Corporate Hedging and Financial Contracting

58 Pages Posted: 18 May 2011 Last revised: 6 Apr 2012

See all articles by Michael F. Ferguson

Michael F. Ferguson

University of Cincinnati - Department of Finance - Real Estate

James A. Overdahl

affiliation not provided to SSRN

Buhui Qiu

The University of Sydney - Discipline of Finance; Financial Research Network (FIRN)

Date Written: April 1, 2012

Abstract

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.

Keywords: Corporate Hedging, Capital Structure, Financial Contracting, Moral Hazard

JEL Classification: G21, G32, D82

Suggested Citation

Ferguson, Michael F. and Overdahl, James A. and Qiu, Buhui, Corporate Hedging and Financial Contracting (April 1, 2012). Available at SSRN: https://ssrn.com/abstract=1844699 or http://dx.doi.org/10.2139/ssrn.1844699

Michael F. Ferguson

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business Administration
Cincinnati, OH 45221
United States
513-556-7080 (Phone)

James A. Overdahl

affiliation not provided to SSRN ( email )

Buhui Qiu (Contact Author)

The University of Sydney - Discipline of Finance ( email )

Room 513, The Codrington Building
The University of Sydney
Sydney, NSW 2006
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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