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Why hedge? Rationales for corporate hedging and value implications

Research output: Working paper

Published
Publication date2007
Place of PublicationLancaster University
PublisherThe Department of Accounting and Finance
Original languageEnglish

Publication series

NameAccounting and Finance Working Paper Series

Abstract

In the presence of capital market imperfections, risk management at the enterprise level is apt to increase the firm’s value to shareholders by reducing costs associated with agency conflicts, ex-ternal financing, financial distress, and taxes. This paper provides an accessible and comprehensive account of these rationales for corporate risk management and gives a short overview of the empirical support found in the literature. More specifically, corporate hedging can alleviate un-derinvestment and asset substitution problems by reducing the volatility of cash flows, and it can accommodate the risk aversion of undiversified managers and increase the effectiveness of managerial incentive structures through eliminating unsystematic risk. Lower volatility of cash flows also leads to lower bankruptcy costs. Moreover, corporate hedging can also align the availability of internal resources with the need for investment funds, helping firms to avoid costly external financing. Finally, corporate risk management can reduce the corporate tax burden in the presence of convex tax schedules. While there is empirical support for these rationales of hedging at the firm level, the evidence is only modestly supportive, suggesting alternative explanations.