Posted: 3 Oct 2006
In this paper, we analyze the influence of hedging with forward contracts on the firm's probability of bankruptcy. The minimization of this probability can serve as a substitute for the maximization of shareholders' wealth. It is shown that the popular minimum-variance-hedge is generally neither necessary nor sufficient for the minimization of the firm´s probability of bankruptcy. Moreover, our model suggests a correction of the widespread view that a reduction in the variance of the future value of the firm is inevitably accompanied by a reduction in its default risk. We derive an analytical solution for the variance-minimizing hedge ratio of a firm exposed to both input and output price uncertainty that takes into account the issue of correlation. Based on this solution we provide a graphical analysis to prove our claim that there is a fundamental difference between hedging policies focused on bankruptcy risk and those following conventional wisdom even if positive correlation constitutes a "natural" hedge.
Keywords: corporate hedging, risk management, default risk, bankruptcy, forward contracts
JEL Classification: D81, G33
Suggested Citation: Suggested Citation
Hahnenstein, Lutz and Röder, Klaus, The Minimum Variance Hedge and the Bankruptcy Risk of the Firm. Review of Financial Economics, Vol. 12, No. 3, pp. 315-326, 2003. Available at SSRN: https://ssrn.com/abstract=934578