Hedging and Competition

Posted: 1 Apr 2009

See all articles by Christine A. Parlour

Christine A. Parlour

University of California, Berkeley - Finance Group

Tingjun Liu

The University of Hong Kong

Date Written: December 3, 2008

Abstract

We consider firms that, all else equal, wish to minimize variability in their internal capital (due to convex costs of raising external funds). The firms can hedge the cash flow risk of the project, but not that of winning or losing the auction. We characterize optimal hedging and bidding strategies in this competition framework. We show that access to financial markets makes firms bid more aggressively, possibly even above their valuation for the project. In addition, hedging increases the variance of bids and makes firm values more dispersed. Further, with hedging, the covariance of internal capital changes with the risk factor is negative, and is more negative, the higher the correlation of the hedging instrument with the risk factor.

JEL Classification: G32; D44

Suggested Citation

Parlour, Christine A. and Liu, Tingjun, Hedging and Competition (December 3, 2008). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=1371293

Christine A. Parlour

University of California, Berkeley - Finance Group ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
510-643-9391 (Phone)

Tingjun Liu (Contact Author)

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

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