The Minimum Variance Hedge and the Bankruptcy Risk of the Firm
WGZ Bank AG
University of Regensburg - Faculty of Business, Economics & Information Systems
Review of Financial Economics, Vol. 12, No. 3, pp. 315-326, 2003
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
Date posted: October 3, 2006
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