The Joint Hedging and Leverage Decision

Abstract

This study’s modeling analysis indicates that optimal hedging and optimal leverage decisions are patently different if undertaken jointly than when undertaken in isolation. The most striking result is that the optimal joint hedging and leverage strategy entails reduced hedging for a weak price outcome for production output. This risk-seeking behavior does not have a classic asset substitution impetus because, by set-up, the debt-holders are fairly compensated for the increased risk. Given a weak output price outcome, it is the presence of unhedgeable risk that makes the operational benefit of a subsequent output price rise vulnerable to the financial risk posed by leverage and the fact that the hedge portfolio would lose value; that is, an output price rebound actually entails adversely high risk of bankruptcy and consequential foregone profitable production. To counter this, some reduction of the overall hedge position increases the likelihood of avoiding bankruptcy in the event of an output price rebound.

Keywords: Hedging, Leverage, Financial Risk, Capital Structure

JEL Classification: G32, G33, G12