stable and less risky, enhancing market perception, boosting investor confidence, and attracting more investment, thus facilitating growth. Effective derivatives strategies can shield firms from market volatility, ensuring steadier cash flows crucial for long-term financial planning and sustainability. Firms must carefully align derivatives with their specific risk exposures and continuously monitor performance to ensure risk management aligns with strategic goals and risk tolerance.

The negative relationship between derivatives use and capital costs aligns with previous studies (Coutinho et al., 2012; Kim et al., 2017; Nguyen et al., 2018), supporting the argument that derivatives reduce costs and mitigate risks stemming from market imperfections. This is consistent with the risk management theories by Froot et al. (1993), Lessard and Lightstone (1990), and Shapiro and Titman (1986), which suggests that active risk management practices contribute to firm value by reducing cash flow volatility. More stable cash flows improve a firm’s creditworthiness, enabling access to cheaper financing. Overall, the findings underscore the potential benefits of derivatives in managing financial risks, lowering financing costs and promoting stability -key factors for boosting investor confidence essential for sustained performance and competitiveness.

The results indicate a negative relationship between the WACC and firm leverage, suggesting increased debt lowers financing costs — aligning with the trade-off theory, which argues firms benefit from cheaper debt and tax shields, lowering WACC. This implies South African non-financial firms may be below their optimal debt level, as evidenced by decreasing WACC with increased debt, indicating the potential to exploit tax shields, consistent with Vengesai and Muzindutsi (2020). On the other hand, the cost of equity was found to correlate positively with leverage, implying that shareholders demand higher returns to offset increased financial risk, aligning with the agency cost theory, indicating that investors value highly leveraged firms less. Similar results were found by Thien and Hung (2023), who concluded that firms with higher leverage are perceived as riskier due to more debt financing. Modigliani and Miller’s irrelevance proposition further explains that equity costs rise linearly with leverage to counterbalance cheaper debt benefits.

Additionally, we found a negative relationship between asset tangibility and the cost of capital, indicating that firms with more tangible assets (which serve as collateral) enjoy lower financing costs. This corresponds with Thien and Hung’s (2023) conclusion that intangible investments tend to raise finance costs due to their higher risk and information asymmetry. Firm size also negatively correlates with capital costs, reflecting the cost advantages larger firms gain from market power and economies of scale.

Ayturk et al. (2016) argue that using a dummy variable fails to capture the extent of hedging fully. To address this, the study incorporated a continuous measure — the ratio of derivatives notional value to total assets — providing a more nuanced analysis. The dynamic panel GMM regression results presented in Table 5 reveal a positive and statistically significant relationship between the extent of hedging and all three measures of capital cost. Notably, firms with more extensive derivatives usage experience higher financing costs. This increase can be attributed to the inherent riskiness associated with derivatives. This finding suggests that while derivatives are designed to manage risk, extensive use may signal increased risk exposure to investors and lenders. The higher capital costs likely reflect a risk premium, as market participants demand greater returns to compensate for the potential complexities and uncertainties tied to derivative strategies. This aligns with Coutinho et al. (2012), who observed a similar pattern in Brazilian listed firms using FX derivatives, indicating that derivatives can inadvertently elevate perceived risk, driving up financing costs.

The results point to a clear trade-off between risk mitigation and financing costs as investors may perceive the risk management benefits of derivatives to be outweighed by the additional risks they introduce. Extensive hedging may create an impression of aggressive risk-taking or over-reliance on complex financial instruments, prompting caution from investors. Firms should tailor their derivatives usage to align with their risk management needs, adopting optimal hedging strategies to balance risk reduction while minimising potential increases in the cost of capital. Diversifying risk management approaches — integrating derivatives with other risk management practices, to establish a comprehensive risk management framework can help mitigate the impact of additional risks introduced by derivatives instruments-controlling costs while still protecting against financial volatility. Additionally, firms should adopt a long-term perspective on derivatives strategies. Short-term fluctuations in financing costs may arise from market volatility or changing investor sentiment, but a steady, well-structured risk management framework can strengthen financial resilience over time. By prioritising sustainable, strategic hedging approaches rather than reactive, aggressive derivatives usage, firms can balance risk reduction with cost efficiency, enhancing their overall stability and investor confidence.

The study delved into the impact of derivatives usage on firm stability, as outlined in Table 6. Initially, the analysis focused on a derivatives usage dummy variable (model 8), revealing a positive and statistically significant relationship, indicating that overall derivatives usage contributes to financial stability. A contrasting result emerges upon further investigation using the hedging extent variable (model 7), which measures the degree of hedging. Firms extensively using derivatives exhibit greater financial instability, evidenced by a negative relationship between stability and the hedging extent variable. This outcome is attributed to derivatives’ high-leverage nature, which magnifies profits and losses, thereby increasing firm variability.

These findings carry substantial implications for corporate decision-making and financial markets. They underscore the critical importance of robust risk management practices and a comprehensive understanding of derivatives’ true impact on a firm’s risk profile. Since derivatives instruments can intensify leverage and earnings variability, firms must carefully evaluate their financing strategies to manage potential earnings fluctuations and maintain financial stability effectively. Furthermore, the study highlights potential broader implications for financial markets, suggesting that widespread derivatives usage may contribute to market volatility and systematic risk, particularly during market shocks. Consequently, policymakers should consider implementing measures such as trading limits to manage systematic risks associated with derivatives usage effectively.

The GMM estimators are consistent if residuals show no second-order serial correlation. The Arellano-Bond AR(2) test confirmed no serial correlation across all eight models (p > 0.05). The Hansen test (p > 0.05) verified proper instrument identification and model specification. Additionally, the number of instruments was less than the number of groups, and the lagged dependent variable coefficients were statistically less than one, ensuring dynamic stability and correct model specification, attesting to correct GMM and dynamic model specification.

The study employed a dynamic panel model with system GMM to examine the effects of derivatives use and hedging extent on firms’ cost of capital. It was discovered that, while hedging typically lowers the cost of capital, this relationship shifts when a more nuanced measure capturing the extent of hedging is considered. Extensive use of derivatives increases capital costs due to their risky nature and dual role in risk management and speculation. Risk management should result in a low cost of capital, and speculation should increase it. The results imply that the risk management function is outweighed by the risk induced by speculation, leading investors to demand higher returns and, hence, a high cost of capital. The study highlights the need for a balanced approach to derivatives. While useful for managing specific risks, they can increase financing costs and perceived riskiness. The benefits (risk management) and drawbacks (potential impact on the cost of capital) of derivatives usage should be carefully weighed to optimise financial performance and mitigate potential risks. The results suggest that investors are cautious about firms’ extensive use of derivatives, which may be perceived as risky.

Firms should diversify risk management strategies and adopt a long-term perspective to help reduce the impact of risks introduced by derivatives and enhance financial resilience. Extensive derivatives use was linked to higher leverage and firm instability, affecting capital structure decisions. High financial instability might have broader implications for the overall financial markets’ stability. This may increase market volatility and systematic risk, most likely during market shocks. Policymakers should address this by regulating derivatives use to curb speculation. The study’s limitation lies in its assumption of uniform derivatives use. Future research should disaggregate derivative types to better understand their varied impacts on firm financing.