Abstract

http://ssrn.com/abstract=934578
 
 

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The Minimum Variance Hedge and the Bankruptcy Risk of the Firm


Lutz Hahnenstein


WGZ Bank AG

Klaus Röder


University of Regensburg - Faculty of Business, Economics & Information Systems


Review of Financial Economics, Vol. 12, No. 3, pp. 315-326, 2003

Abstract:     
In this paper, we analyze the influence of hedging with forward contracts on the firm's probability of bankruptcy. The minimization of this probability can serve as a substitute for the maximization of shareholders' wealth. It is shown that the popular minimum-variance-hedge is generally neither necessary nor sufficient for the minimization of the firm´s probability of bankruptcy. Moreover, our model suggests a correction of the widespread view that a reduction in the variance of the future value of the firm is inevitably accompanied by a reduction in its default risk. We derive an analytical solution for the variance-minimizing hedge ratio of a firm exposed to both input and output price uncertainty that takes into account the issue of correlation. Based on this solution we provide a graphical analysis to prove our claim that there is a fundamental difference between hedging policies focused on bankruptcy risk and those following conventional wisdom even if positive correlation constitutes a "natural" hedge.

Keywords: corporate hedging, risk management, default risk, bankruptcy, forward contracts

JEL Classification: D81, G33

Accepted Paper Series


Not Available For Download

Date posted: October 3, 2006  

Suggested Citation

Hahnenstein, Lutz and Röder, Klaus, The Minimum Variance Hedge and the Bankruptcy Risk of the Firm. Review of Financial Economics, Vol. 12, No. 3, pp. 315-326, 2003. Available at SSRN: http://ssrn.com/abstract=934578

Contact Information

Lutz Hahnenstein (Contact Author)
WGZ Bank AG ( email )
Düsseldorf
Germany
49-211-778-2346 (Phone)
Klaus Röder
University of Regensburg - Faculty of Business, Economics & Information Systems ( email )
Universitstrasse 31
Regensberg D-93053
Germany
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