A Signaling Theory of Derivatives-Based Hedging
49 Pages Posted: 1 Feb 2016 Last revised: 20 Nov 2017
Date Written: November 17, 2017
We model a commodity producing ﬁrm that has private information about future volume and requires outside ﬁnancing to fund a growth opportunity. Due to costly ﬁnancial distress, a ﬁrm’s ﬁrst-best strategy is to sell forward its future production, avoiding any price risk. Low-volume ﬁrms, however, have an incentive to mimic, which in equilibrium distorts the hedging strategy of high-volume ﬁrms. Under certain conditions, high-volume ﬁrms signal their type by hedging more than they would under their ﬁrst-best strategy. In general, high-volume ﬁrms signal by taking on excess risk through derivative positions. When allowing ﬁrms to use multiple types of derivatives, we show that high-volume ﬁrms use both options and forwards, while low-volume ﬁrms only use forwards. The model suggests that heterogeneous and prima facie non-optimal hedging policies may be due to signaling and not speculation or risk shifting.
Keywords: hedging, risk management, derivatives, signaling
JEL Classification: G32, D82
Suggested Citation: Suggested Citation