Corporate Hedging and Financial Contracting
Michael F. Ferguson
University of Cincinnati - Department of Finance - Real Estate
James A. Overdahl
affiliation not provided to SSRN
Erasmus University - Rotterdam School of Management
April 1, 2012
This paper develops a theory of corporate hedging in a financial contracting framework. In an economy with moral hazard and state uncertainty, the optimal financial contract incorporates both non-monitoring (arm’s length) finance and monitoring (bank) finance, and its payoff is equity-like. When external investors (e.g., the bank) face additional costs of holding equity, hedging mitigates incentive problems related to debt contracts and, thus, lowers the cost of debt and enables the firm to substitute debt for equity in its capital structure. The model generates empirical implications that are consistent with extant empirical evidence. For example, hedging will be more likely to be used with bank finance than with non-monitoring finance; the optimal hedge ratio will be positively related to the level of bank finance; and the optimal hedge ratio should be strictly less than 1.
Number of Pages in PDF File: 58
Keywords: Corporate Hedging, Capital Structure, Financial Contracting, Moral Hazard
JEL Classification: G21, G32, D82working papers series
Date posted: May 18, 2011 ; Last revised: April 6, 2012
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