Who Hedges More When Leverage is Endogenous? A Testable Theory of Corporate Risk Management Under General Distributional Conditions
WGZ Bank AG
University of Regensburg - Faculty of Business, Economics & Information Systems
September 11, 2006
Review of Quantitative Finance and Accounting, Vol. 28, pp. 353-392, 2007
This paper develops a theory of a firm's hedging decision with endogenous leverage. In contrast to previous models in the literature, our framework is based on less restrictive distributional assumptions and allows a closed-form analytical solution to the joint optimization problem. Using anecdotal evidence of greater benefits of risk management for firms selling "credence goods" or products that involve long-term relationships, we prove that those optimally leveraged firms, which face more convex indirect bankruptcy cost functions, will choose higher hedge ratios. Moreover, we suggest a new approach to test this relationship empirically.
Keywords: corporate hedging, risk management, leverage, capital structure, bankruptcy, financial distress
JEL Classification: G32, G39
Date posted: October 5, 2006 ; Last revised: July 19, 2011
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