Corporate Hedging, Investment, and Higher Moments of Stock Returns

Abstract

Developing a dynamic production-based model with real options, we examine the implications of firm-level production, investment and financial policies on the higher moments of their stock return distributions. We introduce novel channels showing that cash-flow hedging and capital investment by firms affects their future stock return distribution. Hedging by firms reduces variance, excess negative skewness and kurtosis, moving the return distribution closer to normal, while capital investment counteracts these effects. Using hand-collected hedging data from energy-related firms, we find empirical results consistent with the theoretical predictions. The pull-to-normality effect of hedging is stronger among firms with small size, high leverage, high rollover-risk, low profitability and low market-to-book ratios. In contrast, capital investment increases higher moments, but this is ameliorated by hedging. Our analysis links firm-level real and financial polices to higher moments of stock return distributions highlighted in the literature.

Keywords: Hedging; Investment, Option Prices, Risk Management, Skewness

JEL Classification: G13, G30, G32